Overview

Investing in early stage securities is obviously high risk, however it can be both financially rewarding and personally satisfying knowing you've helped someone build a business, employ people and generally enhance the economy. Early stage and small businesses are the source of the greatest growth in employment and innovation in Australia.

The leading research in early stage investment by the Kauffman Foundation suggests that overall, greater returns are generated by investing in a greater number of companies, rather than investing in a small number of companies. Therefore, taking a diversified approach can enhance the returns by investing a smaller amount of money in a wider selection of companies. Many people think about trying to pick winners, however it would seem that it is more important to avoid "losers".

Like any investment, you need to do your research and undertake due diligence. But remember that doing due diligence doesn't remove all the risks associated with an investment, and the amount of money you invest should provide some guidance as to the level of investigation you do. If you are going to invest $100,000 in an opportunity, you are probably going to want to do a lot of due diligence, however, if you are investing $1,000 to $5,000 in an opportunity you are probably going to do a lot less due diligence. You should still do due diligence on the opportunity, but keep it relative.

What should you be looking for when making a smaller investment in an early stage opportunity?

There are probably 3 key questions you need to ask (and be able to answer) in order to invest:

• - Do you understand how the business makes money?
• - Does management have the necessary skills to manage the business and do they appear to be trustworthy?
• - Is there growth potential for the business and are the funds being raised being used to grow the business?

You should also take into account who else may also be investing. Where possible, make sure you take advantage of due diligence work that others may have done.

Let's have a look at each of these three questions in turn.

Do you understand how the business makes money?

If you understand the products or services being sold by the business, or know people who may buy those types of services or products, then it is likely that a greater number of people will also buy those services or products (and you can actually refer the business to others – because if you invest in the business it is in your interest to help make the business successful).

The business doesn't have to currently be profitable, but you need to be convinced that the business can sell more of its products or services as it grows.

Does management have the necessary skills to manage the business and do they appear to be trustworthy?

You want to see that the entrepreneur or the management team of the business has the necessary skills to manage and promote the business. Often having more than one person on the management team enables a balance of skills as it is unusual for a single person to have all the skills necessary to successfully build a business.

That doesn't mean that a single founder business won't work, so for a business with a single founder, you want to see that they are building other skills around them with good team members and/or good advisory board members. If a founder or the founding team has managed to convince advisory board members to help them and to 'lend' their name to the business it is a sign that others have some faith in the founders.

Does the founder or management team appear trustworthy? Look to see who they have surrounded themselves with. Are they aligned with a VentureCrowd partner? Have other people also agreed to invest in the business and met and worked with the founders? Can you find background information about the founders on the internet?

You should feel comfortable to ask the founders questions and consider their responses. Look at the questions other potential investors are asking and how the entrepreneur responds to those interactions.

Is there growth potential for the business and are the funds being raised being used to grow the business?

You are investing in the business with an expectation that it grows in value. The easiest way for the business to grow in value is to grow its sales and profits. It is easier to grow sales when a business is part of a large and growing market, rather than a small, niche market.

Ideally you want the company to be operating in a very large market size. This could be within Australia or globally. Clearly it is easier for a business in Australia to target Australian customers in the first instance, but you should also take into account the global market potential for the product or service offering.

The funds being raised by the business should be being used for growth. Ideally using the funds for marketing and growth working capital means the business is specifically looking to grow with your investment funds.

The company may also be using the funds to further develop their technology, which can also be very important if the company wants to continue to remain competitive and to encourage growth.

Overview

The term 'early-stage securities' generally refers to shares, or securities that are convertible into shares, in companies that are at an early stage of their development.

This usually means the company has developed a new product or business idea, but has little (or no) revenue.

Early stage securities are a high-risk high-return growth asset. The benefit of investing in companies at this early stage is that the price of the shares will be low (relative to more mature companies), allowing early investors to benefit from high levels of growth if the company is successful.

Of course, investing at an early stage is also where the greatest risk resides. For example, the technology may need further development, the management team need to be capable of executing the business plan and the market may not be ready for the new product or service being developed.

To understand the opportunity represented by investing in early stage securities it is important to understand:

• - the stages of growth of a typical early stage business
• - why companies seek equity finance
• - how companies use the funding to accelerate growth
• - how you realise a return on your investment

These topics are covered in the following sections.

Stages of growth of a typical early stage business

Companies go through a series of development stages, which correspond to the types of capital they seek.

Seed Stage – from idea to prototype

At the seed stage, a company typically has an idea, a business plan, and possibly some initial product development or prototype.

