Don't Invest in This Type of Start-up

The term “start-up” can mean many things:

It might refer to two friends working in a garage with nothing more than an idea...

It might refer to a multi-billion dollar private company on the verge of an IPO...

Or it might refer to something in between.

The thing is, as an investment, one of these scenarios can lead to financial disaster.

Do you know which one?

Start-up Type #1: High Risk, High Reward

Most start-ups fall into the “two friends in a garage” bucket—or as they’re more commonly known, “seed-stage” companies.

Seed-stage companies tend to have:

These companies are high-risk investments, but they can offer major upside.

For example, my friend and business partner, Howard Lindzon, was a seed-stage investor in Uber...

When he invested, Uber was valued at a few million dollars. But today, with its value approaching $50 billion, Howard’s initial stake has grown by more than 1,000 times.

When Facebook’s first investor wrote a check, that, too, was a high-risk bet—but it paid off handsomely:

When he invested, Facebook was valued at about $5 million. When the company later went public with a $100 billion market cap, he made 2,000 times his money.

Sure, at the seed-stage, it’s tough to determine which companies will be successful. But as long as you build a portfolio of seed-stage companies, there are ways for you to manage your risk—and enjoy sizable returns.

But not all start-ups are at the seed-stage...

Start-up Type #2:  Lower Risk, Lower Reward

Yesterday, Matt wrote an essay about “Pre-IPO profit opportunities.”

As he wrote:

A pre-IPO company [is] already on a path toward an Initial Public Offering. Such companies generally have thousands of paying customers and millions in revenues—in other words, they’ve already proven themselves, and it seems likely that they’ll grow into massive, profitable, long-lived entities.

An example of a pre-IPO company is Uber. Even though it’s valued at nearly $50 billion, it hasn’t gone public yet—it’s still a private company. (And The Wall Street Journal still refers to it as a “startup.”)

The idea here is that, with pre-IPO start-ups, you can invest in later-stage private companies before they IPO… and then reap substantial returns when they go public.

These companies are less risky than seed-stage companies—and accordingly, they tend to offer lower rewards to investors:

Instead of shooting for a 10x return (or far more) like a seed-stage investor, a pre-IPO investor might seek returns of, say, 3x to 5x.

Maybe you invest when the company is valued at $250 million, and you sell your shares when the company goes public at a $1 billion market cap.

(As Matt told you, starting tomorrow, June 19th, investors like you will finally be able to invest in Pre-IPO companies online.)

So now you know about seed-stage start-ups and pre-IPO companies...

But there’s one more type of start-up you need to know about...

So you can avoid it at all costs.

Start-up Type #3:  “Stuck in the Middle”

The last type of start-up is stuck in the middle.

It’s no longer at the seed-stage—maybe it has a few dozen employees and some revenues—but it’s not even close to going public.

At this stage, a start-up is still very risky, so investors should be compensated by having a shot at earning high rewards...

But because the company has made progress, it tends to value itself more highly. So when it goes out to raise capital to grow its business, instead of being valued at about $5 million, maybe it’s valued at $25 million.

Valuations like that might be ok under a couple of scenarios:

Otherwise, for individual investors like you, this could be a problem:

Paying a steep price like that can kill your returns...

Here’s The Quick Math

You see, very few start-ups achieve the level of success to become bona fide pre-IPO companies and go public.

IPOs are rare. They’re for the handful of companies like Facebook or Google.

The more likely scenario for a successful start-up is to get acquired.

Most acquisitions, however, take place below $100 million. In fact, most occur between about $30 million and $50 million.

So here’s the quick math:

For Seed-Stage Start-ups — You should invest when a company is valued at about $5 million. If it gets acquired for $50 million, you’ll make 10x your money. That’s enough to compensate for your other seed-stage investments that don’t work out so well—and overall, your start-up portfolio can still deliver market-beating returns.

For Pre-IPO Companies — The risk-reward is dramatically different here, but it can lead to attractive returns. Even if you invest when a company is valued at $250 million, you’ll be investing in a “de-risked” company. If it goes public at $1 billion, you’ll make about 4x.

For “Middle of the Road” Start-ups — The risk-reward in these scenarios doesn’t add up. If you invest when the company is valued at $25 million, sure, you might make a small return once in awhile with a $30 million to $50 million acquisition. But it won’t be enough to compensate for the risk.

And that’s why “stuck in the middle” investments are troublesome...

The price you’re paying to invest in them isn’t worth the potential returns.

Or as we like to say around here: “The juice isn’t worth the squeeze.”

So, bottom line:

As an individual investor, stick to seed-stage or Pre-IPO investment opportunities.

Leave the middle alone.

Happy investing.