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What are early stage securities?

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 capable of executing the business plan and the market may not be ready to 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

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Why include early stage securities?

Traditional versus alternative investments

For retail investors, the options when deciding where to invest have typically been the traditional asset classes of cash, fixed-interest, equity (shares) and property.
These ‘traditional’ asset classes are either accessible directly, as in buying them straight-out in the investor’s own name, like shares; or indirectly through managed funds, which pool investors’ money and the investors own a number of units proportional to their invested amount.

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Due diligence - how to choose?

What to consider when selecting companies

Because ‘early-stage’ companies are, as the name suggests, at an early stage of their development, the potential investor is usually considering investing in a company that has a new product or business idea, but little or no revenue.
This means that there is probably little in the way of hard financial data to go on. But although it may be difficult, the more thorough is the ‘due diligence’ you conduct on companies, the more you increase your chances of return.

A Kauffman Foundation study on US angel-group returns showed that the returns for deals increased with the hours of due diligence invested.

The study found that the mean time spent on due diligence was about 20 hours. Returns for deals with less than 20 hours of diligence were around 1.1 times, on average. Deals with more than 20 hours due diligence had a 5.9 times return; and for more than 60 hours spent on due diligence the return was strikingly higher – at 7.1 times.

To a large extent, the due diligence process involves defining and quantifying the unknown, to delineate the risk of an investment. But there is likely to be no independent third-party risk assessment, as there is in most other asset classes, so most of the analysis is up to the investor.

If there is any hard financial data apart from the business plan – for example, financial statements – analyse the cash flow statement, the profit and loss statement and the balance sheet. You’re looking for the key revenue and cost drivers, but in these companies the founders themselves may not understand their cost drivers. Look for the margins, the percentage of revenue that is turned into profit.

Identify which costs are fixed, and which are variable. Look at the company’s cost of suppliers: can per-unit costs be lowered by buying in larger volumes? If there are functions outsourced – for example, marketing, advertising or book-keeping – check to see whether these can be taken back in-house and done online more efficiently.

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Making an investment

How is my investment held?

Investments may be held in a number of ways and differs from deal to deal. Each deal will clearly detail the way in which your assets are held. Common examples are;

  • Units within a Unit Trust
  • Direct Equity

Is it safe?

All investments carry risk and previous performance figures are not indicative of the future.

Investors receive real-time binding contracts of their equity in the businesses they are investing in.

The VentureCrowd platform is tested to internationally recognised standards for security of data.
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