At this stage, the main source of funding is often the founders' personal savings, credit cards, and investment by family, friends, angel investors specialising in early-stage investing, accelerators and some venture capital firms. Many of these types of investors are VentureCrowd Partners.

The seed stage funding usually enables the company to develop its product or service to the point where it can launch the business and start acquiring customers.

The funds invested during this stage are typically up to $200,000.

Early Stage – business development and customer acquisition

At the early stage, a company has typically launched its business and will begin marketing and acquiring customers. It may also continue developing and making improvements to its product or service.

At this stage, the main source of funding is often venture capital firms or 'angel' investors specialising in early-stage investing. Both kinds of investor often also bring experience, mentoring and industry contacts that can help the company rapidly grow its business.

This stage of funding primarily covers the company beginning its marketing campaign and starting to sell its product or service to its first customers. The funding is often used for further product development, initial production (which may involve manufacturing), employment of key staff and initial marketing and branding.

The investments at this stage are typically $500,000 to $2 million in size.

Expansion Stage – growth, growth, growth

At the expansion stage, the company has typically:

• - confirmed that there is a market for its product or service,
• - confirmed its business model works,
• - secured a solid base of customers,
• - succeeded to the point of being cash-flow positive (and often profitable), and
• - neutralised the major risks that faced the business in the earlier stages.

This stage of funding is committed to help support and accelerate the company's growth. At this stage the company will have made some mistakes, received feedback from the market, adjusted its plans and worked out what it needs to do – and what it needs to spend – to solve any problems that may have been encountered, and (more importantly) to pursue the opportunities that it has discovered.

Normally this is the stage that is most attractive to traditional venture capital firms.

The investments at this stage are typically $5 million – $20 million in size and the valuations of companies at this stage are much higher than they were in the earlier stages.

VentureCrowd allows you to own an interest in emerging companies before they reach this stage, giving you the benefit of the growth in the value if they are successful.

Late Stage – preparing for an exit

At the late stage, the company will be profitable and expanding, and increasingly ready for an 'exit', either through a trade sale (the sale of the company to another company) or an initial public offering (IPO) on the stock market.

An exit is also referred to a 'liquidity event', because it is usually the first chance investors get to recover their investment and any capital gain they have made.

Why do companies seek equity finance?

Companies can be capitalised through:

• - debt (borrowing money), or
• - equity (issuing shares of the company).

Equity is usually a more attractive source of funding for early stage companies for a number of reasons, including:

• - debt needs to be serviced, which requires cash flow which is likely to be lacking at the seed or early stages.
• - unlike a bank, early stage shareholders do not expect regular payments. They are speculating that the value of their shares will grow over time as the company develops through the stages of growth detailed above.
• - banks are often unwilling to lend on the promise of an early stage company's intellectual property and a business case, whereas equity investors will.
• - bank debt is almost always secured on residential property, which the company founder may not have.

Equity funding is the life-blood of early-stage companies. In return for providing equity funding, and taking the risk associated with investing early, early-stage investors are able to acquire their interest at a low valuation (relative to mature companies). This allows the investor to capitalise on the high growth potential if the business is successful.

As the business develops through the growth stages, new investors are likely to provide further funding for equity. As a result, earlier investors may have their equity interest diluted (made smaller) by later investors but at higher valuations.

It may seem paradoxical that the founders give up large portions of the ownership of their company, and expose themselves to having their own stake being diluted with every new round of funding, but they do this because the funding helps the valuation of the company to rise. The portion they retain, even if it reduces, ideally ends up being worth much more than 100% of the company at the earlier valuations.

How do companies spend the money invested to accelerate growth?

Companies that take early-stage investment use it for a variety of purposes, such as product or brand development, renting larger premises, beginning production, developing their brand, hiring staff with specific required expertise and commencing marketing.

Generally the companies will use the funding in the manner, and to achieve the key milestones, detailed in their information overview or memorandum. It is important that you read the information provided and satisfy yourself about what the capital will be used for.

As the company progresses through the stages of its business plan, it will ideally be increasing sales, number of customers and market share, and building its competitive position.

How do investors realise a return?

Early-stage investors usually realise a return on an 'exit', either through a trade sale (the sale of the company to another company) or an initial public offering (IPO) on the stock market.

The returns from successful exits from early-stage investments can be very high, but the opportunity is also high risk.

Early stage investing is highly asymmetric and thus more risky than other stages of equity investing. To mitigate this risk early stage investors adopt a portfolio approach (ie, investing in many different early stage companies to spread the risk) expecting that about 90% of their returns will be generated by about 10% of the portfolio. Therefore the size and diversification of your early-stage investment portfolio are critical to capture the 10% of early stage companies that might generate 90% of the returns.