Back in 2007, two 27-year-olds living in San Francisco, Joe Gebbia and Brian Chesky, were struggling to pay their rent. So, when a design conference came to the city and hotels were fully booked, they came up with the idea of renting out three airbeds on their living-room floor and cooking their guests breakfast. The next day they created a website, airbedandbreakfast.com and six days later they had three guests sleeping on their floor. They charged them US$80 each a night.
Brian recalls: “As we were waving these people goodbye Joe and I looked at each other and thought, there’s got to be a bigger idea here.’’
It has been estimated that their business, Airbnb now has a market capitalisation of between US$53bn and US$65bn.
That’s the attraction of start-up businesses. It’s a simple rule that something that starts very small, has the potential - if it grows – to do so by huge multiples. Also, it’s often, if not usually start-ups, such as Airbnb, which come up with the kind of ideas which can disrupt entire industries.
Some of the most successful start-ups have been spun out of university research departments to develop and commercialise the research of top academics in their field. Or they’re set up by people who have become expert in a field and have had the idea for some ground-breaking technology. With the right management team in place, these start-ups can bring a drive, focus and enthusiasm that big corporations cannot match despite their vastly greater resources.
This is why big corporations are eager to invest in start-ups. The number of global active corporate investors tripled between 2011 and 2016 to 965 and 75% of the Fortune 100 have an internal venture capital arm. Microsoft Ventures, now called M12 invested in more than 50 start-ups up to last year and Qualcomm Ventures, the corporate venture capital arm of the chipmaker, is investing up to US$100m in start-ups working in artificial intelligence.
Of course, one advantage that big corporations have over the average investor is that they can afford to lose money and start-ups are a higher risk form of investment.
According to the State Of Small Business Britain Report 2018 by Enterprise Research Centre, the overall survival rate for a cohort of start-ups in 2014 cohort was 54.7%, indicating that almost half of all start-ups don’t make it to their third year and this also held true for all the cohorts of start-ups analysed since 1998.
It shouldn’t be forgotten that some firms close by choice because the owners retire or move on to something else and decide that it is easier to shut down the business than it is to try to sell it. Also, many start-ups are doomed from the start, perhaps because of inexperienced or incompetent management, and would never attract serious investor interest.
Having, said that, there is still an element of risk with start-ups and the question for the investor, who still wants the chance to benefit from possible rewards, is how to mitigate that risk.
A first step with any start-up investment, is to apply the Five Ms test. These are Management; Market; Model; Momentum and Money.
The best business idea will fail without a management team that can turn it into a reality. A start-up needs management with specialist expertise but also commercial experience. Other skills required could be in production, sales and marketing or in finance and, if there’s a gap, there must be plans to fill it.
Even if the necessary skills are there, are these people likely to get on and be able to work as an effective team?
Any business has to have a market and has to be able to sell profitably into that market.
Judging market opportunity demands much research into the size of the market, the strength of the competition and the resources needed to make an impact. The people behind a start-up should present a business plan which includes an analysis of market opportunity.
The business model should state what a company is going to do and how it’s going to make a go of it: how it will generate income and turn that into a profit.
This will ideally be backed up with an identification of sources of revenue, the customer base, its products or services and details of its funding.
As a minimum the investor will want details on:
Financial projections for the business, usually over five years;
A clear picture of how investment will be deployed in the business;
The route to market acceptance and resources needed to fund it;
The sales channel strategy;
The timeline to breaking even and then to scaling up before an eventual exit;
How any intellectual property will be protected.
Momentum comes in the form of a growing interest in the start-up’s product or service, even before launch. This can be generated by activities such as customer trials, conference talks, workshops and online marketing drives. Good signs are growing media interest in the business, along with any relevant social media indices. There should also be a sense of purpose and enthusiasm all the way through the organisation.
It’s also important that a new business has enough funding to achieve its business plan. Many start-ups fail because they are under-funded.
Even if the business can succeed and make a profit, is the projected return going to be adequate compensation for the risk of investment and is it going to exceed the returns available from investing elsewhere?
Apart from applying the Five Ms, developments in technology and the internet have provided another way of mitigating risk when investing in start-ups.
Online crowdfunding platforms have been set up, which bring together high growth businesses - usually start-ups or early stage – which are looking for funding and investors who are seeking a decent return on their capital. The procedure is that a business seeking funding applies to be listed on an online platform, which does an element of due diligence to assess the feasibility of the business plan before the business is listed. Investors who subscribe to the site can then examine the business proposal and choose to buy shares through a simple online transaction.
A refinement of crowdfunding is co-investing, again where the public can buy shares in a company, on an online platform, but they do so alongside any combination of angel investors, VCs, institutions and regional growth funds. This gives small investors the comfort of knowing they’re in partnership with experienced institutions and individuals who’ll subject the fundraising company to serious scrutiny, so that the risk is lower than it would be by investing alone.
Also, because an investment can be made with as little as £100, the investor can put money into several start-ups and achieve a diversified portfolio. Diversification is the tried and trusted way of mitigating risk, spreading investments across businesses engaged in different sectors and operating in different geographical areas.
Start-ups present a great investment opportunity but the greater possible returns go hand-in-hand with a greater element of risk. However, the investor can mitigate that risk by doing some research, applying the Five Ms test and by using a co-investment platform, which means investing alongside experienced investors and which makes it easier to build a diversified portfolio.