The UK and Europe have become a hotbed for innovation, with incredible companies being started and scaled up every day.
According to Business Insider, in the past year 11 European start-ups have achieved ‘unicorn’ valuations above $1 billion. However, there is a whole
tech ecosystem well beyond these successes, with thousands of fast- growing companies being started every year. Each new start- up success story is making the space a highly attractive investment class for family offices and HNWs to consider, given the environment of low interest rates and mediocre investment returns from other asset classes.
It is not just the investment opportunities that attract family offices to invest in this sector. In the UK, eligible companies can raise funds using government tax incentives such as SEIS and EIS (Seed/ Enterprise Investment Scheme) to attract invest- ment. Qualifying investors can receive an income tax rebate of up to 50 per cent and capital gains made on qualifying investments are potentially tax-free if the conditions are satisfied by the company and investor.
However, among the excitable articles are a growing number with a more sombre tone. In November, Fidelity Investments wrote down the value for a number of its high-profile investments, including Snapchat (down by 25 per cent), Zenefits (48 per cent) and NJoy (99 per cent). CBInsights’ running list of post-mortems for failed high-profile start-ups stands at 146.
But failure is to be expected. The increase in the number of failures is a direct result of the increase in the number of people trying. For these reasons it is imperative to establish and follow a disciplined, pro- fessional process for investment decisions with sup-port from industry experts and professional advisers.
Investing in start-ups could form part of a balanced investment strategy across a number of investment classes. Therefore, before even looking at the ‘start- up’ space you need to look to your current objectives, risk appetite and asset allocation and understand if it would be appropriate for you to consider investing. Many start-ups fail with all invested capital lost, so you should only invest what you are willing to lose.
Tax structuring can be utilised to mitigate risk, which could shift the emphasis from tax relief for the investment to potential tax relief for the risk of failure.
The next consideration is whether investing directly (as opposed to via a fund) is the right route. While funds will reduce your ability to influence the underlying investments and have fee implications, they do help to overcome some of the challenges of investing directly. If you decide to invest directly, it is essential to carry out due diligence. However, in early stage funding rounds there is often a lack of information — there may be no financial track record, no legal documentation, and no tax considerations. It is therefore key also to focus on other, more commercial aspects of the business such as the founders and management team, the uniqueness of the product or service, the market size and market potential, as well as funding and support they have received to date.
Fantastic founders can turn average ideas into successful businesses, but conversely a poor team can destroy even the best idea. Make sure you check their experience and understanding of the market and their ability to explain succinctly the business and what makes it unique and defensible.
Once you are happy with the team, it is important to understand the product or service. Things to consider are whether the product or service solves a real problem and whether there is a market for it. How developed is the offering, and is it /can it be protected? What are the barriers of entry for competitors?
Even with a great team and unique product or service, if the market size is too small then the overall return may be limited. What is the current market size, and is it expected to grow? Is the business scalable both in primary markets and different geographies and verticals? Who are you competing with?
Financial considerations should cover historical information as well as projections. Check that the historical numbers support the projections, the model is robust, the projections are realistic, and whether the company has advanced HMRC clearance for SEIS/EIS.
If you have gone through the process so far and still think the business is for you, it is time to consider the investment required, the valuation of the business and whether an investment on this basis would generate the required returns. There is no scientific or generally accepted method for valuing early stage businesses; lately valuations have been increasing, fuelled by the increased availability of capital in a low interest rate environment and tax incentives.
At the end of the day, valuations need to be justified. Only companies with real customers, real revenues and a sustainable business model will succeed. Use common sense without losing sight of how market valuations are actually changing. Often worst case scenario projections for a business can provide some grounding, but this in itself is subjective.
Investing in start-ups can be highly rewarding and profitable, but it is equally a risky and time-consuming process. It is thus best to start slowly and build investment experience over time. There are many ways to begin investing or to become more familiar with the investment landscape. Among the pathways are accelerator programmes and crowdfunding.
Accelerator programmes are typically short-term programmes designed to help start-ups develop products or services and find a product-market fit. Start-ups are usually given a set of mentors and attend workshops. There are two primary ways you can get involved. One is mentoring — start-ups need solid advice and guidance, and becoming a mentor may allow you to get to know a start-up and the team intimately before deciding whether to invest. The second is demo days, where it is customary for the cohort to pitch their business to an audience of investors. This is a great way to see several high-quality companies pitch at one time.
Equity crowdfunding can be a good way to build a diverse portfolio over a short time-frame and with lower individual investment amounts, though the quality of opportunities can be mixed. You can look at many pitch decks and see what works and what doesn’t, as well as seeing questions that other potential investors have asked. Crowdfunding platforms in the UK include Seedrs, InvestDen and Crowdcube.
Investing in start-ups is exciting, fulfilling and has great upside when it works, but it is also risky and most will fail. If you decide to invest, make sure you understand your own investment needs, risk appetite and experience beforehand. Even if you decide against investing, there are great ways to get involved in start- ups, such as mentoring in a field that you have expertise in, joining advisory boards, or simply using products and services that start-ups have to offer.
Patrick Imback is a Start-Up and High Growth Technology Specialist at KPMG in the UK and peter Aspinall is a Corporate Finance Specialist at KPMG in the UK.
The article was originally published in Spear's 'The Future for Family Offices' supplement.