High risk, high reward: invest in startups and venture capital

Thanks to modern innovation, you can invest in startups in the UK. This isn’t a recommended strategy for financial independence, but if there are gains to be had we should at least consider it. This is my brief guide to investing in startups as low-budget retail investor.

This is absolutely not financial advice. The posts on this site are not financial advice anyway, but this one is particularly “out there”. Investing in private equity is incredibly risky. If you try this, you do so at your own peril. The content here is for information and entertainment – I hope you enjoy reading it!

When you buy shares on the stock market, they’re second-hand

It’s called a “secondary market”. You buy shares that were issued and sold on to market makers/ underwriters/ previous owners, who later sold them on to you. The shares in your account have usually changed hands a few times before you push “buy”. When you want to sell them, you’re selling back into a secondary market.

Public companies and private companies

Shares on the stock markets (such as the London Stock Exchange) are regulated shares in public companies. These companies have “PLC” in their name, which is how you can tell. This is a legal requirement in the UK and the acronym means that is is a public company limited by shares.

Companies can be public or private. Public companies must be limited by shares. This means that there must be a reserve of cash created from the sale of shares to act as security against the companies’ debts. Companies generally run on debt. The “limited” part is that if the company goes bust, the shareholders (members) only own the money they’re already paid into the share reserves – companies who’ve lent money can’t chase down the shareholders and demand to be topped up.

The other types of company are private. Private companies can be limited by shares, too. These are called “limited” or “ltd” in their name. When I talk about investing in startups, I’m talking about buying shares in these limited companies or buying shares in small PLCs that aren’t on the stock markets.

There are two other types: “limited by guarantee” and “unlimited”. Charities or not-for-profits are sometimes limited by guarantee so that they don’t have to deal with shareholder provisions. An unlimited company is one where creditors can chase company members for money – which is why they don’t exist much. I can’t think of any good examples of an unlimited company in the UK. They’re legally interesting but it’s way beyond the scope of a financial independence blog to talk about these, you just wouldn’t invest in them.

Who can invest in public companies?

Public companies have some exacting rules, because they’re the only type that can be marketed to the public at large. They need to have well-established board, there are rules for governance, they hold an Annual General Meeting of shareholders every year. Accounts must be public, there must be reports. If a company wants to create and sell new shares, it needs permission from the shareholders, which is harder to get in a public company. There are a whole host of controls that make them relatively safe for retail investors.

The advantage for making a company public is that it can sell its shares on stock exchanges (or the Alternative Investment Market, which is a bit different). That means it can sell in bulk and raise big sums when required. It also means that shareholders can sell their shares easily without having to tell the company. [There’s an exception for people who own more than 3% of a listed company but if you’re still pursuing financial independence and reading this blog, you probably don’t own 3% of a £multi-billion public company. If you do, a donation to the site would be welcome!!!] This makes listed shares liquid – you can sell them pretty easily. That, in turn, makes it easier for these companies to get investors later. It’s a big deal, and it means that public companies tend to listen to shareholders and the stock market: they don’t want to upset the ecosystem. These big public companies tend to be more stable and conservative.

What this all means is that listed public shares can be bought by pretty much anyone in the UK.

There are unlisted public companies, but these are few and far between. This is usually used for crowdfunding when the company wants to offer its shares to the general public. Brewdog plc is a good example (at the time of writing, they aren’t listed – but they plan to be).

Who can invest in startups in the UK?

So, if anyone can invest in public companies, anyone should be able to invest in private companies too, right?

Wrong!

Private companies have very few rules compared to public companies. There’s nothing to stop you setting up a one-man-band private company. You can have as many or as few shares as you like: you can start a company with a share reserve of £1. Directors? You need at least one, but it can be anyone. They can even be the main or sole shareholder. There are rules on reporting to Companies House, but they’re fairly easy to comply with. A private company can be as big or small as it wants to be.

