Investing In Startups: Understanding How Exits Can Impact Your Investment Strategy - KingsCrowd

November 8, 2021

Investing In Startups: Understanding How Exits Can Impact Your Investment Strategy

There’s never been a better time to diversify your finances by entering the world of startup investing. As of September 30, 2021, startups have already raised $240 billion this year, even amidst economic volatility thanks to the pandemic. Startup investing is an exciting endeavor — though it can be highly risky with 90% of startups not making it to an initial public offering (IPO). Nonetheless, it can also be incredibly lucrative, particularly when an investor bets on the right business.

A great example of incredible returns from startup investing is  Google. In 1997, it raised $1 million in seed funding from a family and friends investment round, followed by $25 million in venture capital funding in 1999. Upon it IPO in 2004, Google’s original investors got an incredible return of almost 1,700%, underlining the power of good startup investments. While this is impressive, it is not the norm. However, general startup investing can still bring a respectable return, with a successful investment performing better than an index fund like the S&P 500.

So you’re probably wondering, how can I earn money through startup investing? While there are many answers to this question, one fundamentally trumps them all. Companies that are likely to end up with exit opportunities via an IPO or merger and acquisition will position you for success in the startup investment space. Secondary markets also provide a less conventional option for earning money on startup investments. Either way, it is important to understand what the different exit types look like and how they can influence your investment.

Initial Public Offerings

Likely the most well-known of the different exit types, an initial public offering occurs when a private company issues new stock to public investors in order to raise money, thereby making it a publicly traded company. While valuations can differ for companies going public, it is often at the $1 billion mark that it becomes a real consideration.

There are a number of different ways for companies to undergo an IPO, and all have implications for investors. Here are the different types and what they should mean to you.

  • Traditional IPO: As previously mentioned, the traditional IPO involves a stock issuance to public investors in order to raise money. There is a great deal of due diligence and process associated with this, starting with the hiring of a reputable bank to underwrite the deal. Companies work with legal teams to conduct due diligence, after which the official IPO documentation is filed. From there, the IPO is marketed for interest, a share price is set, and the company goes public. This lengthy process helps mitigate risk for investors, thanks to the work of the underwriters, legal teams, and federal authorities. However, there are still no guarantees as to how the stock will perform once the company is public. The two versions of an IPO include a fixed-price and book-building IPO. Fixed-price means that investors will know the share price before the company goes public, while book building offers a 20% price band for investors to bid within. Therefore, investors must pay full price for a fixed-price IPO, while the price for book-building deals is based on investor bids.
  • Direct Listing: This involves a private company going public without the traditional underwriter and lock-up period. As of 2020, direct listings can raise new capital for the company, meaning they can sell their stock immediately once public. However, this option carries inherent risk, as the lock-up period and underwriter help mitigate risk through what is essentially a qualified “vetting” process for the company.
  • SPAC: Better known as a “special purpose acquisition company,” a SPAC is a “blank check company” that forms as a shell company and goes public. Then, it purchases a private company, bringing it public via the acquisition. This option provides an opportunity to bypass the lengthy and costly IPO process while also avoiding disclosure (and thereby protecting proprietary information). However, SPACs can also be risky due to less clear due diligence and based upon the fact that investors in the shell company have the right to withdraw.
  • Reverse Merger: A reverse merger is similar to a SPAC, in that it occurs when a private company becomes public by overtaking a public company. While this is relatively rare, it does occur. Unlike a traditional IPO, this does not occur for the purpose of an initial capital raise, and so it is expected that there are sufficient funds to float both companies. This is also a risky proposition as there is a decent likelihood of failure and fraud, thanks to the lack of oversight and need for existing funds.

Each type of IPO carries inherent benefits and risks for the investor. Beginning with a good understanding of what each process entails and how it may impact your investment strategy is a great place to start figuring out your investment entry point.

Mergers and Acquisitions

While the IPO often feels like the reigning exit strategy, mergers and acquisitions (M&A) are another common tool for startups to conduct an exit. This occurs when companies merge to become a new, single entity, or one company acquires another to live under it. Unlike the SPAC or reverse merger, M&A does not have to involve going public, meaning that it does not require that the business meet all the same requirements of public companies. In fact, there is a growing trend of startups acquiring other startups to strengthen their business model.

Mergers and acquisitions often do not carry the same return for investors as IPOs do, but they are nonetheless a common tool for startups to find a home and bring in a return for their initial investors. In fact, this may actually be the preferable means for startup founders to actually exit, given that very few companies make it to IPO. It is often a great opportunity for the acquiring company and the target of acquisition, given that both need one another to a great degree. And while an IPO is an exciting exit, an M&A still offers a return to its investors, particularly as the more likely outcome for a startup.

Secondary Markets

While investing in startups directly is a means for high return potential, a less traditional option exists for secondary market trading as well. Startup investments in secondary markets involve buying or selling shares with other investors, rather than directly with the company itself. A relatively seamless and flexible means of investing, it also lacks the transparency and relative stability of primary markets. However, it does allow investors to get ahead of IPOs with popular and potentially lucrative stocks.

In fact, a number of platforms are beginning to offer this type of trading for investors. These platforms include Forge, an online marketplace for secondary deals that intends to go public this year, as well as EquityZen, StartEngine, and SeedInvest. While these markets offer investors the opportunity to access potentially lucrative shares, there are also fewer controls to protect investors. For example, insider trading is basically not a thing, because private markets are not subject to this rule. Likewise, the lack of transparency means that investors may be trading at an informational disadvantage. This adds obvious risk to this type of investment, though still offers a unique opportunity and access to potentially lucrative investment options.

Conclusion 

Startups are an exciting way to diversify your investments, but doing so can come at a cost if not approached properly. Being equipped with the relevant information about how companies exit is a great jumping-off point to start your investment journey. With the right knowledge and focused effort, you may find yourself at the helm of some incredibly lucrative investments.


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