Investing in startups can be an exciting and potentially lucrative venture, but it's important to have a realistic understanding of the risks and timeline involved. This article will cover the key characteristics of startups, what an exit means in startup investing, the differences between startups and normal stocks, the risks involved, the average timeline for a startup to reach an initial public offering (IPO) or exit and when investors can expect to see a return on their investment.
What Is a Startup?
Startups are new and innovative companies that are in the early stages of development. They are typically characterized by a high degree of risk and high growth potential. Startups are often founded by entrepreneurs with a vision for a new product or service that has the potential to disrupt existing markets or create entirely new ones.
In the context of investing, startups are illiquid, meaning once you invest, you’re not able to sell. This is much different from the larger stock market, where you can buy and sell instantly. This distinction is important to understand because once you invest in a startup, you will likely have to hold until the founders exit.
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What Is an Exit in Startup Investing?
An exit in startup investing refers to the process by which investors realize a return on their investment. This can happen through a variety of means, including an initial public offering, acquisition by another company or a merger. The goal of an exit is to provide a liquidity event for investors. Liquidity events allow investors to sell their shares and realize a profit.
The types of exits in startup investing include:
- Initial public offering: When a company lists on the stock market
- Acquisition: When a company buys a startup
- Merger: When two companies become one and buy out certain stockholders
- Stock buyback: When a company offers to purchase stock back from investors
- Tender offer: When an investor offers to buy stock from other investors
- Secondary trading: When a company lists on a secondary market allowing investors to buy and sell their shares before an IPO.
Investors can also see a return if a company decides to offer dividends.
What Happens When Your Startup Investment Sees an Exit?
When a startup investment sees an exit, investors have the ability to receive a return on their investment. An exit is any event that allows the investor to sell their shares and realize a profit.
In a merger and acquisition (M&A), a larger company acquires the startup, often to gain access to its technology, intellectual property or customer base. The startup's investors receive a payout based on the terms of the acquisition agreement. This payout can be in the form of cash, stock in the acquiring company or a combination of both.
In an IPO, the startup goes public by offering shares of stock on a stock exchange. This allows the startup's investors to sell their shares on the open market. The value of the shares are determined by the market, and investors may receive a significant return if the stock performs well.
A strategic sale is similar to an M&A, but the acquirer is typically a competitor or other company in the startup's industry. The startup's investors receive a payout based on the terms of the sale agreement.
Stock buybacks and tender offers are simple. These are typically hard offers to buy your shares. A tender offer is when another shareholder makes a broad offer to buy shares. This will have a fixed price and investors can choose to accept the deal. A buyback operates in the same way, but the company is buying the shares.
In any of these scenarios, the timing and size of the payout will depend on a variety of factors, including the terms of the investment agreement, the valuation of the company at the time of the exit and the overall market conditions. It's important for investors to be aware of these factors and to have realistic expectations for their investments. In some instances, investors may have the ability to hold their shares as a means of accumulating further value, while other times investors will have no choice but to exchange their shares for cash.
How Are Startups Different From Normal Stocks?
Startups are very different from normal stocks in a number of ways. One of the biggest differences is in terms of liquidity. While stocks on the public markets can be bought and sold at any time, startup investments are typically illiquid. Meaning once an investor buys shares in a startup, there's no selling until the company sees an exit.
Valuation is another key difference between startups and normal stocks. Startups are usually valued based on their potential for growth and market disruption not their current revenue or earnings. This can make it difficult for investors to determine the true value of their investments.
Access to information is also different for startups. Public companies have various required disclosures and regular earnings. Startups are not always required to regularly disclose financial information or other key metrics. This can make it difficult for investors to make informed decisions about their investments.
Risks Involved in Startup Investing
Investing in startups is not without risks. The majority of startups fail, meaning that investors may never see an exit. Even successful startups may take years to reach an IPO or exit. This requires investors to be patient and committed to the long-term success of the company.
In addition, startups often lack a proven business model, making it difficult to predict future success. They may also have limited financial resources, requiring them to rely heavily on outside investment to fund their growth.
Average Timeline for a Startup to Reach an IPO or Exit
The timeline for a startup to reach an IPO or exit can vary widely depending on a number of factors, including the stage of development, the industry and the overall economic climate. On average, it takes between seven and ten years from founding for a startup to reach an IPO or exit. Top venture capital funds invest at the Series A stage, and typically aim for companies in their portfolio to scale to an exit within 5 years.
Different stages of startup development can have different timelines. For example, seed-stage startups may take the full seven to 10 years to reach an exit because it’s the earliest stage. Later-stage startups may only take one to five years before an exit. Factors that can influence the timeline include the amount of funding the startup has received, the size of the market it is targeting and the strength of its business model.