This makes them high risk. Private companies can’t promote to the public at large because they aren’t so heavily regulated. You can see the logic, though. A lot of people buy shares because they “look cool” or they’ve “heard good things”. Very few people know how to read a company’s balance sheet or make an assessment of market competition. A lot of people can’t comfortably assess product substitutability. Here’s an example:

An example of why the public is protected from buying higher risk investments

Peloton is a public company, traded on the NASDAQ. At the time of writing, shares in the home/ gym spinning company Peloton have a price:earnings (“P/E” or “PE”) ratio of 1,601.29. That’s according to this website. This means that it would take 1,601 and a bit years for Peloton to earn its own shares back based on the money it currently earns.

Are people really expecting Peloton to grow its earnings by 80x so that it falls to a more modest P/E of 20? Possibly, but it’s more likely that people just buy what they hear is a good business.

Now imagine how dangerous it would be if Peloton wasn’t a regulated public company!

To get around this, there are a few targeted ways that private companies can market their shares to people. These are covered in a truly riveting bit of law called the Financial Services and Markets Act 2000 Financial Promotion Order 2005. I’ll spare you the agony of reading it. The key exclusions are:

• People with High Net Worth (annual income over £100k or over £250k of assets excluding their home)
• “Sophisticated investors”, who have signed a waiver
• A company’s own employees in an employee share scheme
• Investment professionals

There’s a lot of detail missing there, but that’s enough to get the point across: not everyone can be invited to invest in private companies. As most startups are going to be private companies, that means most people can’t be invited to invest in startups.

That doesn’t mean you can’t invest in them, it just means that these can’t be targeted at you by anyone who isn’t some kind of financial advisor. You have to deliberately seek out the opportunity.

[There’s a lot more information on this and quite a few exclusions, but this is a blog about financial independence in the UK: it’s not a blog about law. I’m going to move swiftly on!]

Are startups really a sensible investment?

Why bother investing in startups in the UK?

Here’s the thing: you can expect a startup to grow pretty quickly, if it does grow. 10-20x isn’t unheard of within 10 years. Given that a globally diversified index fund is expecting 9%ish annual returns, index fund investing will double your money in about 8-10 years. It’s an attractive proposition.

Unfortunately, startups are also tiny businesses that have a huge failure rate. Fundsquire report that 20% of businesses will fail in their first year and 60% will fail in the first 3 years. That’s a pretty big risk for all your cash invested in them! To give you an indication, here’s a post on US-based venture capital funds (i.e. professional startup investors) that reckons that 90% of profits from investing in startups comes from less than 20% of the investments made. That means that investing in startups requires a) a thick skin for losses, and b) a selection of different investments, to make sure that you get at least one big winner.

On the plus side, the returns can be great and there’s one thing that makes them better: tax treatment.

Tax treatment on investing in startups

There are two awesome schemes for investing in startups that soften the blow for if you invest in startups: Enterprise Investment Scheme and Seed Enterprise Investment Scheme rules. There are quite a few parts to these for the company, but for the investor in startups this means getting an income tax rebate back at the end of the year. This is either 30% of the investment (for EIS) or 50% of it (SEIS), provided that the investor paid enough income tax that year to refund it from.

EIS and SEIS investments are exempt from capital gains tax when you sell them, as long as you’re held on for 3 years. This is pretty cool, too.

You can check this out on the government website.

If these are so good, why aren’t they recommended for financial independence?

I’ve alluded to up earlier: the returns when you invest in startups – from professional venture capital firms – come from 20% of investments. Even with the boost from the tax rebate, that suggests that 4 in every 5 investments aren’t going to pay off, even if you’re as good as a professional at picking them. That’s not great odds.

Even worse, there’s very little standardisation on the documents that a startup can offer you as an investment. The company can show you whatever it wants, pretty much.

To give yourself the best chance when you decide to invest in startups, you need to be able to see past the marketing documents. You should be able to see what’s missing in the projected data, usually intentionally. You need to be able to read the balance sheet, if there is one. You should know how to look up a company on the Companies House website. You should consider the competitive advantages of the company within its market and understand the company’s business model. You should be able to make an assessment on how qualified the board are to get the company off the ground…

…and even after all that it might not matter. Through sheer dumb luck, timing, or competitors, the business might still fail.

Alternatively, you could just treat it as gambling and just blindly throw money at new companies with cool names or products.

In short: it’s incredibly high risk, even if you know what to look for. That doesn’t make a lot of sense for financial independence. Well, at least not for the long term. That’s also something that’s out of your hands: the timeline.

