INVESTOR EDUCATION

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

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.

Early stage funding may consist of two ‘rounds’ of funding, known as:

  • Series A, which capitalises the company while it hones its product or service for market, beds down its branding, hires its initial employees and conducts its initial marketing, and
  • Series B, which is the capital the company uses to operate the business, conduct a serious marketing campaign and work on customer acquisition.

The investments at this stage are typically $500,000 to $3 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.  

Late stage funding is often known as Series C or Series D funding, and the investments are much larger than the Series A and Series B funding: typically, $20 million-plus.

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, 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 companies, 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.

Proving the business model and getting the business to market requires cash, and the equity investors have it.

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 memorandum. It is important that you read the information memorandum 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. The business strategy may envisage expanding into other markets or geographical areas, developing innovative products, entering strategic alliances or acquiring a competitor to gain greater market share.

The management and succession plan should envisage lessening the key-person risk by building the capability of the management team, which should be properly incentivised to increase the value of the business.

The company should also devote significant time to understanding what drives its customers to use its products or services, and to making these better all the time. All of these factors work to increase the value of the business.

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.

In a small number of cases the exit may be achieved through a major re-financing or a management buy-out (MBO).          

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.For more information about the role of early stage securities in a balanced investment portfolio, click here.

Why should I include ‘early stage securities’ in my investment portfolio?
Due diligence – how to choose?
Making an investment via VentureCrowd.