Startups are vibrant, energetic, and disruptive. Managing a portfolio of early-stage companies can sometimes seem chaotic. However, it’s worth actively monitoring your portfolio and seeking to add additional value to the companies after you have made an investment. Before making an investment, it’s important to understand the risks and maintenance that are involved when creating a collection of startup investments.
Having a space to organize your portfolio allows you to see things more clearly. Through SeedInvest, you can monitor the changing value of your investments, make decisions on whether to participate in follow-on investments, and engage directly with the founders and offer assistance to them.
Timing of Return
Startup investments typically require at least five to seven years to show a return. Most startups usually take a minimum of at least five years to achieve any liquidity event. You should only invest capital that you are able to have remain invested for at least five years.
Possible Outcomes of Your Startup Investment
The range of possible scenarios for your investment returns in a startup include:
- Total loss of capital invested
- Recovery of some principal but with some losses
- Return of capital
- Return of capital with a small profit
- Significant investment return above the capital invested
The above scenarios can occur as a result of a range of factors such as the performance of the startup, the terms of your investment, the terms of any subsequent financing rounds, and the terms of any liquidity event.
Companies will oftentimes raise multiple rounds to fund their growth. If you are an early investor, then your percentage ownership of the company may be diminished (e.g., diluted) when new investors are granted newly issued shares in the company.
In the situation where you have pro-rata rights or pre-emption rights, you are granted the right to purchase additional stock in the company through the current fundraising round to maintain your percentage ownership. Where you do not have anti-dilution protection or you do not exercise your pro-rata rights, you are not granted this right and your percentage ownership in the company may be diluted in future rounds.
Net Positive Dilution
Dilution of your ownership percentage may in fact be a good thing for your investment in certain cases where new investors are investing at a higher price per share than your original investment and the additional capital is being used to grow the business. When net positive dilution occurs, you end up owning a smaller slice of a larger pie.
Consider the example where you invest $200K into a startup at a $1M pre-money valuation. If there are 100,000 shares outstanding and the share price is $10, your investment will buy you 20,000 new shares, which is 17% of the 120,000 shares outstanding after your new shares are issued. In the next round of financing a new investor invests $500K at a pre-money valuation of $2.4M. They receive 25,000 new shares at a price per share of $20, which brings the total number of shares outstanding to 145,000. You still own 10,000 shares so your percentage ownership is “diluted” from 17% to 14% but the price per share and valuation of the company has increased, so your investment is now worth $400K. Of course, the value of your shares are not realized until you sell or liquidate them in the future so the $400K is is only a “paper return”. The new investment is “net positive dilution” because you own a smaller percentage of a larger pie.
As a general rule, if the valuation of the next round is higher than the round that you invested in, then having your percentage ownership “diluted” is not a bad thing. Dilution is sometimes thought of as a bad thing by investors who are new to the asset class because it can also describe the situation where the company issues new shares for no consideration to some classes of shareholder and not others, or issues shares for a lower price per share than the prior investments.
Most startups raise multiple rounds of investment. You may be given the opportunity to invest in these follow-on rounds of investment, most often dependent on the terms of the offering. You may have a legal right to invest in follow-on rounds through “pro-rata” rights to maintain your percentage ownership, or a first right of refusal on a certain amount of stock in future rounds. In some cases, you may also have early access to future rounds as a result of your established relationship with the company.
Follow On Investment Strategy
Part of the value of an early-stage investment may include the right to invest into future rounds in the same company. It’s worth considering in advance whether you plan to take advantage of any rights to invest in future investment rounds. This investment strategy is colloquially referred to as keeping “dry powder” to make follow on investments.
Startups that you have invested in should provide regular business updates (some of these updates may be a legal requirement of the offering). A good investment update will include information about the progress of the company, information about developments in the industry, any business challenges, and ways you (the investor) can help. The updates may also include requests for advice, assistance or strategic introductions. You can add strategic value to the startup investments in your portfolio by responding to business updates and requests for assistance.
Loss of Capital
The majority of startup investments result in a total or near total loss of the principal invested in the startup. You should monitor the companies that you are invested into and ensure that your take a portfolio approach to investing in the asset class.
These losses may be tax deductible depending on your personal situation. Consult your personal tax advisor to learn more.
A liquidity event is the name given to an event or transaction that results in the liquidation of some or all of your shares into cash. Those startups that are successful usually provide a return to their investors through a liquidity event such as a acquisition or an initial public offering rather than through dividend payments.
Your investment may include the right to be notified of any acquisition offers to purchase the company. The returns that investors receive in an acquisition depend in part on the price per share paid by the acquirer and in part on any liquidation preferences which are usually set out in the company’s charter or articles of organization and/or the shareholders agreement.
When a company is wholly acquired your shares may be compulsorily acquired along with the rest of the shares in your share class. This is called being “dragged along”. Alternatively, an acquirer may wish to only purchase some of the shares in a share class. Your investment may include the right to have the acquirer also purchase your shares. This is called “tagging along”. Drag along and tag along rights are a small but important part of the protections to consider when assessing a company for investment.
Initial Public Offering
If the company is listed on a public exchange, your shares may become freely tradable and you will be able to sell them in the same manner as any other public stock.
In certain limited circumstances you may be able to sell your shares to a third-party. These types of sales may be limited by the terms of your investment, transfer restrictions under securities laws, and/or a lack of willing purchasers. In the future, secondary markets may emerge that facilitate these transactions but your investment decision should assume that you won’t be able to sell your shares until an acquisition or IPO occurs.
In future rounds of investment it is possible that a new investor may offer to purchase your shares as part of a capital restructuring. Depending on the nature of the offer and the legal terms of your investment, this offer may be voluntary or compulsory. It’s also possible that the company itself may offer to redeem your shares through a share-buyback.
This post was written by seedinvestedu on July 16, 2016
Managing a portfolio of startup investments