How do you cash out?

If you invest in a startup, it’s probably a limited company. That’s a problem because you can’t just sell off the shares. Unlike a company listed on a stock exchange, there isn’t a ready-made market for selling shares to. That means you need the company to be bought out by a bigger company (who will usually want all of the shares), some offer to purchase from the company itself, or an eventual listing as a public company so that you can sell the shares on an investment exchange or stock market. Retail investors who invest in a startup don’t get to choose the timing: that’s almost entirely in the hands of the company directors.

How to invest in startups in the UK as a retail investor

Let’s say that you, like me, decide that you still want to try out investing in startups. You like the idea of helping to set up new businesses, the excitement of seeing your investment grow. How do you do it?

There are really only two options for a UK investor. Well, unless you know one of the founders and they cut you in to the company. These are crowdfunding and venture capital trusts.

Invest in startups through crowdfunding

There are two main types of crowdfunding. The first type is basically a preorder for something that hasn’t been made yet, like Kickstarter. Yes, you might get a completed product of the thing you’ve funded, but that’s about it. You wouldn’t use it for investing. The other type is investing through something like Crowdcube or Seedrs.

Usually, this is equity crowdfunding, which means that you buy shares. However, I have seen offers on Crowdcube for convertible loans instead. still, this is basically it.

I haven’t personally used Seedrs, but I know that Crowdcube requires prospective investors to sign the waiver to say that they are sophisticated investors. There is a questionnaire at sign up to confirm that you have at least some qualities to back up your claim.

Invest in startups through Venture Capital Trusts

Back in the days when a Stocks and Shares ISA was limited to £4,000 a year, these were more popular. VCTs are basically a fund, traded like an ETF, that invests in startups and sometimes small AIM companies. Interestingly, the dividends from these are tax free, too.

A VCT doesn’t suffer from a lot of the downsides of investing in startups directly. For instance, the VCT fund managers choose which startups your money invests in. You still have to lock your money up for 5 years (if you want the tax refund), but after that time you can actually sell your shares in the fund on the stock market.

You can also buy VCT shares on the stock exchange second-hand. They usually pay dividends that come from selling off the companies they invested in when the fund was set up, which are tax exempt. The problem with them though is that you don’t get most of the tax benefits (the 30% income tax rebate) when you buy them second-hand.

How I invest in startups

I mentioned that I sometimes invest through Crowdcube in my FIRE Campaign Plan post. I only really do this on occasion with “extra” money from side hustles, and only if I see an opportunity that I think is too good to ignore.

I don’t routinely invest in startups. It doesn’t make sense to with my monthly budget. On the whole, I’m better off with my ISA or SIPP payments or overpaying my mortgage or even earning cryptocurrency interest on stablecoins.

That said, I bought into Brewdog for £300 in 2010, which I later sold for about £9,000. There was still some mileage in the company, but it funded my lifestyle through a Masters in Law.

I tend to buy into Fintech or Legal Tech, because I can see how the business models work. Through my law and financial diploma studies, I’ve learned enough about reading balance sheets and assessing market opportunity to feel confident in taking a risk on some companies. Note: feeling confident doesn’t necessarily equate to being competent!

I don’t track my Crowdcube investments in my net worth. As far as I’m concerned, money spent on them is gone. I write it off as soon as it’s spent. Basically, I treat it as a hobby investment, it’s not part of my strategy. That way, if I make a gain I’m overjoyed but if I lose everything that’s just the way life goes. It’s a cool feeling to be investing in something that’s early in its life. It’s like a sort-of romantic view of investing: putting capital together to make something new.

Most of my Crowdcube investments pre-date my serious financial independence campaign. Moving forward, I have no real ambitions to invest more through Crowdcube. I think that investing in startups over a 5-10 year time horizon is a lot of risk and I don’t like the lack of liquidity. Plus, you can’t guarantee getting an income or even any money out of the company.

If you do try this, good luck to you. If you’re serious about your financial independence campaign, maybe think twice before including some of these high-risk investments into your portfolio. Have you maximised your ISA? If so, are there other things with a more likely return that you could invest in instead?