Early-stage investing is a very different prospect from other investment approaches, such as investing in stocks and shares listed on a stock exchange. There are pros and cons, risks and opportunities, and every investor needs to understand their risk profile and how to introduce effective diversification into their portfolios.
In this guide, EMV Capital defines early-stage investing, the types of companies or enterprises this encapsulates, and the unique aspects of investing in businesses at the first stages of their lifecycle.
Early-Stage Investing Explained
As the name suggests, early-stage investing means investing in companies that have been newly formed – either as a start-up or a business with up to a few years of trading history. Many early-stage companies use private funding raises or venture capital schemes to attract the capital necessary to get an idea or innovation off the ground.
Because a young company isn’t yet established, it is inherently riskier since a new business is unlikely to generate an immediate profit or have a stable asset base.
The positive is that investors who support a company from the start have the potential to earn very high returns should the business be successful. However, dividend payments are rare since a young business will not have the liquidity to offer profit disbursements and will typically reinvest any initial profits into developing the company.
Rather, investors should view an early-stage investment as a medium to long-term exercise, with the greatest returns normally realised through capital appreciation.
What are the benefits for investors?
Investing in an early-stage business can be a promising venture, offering a range of distinct advantages. The allure lies in the unique potential for growth and innovation that early-stage companies would bring to the table.
Large earning potential
The potential returns on early-stage investments is high. This is because early-stage companies can move quickly to respond to market demands in ways that established companies cannot, learning to exponential growth should there be an established need for their product or service. This potential for growth is the main pull for high-net-worth investors looking to grow their capital significantly.
Investing in early-stage businesses is a very tax-efficient way to invest. In fact, in the UK, there are several government-backed schemes designed to incentivise investments in startups and early-stage companies by offering tax breaks to investors.
As we have discussed, the Enterprise Investment Scheme (EIS) encourages investment in small, early-stage trading companies that meet specific criteria. Through EIS, investors can claim income tax relief of up to 30% on the amount invested (read more about EIS tax relief here). This relief can reduce the upfront cost of investment but also mitigates risks by providing an additional incentive for investing.
Investing in innovation
Aside from the potential to earn a larger profit is the chance to back pioneering companies of the future. The Apples, Microsofts and Alphabets of the world were once early-stage businesses at the forefront of innovation. Being among the initial backers of such a business affords investors the privilege of contributing to its foundational growth, potentially playing a pivotal role in shaping its trajectory.
The ability to be agile
Early-stage businesses can quickly pivot, adapt, and innovate to seize opportunities. Unlike larger, more established enterprises, they’re not weighed down by bureaucratic red tape. This inherent agility of early-stage businesses serves as a distinct advantage
These enterprises possess the nimbleness to pivot swiftly in response to market dynamics, technological shifts, or unforeseen challenges. This adaptability can foster accelerated expansion and a competitive edge.
The different stages of companies explained
What exactly is an early-stage company? To understand what an early-stage company is, you’ll need to understand where the company sits in it’s development. Typically, companies go through 7 various stages of growth and development if they navigate the early stages well and achieve long-term success. A common framework includes:
Seed Stage: This is the initial phase of a company where the idea is born and the founders work on refining their concept. Market research is carried out and the initial product or service is developed in it’s most basic form. Once there is proof of concept, an early-stage company may seek seed funding.
Startup Stage: At this point, the officially launched may have been for 2-3 years. The focus here is product development, market validation, and building a customer base. Again, startups could seek seed early-stage funding or angel investment to fund their growth.
Growth Stage: If the company is successful in the first two phases, it can enter the growth stage which focuses on rapid expansion. As a result, revenues start to increase, and the customer base expands. It’s still common for a company to undergo more funding rounds (Series A, B, C funding) to support its growth initiatives.
Scale-up Stage: Now that the company’s operations are well-established, and it’s focused on scaling its business model. This might involve entering new markets, expanding the product or service offerings, and optimising processes for efficiency.
Maturity Stage: When a company is mature, tt has a strong market presence, a loyal customer base, and a consistent revenue stream. The focus shifts more towards maintaining market share, refining operations, and possibly considering diversification and innovation.
Exit, Decline or Renewal Stage: This stage involves assessing whether the company’s business model is still relevant and competitive. If the company fails to adapt to changes in the market, it might face a decline. Or, with strategic innovation and adaptation, the company might be able to renew itself and go through another growth cycle.
Types of Early-Stage Investment
We mentioned venture capital investment, one of the most-used methods for start-ups to raise financing. They can also raise capital through seed funding or angel investing.
