Tech startups offer risk-tolerant investors exposure to the profitable growth opportunities in the technology market. Here’s how to get in early.
One of the many strengths of the tech industry is its vibrant startup culture. Tech startups represent significant growth opportunities for bold investors.
Designed to scale quickly, tech startups range from newly established private companies to recently listed public companies. As the name implies, these are small-scale operations usually in the development or early implementation phases, and they are generally on the hunt for funding from venture capitalists and angel investors to commercialize their products.
Some of the most successful tech startups in the past decade are now among the world’s most recognizable technology companies in history, including Facebook (NASDAQ:FB), Twitter (NYSE:TWTR), Airbnb (NASDAQ:ABNB), Snap (NYSE:SNAP), Snowflake (NYSE:SNOW) and DoorDash (NYSE:DASH).
While the technology sector is highly volatile and investing in tech startups can be a risky venture, getting into an early stage company can prove financially fruitful if investors bet on the right horse.
For example, someone who purchased 589 shares of Snap, the parent company of Snapchat, when it launched its initial public offering (IPO) in March 2017, would have made an initial investment of US$10,013, with each share worth US$17. As of March 12, 2021, that investment would be worth an impressive US$36,924 — that’s a compound annual growth rate of 38.5 percent.
For every facet of the tech market, there are numerous tech startups to choose from. So much so that it can be difficult to decide which companies are worth the risk. Here the Investing News Network breaks down how to invest in tech startups, from what to look for to how to enter the space.
What to look for in a tech startup
The harsh reality of startup investing in any industry is that 90 percent of these companies fail within a decade. However, investors can mitigate that inherent risk by practicing serious due diligence. Among other factors, investors should seek out companies with a clear sense of identity, the potential to lead in their specific market niche and a strong management team.
Because the tech industry can change so rapidly, it’s essential for companies to articulate a clear vision of what they are, who they want to support and who they are targeting as competitors. Technology is a closely interwoven ecosystem, with many companies working in tandem to create amazing end products. Without a clearly defined identity companies can cause disruption — but not the good kind.
However, tech startups don’t just need a clear sense of identity. They also need a bold vision of the impact they will make on their target market. For those looking to invest in tech startups, this potential for market leadership is a key factor to consider. The first and best company in a specific niche has a clear advantage over other competitors, making it an appealing investment opportunity.
Companies with an innovative value proposition that targets a new area of the market, or an unmet need in an existing sector, can become future market leaders.
Investors should also consider the management team as part of their due diligence. Look for management teams stacked with individuals with proven track records for building successful companies in the past and who can apply models they’ve used previously at their current company.
Does the management team exhibit unique and extensive expertise that provides the company with a competitive advantage in the sector it is pursuing? A well-rounded team will also include professionals in the areas of finance, marketing and operations.
Investing in tech startups means knowing the tech market
To know if a startup company is truly addressing a valuable, yet underserved niche in the technology sector, investors need to understand the tech market itself.
The tech sector centers on “the manufacturing of electronics, creation of software, computers, or products and services relating to information technology,” according to Investopedia, and includes “consumer goods like personal computers, mobile devices, wearable technology, home appliances, televisions.” It also covers B2B products and services related to enterprise software, logistics systems management and the collection, protection and analysis of critical data.
All of these B2C and B2B goods and services are so vital to the global economy that it’s easy to see why the technology industry is considered one of the most attractive sectors for investors.
The leading growth segments for the tech industry in recent years have been social media, blockchain, cloud-based computing, fintech, mobile apps, the internet of things (IoT), artificial intelligence (AI), medical devices, gaming and cybersecurity.
The cloud-driven everything-as-a-service segment of the market is forecast to do especially well in the coming years. According to a Deloitte 2021 outlook report, “global as-a-service revenue will reach US$345 billion over the next few years, with further growth powered by emerging business models such as content-as-a-service, artificial intelligence-as-a-service, and Internet of Things-as-a-service.”
Meanwhile, revenues in the AI segment of the tech industry are expected to reach US$100 billion by 2025, “driven by machine learning, deep learning, and conversational AI applications. Health care, remote work, and education usage scenarios could experience some of the heaviest adoption of AI.”
Fintech represents another multibillion-dollar market. Research and Markets estimates that this segment of the tech space will reach a market value of around US$305 billion by 2025.
Other top emerging technologies to watch in the near future, according to Lux Research’s Foresight 2021 report, include autonomous vehicles, natural language processing, bioinformatics and 3D printing.
Getting into a tech startup pre-IPO
Investing in a tech startup before it reaches the IPO stage gives individuals an ownership, or equity, position in a company that can then potentially be sold for a profit once the company hits the market or is acquired by a larger company. For the most part, much of a tech company’s value is created at the private level, before going public.
