If done correctly, investing in start-ups can see the average investor reap pretty significant returns on their initial investment. Facebook, Google, Apple, Afterpay, all of them were start-ups not that long ago that grew exponentially, offering early stage investors massive yields. But with high rewards, comes high risk and investors must be smart when denoting part of their portfolio to start-up opportunities.
According to Jun Bei Liu, portfolio manager with Tribeca Investment Partners, the first port of call for investors looking to step into these uncharted waters is to develop a complete understanding of what the business does and the market opportunity for its product or services.
“For early stage companies, there is a lot of risks involved. The main reason being that a start-up is likely trying to innovate or invent a niche space or niche market that is not in existence. So, it really requires a lot of work to understand whether the market will continue to exist once the company passes certain hurdles,” she said.
“At the early stages, market opportunity is very important. You should look for a competitive advantage, which will indicate how likely a company is to be sustained into the future.”
Ms Liu said it is important to focus on the fundamental rather than the price, as in the end you need to have an interest in the product and where it fits into the market in order to assess its potential success.
From there, it’s time to do your homework. Conduct due diligence through reaching out and asking questions of other investors and the company itself.
She said, “It is essential to ask the questions: does the management have the expertise in creating and delivering this product or services? Do they have the ability to achieve certain milestones in building this business? Do they have a good track record of winning partnerships or contracts? And, importantly, can they clearly communicate their strategy to the equity market?”
Ms Liu asserted the need for investors to take note of these communication skills, as it is likely that the start-up will require a significant amount of capital injection from the equity market during the trial or early stage build-up phase. As such, transparency at the beginning is vital to ensuring such support is generated and allows you, as the investor, to keep track of progress and assess whether their strategy changes into the future.
“Generally, the company’s website is a good area to start. It should have a discussion of what they do, their segment and what their vision is. If the company has just been listed on the stock market, its prospectus is also a good [way] to fully understand what the company is and its financial forecasts,” she said.
Ms Liu said having a good understanding of this vision and purpose is important when initially buying in, as you will be able to pick up on the flailing red flag should these channels of communication dry up or the company changes its story.
“When they first start they are quite transparent. They want to show you where they are at and their vision. But after some time, they can change how they disclose their progress or milestones and you know that perhaps they’re not doing as well as they hoped," she said.
Another area of due diligence she recommends you pursue is pre-investing, which involves seeing if you can find analyst coverage of the company. Although smaller companies are unlikely to have analyst coverage, start-ups with between $50 and $100 million in market capitalisation will be covered by a list of broker analysts.
“Analysts’ reports are good because they actually provide a snapshot of what the equity market is looking for. So, when the start-up does report a result or a milestone announcement, you can refer to those reports and see whether they have disappointed, missed the mark or overachieved in relation to the expectations," Ms Liu said.
Finally, she recommended reaching out and speaking one-on-one with the start-up, its customers and other investors to develop relationships and assess whether you have confidence in the skill and vision of the company’s management.
“Reaching out to the company is something that we as institutional investors always do. We go and engage with them, talk to them, see them many times a year, see their customers and talk to everyone possible within the sector to do due diligence. Being an individual investor is harder, but smaller companies are a lot more accommodative with allocating some of their time for future investors," Ms Liu said.
If it passes all of these tests, you are aware of the risks and you are prepared to continually perform due diligence, Ms Liu asserts start-ups can be an exciting space to develop wealth over time.
“We’re seeing again and again these really early stage companies generating a huge amount of return for investors. To balance the risk, I recommend allocating a small proportion to invest in start-ups that can give you 10 times the return, rather than putting everything into more defensive and stable companies that can give you between six and 10 per cent return. The return outlook is huge with start-ups, but you don’t want all of your eggs in one basket for something so high risk,” she concludes.
“It’s very exciting to invest in the early stages of a company. I think the key is just to be aware of the risks, do your homework and only allocate a small part of your wealth into that company.”
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