Generally, it’s good practice to expect to hold for at least five years when investing in any startup because that is a reasonable timeframe to understand whether the company will see an exit or go bankrupt. Because of the risks and long holding timeframe, it’s crucial to never invest more than you can afford to lose.
When Can an Investor Expect to See a Return on Their Startup Investment?
The return on investment (ROI) for startup investing is not guaranteed and might take years to materialize. However, investors can expect to see returns at different stages of a startup's development, depending on the investment structure and the startup's exit strategy.
If a startup decides to pursue an initial public offering (IPO) as its exit strategy, investors can expect to see a return on their investment once the company goes public. This can take anywhere from five to 10 years or more, depending on the startup's growth and market conditions.
Alternatively, if a startup decides to pursue an acquisition as its exit strategy, investors can expect to see a return on their investment once the company is acquired. This can happen earlier than an IPO and can take anywhere from two to five years or more.
How Do You Choose What Startup to Invest In?
Making any investment decision is deeply personal. You have to evaluate many factors, some of which include how much money you can stand to lose and how much knowledge you have about the field you’re investing in. You must always also bear in mind that startup investing is inherently risky. That’s why the JOBS Act limits annual contributions from nonaccredited investors and restricts how much money startups can raise through equity crowdfunding each year.
You would do well to think of startup investing like fishing. Regardless of what bait you put on your lure, or where your favorite fishing hole is, you will cast your line into the water and come up empty a lot more often than you catch a fish. But like fishing, a successful startup exit can be the big one that makes it all worth it. One successful exit could make you millions.
Factors That Determine a Startup’s Return on Investment
Starting a business of any kind is a risky endeavor, even with the help of venture capital and equity crowdfunding. Those financial resources are valuable in helping a startup build its infrastructure, but several fundamentals of business will go a long way toward determining the startup’s prospects of making a successful exit. Some of those factors include:
Leadership
A startup will never be better than its leadership team. Many of the most successful startups have leaders known as successful exit founders.
A successful exit founder is anyone who has successfully led a company from the startup stage to a successful exit. Not only is that experience invaluable from a day-to-day management perspective, but successful exit founders also have a larger network of contacts they can work for early funding.
Market Size
For a startup to be successful, it must serve a market that is large enough for it to exist along with competitors. Without a large market, the revenue potential isn’t there.
This is why dynamic sectors like biotech, social media and gaming are where so many startups operate. They represent business sectors with potential customer bases and global appeal. A startup that caters to a niche that is too small will not attract investors and may never generate enough revenue to exit.
Ability to Generate Buzz
Generating buzz is important to a startup’s success. If the company can generate buzz in the market — both through social media campaigns and traditional media outlets — it’s free advertising. That will attract new customers and new investors to contribute to the equity crowdfunding campaign.
Innovation
Although many successful startups operate in large, established business sectors worth billions of dollars, the only way the startup will stand out is to have an innovation that doesn’t yet exist in the sector.
Funding
Last — but certainly not least — is the startup’s ability to raise the funds necessary to operate. Funding is the lifeblood of the startup until it is profitable. Regardless of the sector, operating a startup is cash-flow intensive.
The pace at which startups spend money in their early stages requires them to be able to raise huge amounts of capital. Without funding, no startup will ever see a successful exit.
Importance of Patience and Long-Term Investing
Startup investing requires patience and a long-term investment approach. The average timeline for a startup to reach an exit stage can be several years. Startups are risky and you can't be guaranteed a return on investment. It is essential for investors to have a long-term investment approach and not expect immediate returns.
Startups are innovative and high-risk businesses that require significant investment to succeed. Startup investing is different from investing in normal stocks. Unlike the stock market startups are illiquid. Startup investing is further limited by investors limited access to information. Investors must be aware of the risks involved in startup investing and have a long-term investment approach. While the average timeline for a startup to reach an IPO or exit is several years, the potential return on investment can be high.
Frequently Asked Questions
What is the most common exit for a startup?
The most common exit for a startup is through acquisition. This is when a larger company buys the startup, usually to gain access to its technology, talent, or customer base.
What is the average exit of a startup?
The average timeline for the exit of a startup can vary significantly depending on various factors such as industry, market conditions, and the specific goals of the founders. However, on average, it can take anywhere from 5 to 7 years for a startup to reach an exit event such as an acquisition or an initial public offering (IPO). It is important to note that this timeline is not set in stone and can be longer or shorter depending on the unique circumstances of each startup.