“Private markets, broadly categorized as ‘Alternative Assets,’ can bring returns that would otherwise be difficult to find in publicly traded companies,” explains Andy Reed, Director at Propel(x), in a post.
But how can investors get in on the ground floor? According to the Wall Street Journal, investors should look at angel groups or online platforms for early stage investors AngelList and Propel(x)
Investing expert Tim Lemke has said that online platforms offer investors a way to diversify their broader portfolio and feel good about supporting a company they believe in. A few he recommends are Seedinvest, Wefunder, Republic (founded by alumni of AngelList) and MicroVentures (an early funder of many top companies, including Twitter).
Tech startup venture capital funds
The biggest downside to investing in a private company is the lack of liquidity. Unlike public shares on the stock market, equity in a private company is not something that can traded or easily sold.
Another route into the tech startup market identified by the Wall Street Journal is “invest(ing) in later-stage, but still young, companies through publicly traded funds that hold stakes in companies already backed by venture capitalists.” These venture capital funds allow investors to gain exposure to private companies that are not publicly listed. Here are a few:
- SuRo Capital (NASDAQ:SSSS), formerly GSV Capital, held Spotify (NYSE:SPOT), Dropbox (NASDAQ:DBX), Lyft (NASDAQ:LYFT) and Snap in its portfolio prior to their respective IPOs.
- Founded in 1972, Sequoia Capital (NASDAQ:SEQUX) partners with companies in early and late-growth stages with a focus on the internet, mobile, healthcare, financial and energy sectors. Some of the fund’s most profitable exits include NVIDIA (NASDAQ:NVDA) and Instagram.
- Firsthand Technology Value Fund (NASDAQ:SVVC) partners with technology and cleantech companies in various stages of maturity through to IPO or acquisition. In recent years, two of its current portfolio holdings listed on the ASX: Pivotal Systems (ASX:PVS) and Revasum (ASX:RVS).
Private venture capital funds also offer investors a way into tech startups pre-IPO, including:
- Established in 1965, Greylock Partners focuses on early stage companies in the consumer and enterprise software sector, and was an early investor in Airbnb and Facebook.
- Lightspeed Venture Partners supports early and growth-stage startups in the consumer, enterprise, technology and cleantech sectors. The firm was the first outside investor in Snap.
- Accel Partners invests in early and growth-stage companies in the consumer software, mobile technology, enterprise software and internet segments. Accel was an early investor in Facebook, CrowdStrike Holdings (NASDAQ:CRWD) and Animoca Brands.
- Intel Capital, a corporate venture capital arm of Intel (NASDAQ:INTC), primarily focuses on tech firms in the AI, 5G and communications, software security, IoT and robotics arenas.
Participating in tech startup IPOs
IPOs offer investors the opportunity to get in on a tech startup as it starts trading on the open market. “IPOs are usually discounted to ensure sales, which makes them even more attractive, especially when they generate a lot of buyers from the primary issuance,” explains Investopedia.
Until recently, many tech companies chose to stay private for longer, either delaying their IPO launches or forgoing them altogether. However, in 2020 and into 2021, tech companies have been keen on IPOs.
Research from Baker McKenzie shows that 2020 was a record year for global IPO raises, with US$331 billion raised across 1,591 listings — up 42 percent over 2019. The financial and technology industries top the list in terms of both volume and capital raises. Three of the biggest IPOs for 2020 included Airbnb for US$3.49 billion, DoorDash for US$3.37 billion and Snowflake for US$3.9 billion.
Click here to learn more about how to participate in an IPO.
Tech startup exchange-traded funds
For investors interested in small-cap tech companies, there is the Invesco S&P SmallCap Information Technology ETF (NASDAQ:PSCT). PSCT tracks a broad index of small-cap growth companies in the information technology sector, with a focus on the software, internet, electronics, semiconductor, communication and hardware segments.
While PCST’s top holdings include more established tech companies, the Renaissance IPO ETF (ARCA:IPO) solely focuses on newly listed companies, as its name suggests. IPO’s top five holdings are Uber Technologies (NYSE:UBER), Zoom Video Communications (NASDAQ:ZM), CrowdStrike Holdings, Peloton Interactive (NASDAQ:PTON) and Pinterest (NYSE:PINS).
Another ETF that tracks the performance of recent IPOs is the First Trust US Equity Opportunities ETF (ARCA:FPX). FPX also has a healthy mix of mature companies, which helps to diversify its risk profile. Its portfolio includes Snap, Uber, CrowdStrike Holdings, Spotify, Zoom and DocuSign (NASDAQ:DOCU).
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This is an updated version of an article first published by the Investing News Network in 2016.
Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.