- Venture capital investment is designed to help promising companies develop and grow, financing new product concepts or innovations or providing the financial backing to expand or disrupt an existing market. The Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) are government-backed venture capital schemes. Read more about investing in early stage UK companies with our EIS fund.
- Seed funding can be contributed by supporters, family or friends, angel investors or venture capital investors. Seed financing is a start-up fund which a business might use for research and development, product design, or promotional marketing activities.
- Angel investors are normally affluent individuals who choose specific early-stage companies to invest in, selecting business models they believe have strong growth potential.
Each method of financing has respective advantages and drawbacks for both the business and the investor. Still, all are valid ways of raising funding or engaging in an early-stage venture.
Risks of Early-Stage Investment
The company’s age is the primary risk factor. Regardless of the product, innovation, solution, or idea presented, investors should carefully analyse the management team behind the business and assess the skills and knowledge that reinforce the business plan.
Some early-stage businesses are built on a partnership basis and could be supported by scientists, developers, programmers, or experts in a specific technology or field, working on the technical aspects of the brand model in conjunction with marketing officers and a board of directors.
However, even an early-stage venture with a high degree of expertise behind it is subject to elevated risk since the market for the product or service may not have been tested or may not yet exist.
It may be possible for competing businesses to develop a comparable service or product and be able to bring it to market faster, with established supply chains, brand awareness, and market share.
Investors may also wish to consider the company’s success thus far in meeting its capital raise targets. If an early-stage company fails to raise the necessary amount to launch itself into the marketplace or complete a product design, it may have limited opportunities for success.
Potential Benefits of Investing in Early-Stage Businesses
While there is an intrinsic level of risk linked with early-stage investment, there is also the possibility of making returns far above market averages. Smaller companies can grow rapidly and have greater agility than larger organisations that take time to respond to changes in trends or consumer demand.
Early-stage companies that develop a ground-breaking idea can transform the market they enter into, making legacy solutions redundant and effectively acting as a disruptor – where the first investors who will have invested in shares or fund shares at a far lower valuation stand to benefit.
The general advice is to ensure you research early-stage investment options carefully and conduct due diligence of the team behind the business. Although there is no way to eliminate investment risk, diversification is considered best practice, investing in diverse shares, companies and sectors – if one fails, the others are unaffected.
Selecting an Early-Stage Investment
Investors normally work toward a predefined investment strategy. They may have specific preferences regarding the industries they engage with, the types of companies they are interested in, or the products and innovations they believe will provide the most notable returns.
Aside from your investment approach and priorities, it is also worth considering several aspects of any potential early-stage investment to look for red flags, or ensure you have sufficient knowledge of the business, or the investment fund, to judge the associated risk.
Below we work through some of the aspects of early-stage companies that can impact their viability and anticipated investment pay-out.
We talked about the management team, and this is an all-important factor. Start-ups and early-stage ventures with a capable, proven, and talented management team behind them have a greater chance of success. Teams with industry experience, excellent knowledge, and a clear vision to show how they will build and move the company forward are ideal.
Early-stage businesses can be an attractive prospect for investors since those with unique and novel ideas can present a new solution to a problem or solve an issue that nobody before them has been able to. A product or service that carries genuine value and will be something that commands significant attention within the consumer market is also something people will be willing to pay for.
Although an early-stage business may have yet to bring an idea to market, its plan should be outlined so you can determine whether the intended market is appropriately large and established yet with enough potential to grow to accommodate a new competitor.
Knowledge-intensive companies are those that rely heavily on intellectual property, technology, specialised skills, and expertise to drive their business. Investing in knowledge-intensive companies, especially in the early stages, can offer several potential advantages such as high growth potential, precipitation for innovation and excellent tax breaks.
Comprehensive Business Modelling
Every early-stage business hoping to attract investment should have a detailed business model with data-based statistics and analysis to evidence how it expects to return a profit and how it plans to introduce its product or service to the target market.
While early-stage investment remains high-risk, it can also be an attractive opportunity for investors to contribute capital to the brands of the future – although research and careful risk analysis are key.
Investing in early-stage funds: EMVC
EMV Capital focuses on nurturing emerging, deep-tech companies in their early stages. Our expertise lies in the life science, sustainability, and industrial sectors, both within the UK and on a global scale. If you’re interested in benefiting from an early stage investment, get in touch with us today.
In conclusion, early-stage investing offers a unique avenue for investors to support newly formed companies and startups during their crucial stages of development. This approach presents distinct opportunities and challenges that set it apart from traditional investment strategies in established markets.
Investing in early-stage ventures involves recognising the inherent risks associated with young businesses while also embracing the potential for substantial returns through capital appreciation.