How to invest in the next Google while it’s still small

Picking the start-up stars of the future can be a potential minefield, but listed incubators and accelerators offer some great buying opportunities, says Frdric Guirinec.

"The trouble with our times is that the future is not what it used to be," wrote the poet Paul Valry. It is a maxim that investors would do well to remember in this era of rapid change.

Past corporate successes cannot be easily replicated, so investors need to look for new sources of growth in small firms that are disrupting existing industries. Investing in start-ups can be particularly rewarding both financially and socially, since it contributes to job creation, innovation and economic development. However, successful start-up investing is easier said than done.

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It's difficult for those who are not industry insiders to identify the future champions ie, the next set of FANGs (Facebook, Amazon, Netflix, Google). Most of us have limited knowledge of sectors dealing in advanced materials, healthcare, financial technology, cybersecurity and agricultural technology, where much of the most interesting research and development work is happening.

Indeed, the risk-return profile of investing in start-ups is not always appealing, notwithstanding the fact that it offers generous tax breaks in the UK. The ratio of losses to gains is high and the volatility of returns is significant. Most people will invest through venture-capital (VC) funds, which often charge hefty management and incentive fees. Still, with €6.4bn raised by VC funds in 2016 in Europe nearly twice the amount raised in 2012 there's clearly a strong appetite for this asset class. So what should investors know before diving in?

Getting started

First, let's quickly define what we mean by a start-up. This is typically a young, innovative firm with growth ambitions operating under significant uncertainty (such as an unproven technology). At a very early stage in the process, the firm will require "seed financing", in which funding is used to complete research and create prototypes. Later, when the firm has already developed a product or service that is ready for mass distribution, it may need to raise further start-up funding to cover capital expenditures and initial working capital.

Traditionally, entrepreneurs bootstrap the initial capital by raising money from friends and families. If the company scales up on its way to success, they can access successive larger and more traditional types of funding. Still, a brilliant idea and access to funding are not enough implementation is crucial. Entrepreneurs often require infrastructure, legal advice and sometimes coaching support.

We can broadly divide the types of organised funding and support for start-ups into three categories. First, there are incubators, which support the start-up in its earliest stages. Governments and universities have long supported start-ups, providing grants for innovation or access to offices on science parks. The first incubator was established in the Batavia Industrial Centre in the US in 1959. St John's Innovation Centre in Cambridge, which was established in 1987, is considered to be the first British incubator for knowledge-based businesses.

There are two operating models for commercially run incubators. Some involve the incubator investing capital and offering resources in return for equity in the start-up. Examples in the UK include Touchstone Innovations and IP Group.

However, others charge fixed fees to cover overheads and essentially run a real-estate business model offering shared offices and other services. An example of the latter is WeWork, which provides shared workspace for entrepreneurs, freelancers and start-ups in 53 cities and 226 offices, including 24 in London.

The firm runs its own incubator, WeWork Labs, which provides services for start-ups, including opportunities for founders to pitch to potential sources of funding, which could include both venture capital funds and angel investors (affluent individuals who invest directly in start-ups). WeWork, which was founded in 2010, was valued around $20bn in its latest fundraising round and may go for an initial public offering next year.

Accelerating growth

After incubators come accelerators. The distinction between the two is not always clear-cut, but broadly an accelerator will work with a start-up for a shorter and more specific period of time. It will provide both capital and guidance and invariably take some equity in the company.

The accelerator model was largely developed by Y Combinator, a US-based company founded in 2005. Twice a year Y Combinator invests around $120,000 for 7% equity in 60 start-ups. The start-ups move to Silicon Valley for three months, where the accelerator works closely with each company, shaping and reshaping ideas, providing advice to pitch to investors, helping to hire talent, and giving some legal advice.

Entrepreneurs are given the resources and tools to gain intensive experience and business mentorship. On the "demo day", start-ups present their business plans to a selected audience of investors in order to help them secure further funding. This saves time for the entrepreneurs and gives them good visibility. Y Combinator has invested $16bn across 1,400 companies so far, helping launch Reddit, Heroku, Airbnb, Scribd and Dropbox among others.

Other well-known accelerators include Techstars in the US (which has invested $4.2bn since inception); Seedcamp, Springboard and Bethnal Green Ventures in the UK; Axel Springer Plug and Play in Berlin; and Le Camping in Paris. These usually take 6%-12% equity in exchange for capital and guidance. Entry to the most well-established accelerators is very competitive Y Combinator and TechStars boast application acceptance rates of 1% to 3%.

Backing from blue chips

The incubator and accelerator ecosystem is growing fast. In the UK there are 205 incubators and 163 accelerators supporting around 3,450 and 3,660 new businesses per year respectively, according to the Department for Business, Energy & Industrial Strategy.

This has attracted the attention of large companies, which are concerned by the risk of rapid technological changes that left past champions such as Nokia, Yahoo or Alcatel behind, and is encouraging them to develop their own incubator programme. Doing so can allow them to identify future markets for expansion, spot potential competitors, rejuvenate corporate culture, and create an entrepreneurial mindset among employees in a way that is difficult within the inertia of a large, traditional organisation.

Large groups represent over half of incubators and accelerators in the UK. Wayra UK, backed by telecoms firm Telefnica, has accelerated 73 start-ups to date, raising $28.6m. Google, Microsoft and IBM have developed their own programmes to support start-ups: Google Campus, BizSpark and Bluemix. Banks such as Barclays and Japan's Mizuho have launched their own fintech programmes in an attempt to tackle the sclerotic corporate culture in banking that has resulted in sprawling technology teams that are risk-averse and mostly concerned with maintaining the status quo.

Real-estate firm Canary Wharf Group has a programme called Level39, under which it offers space in the One Canada Square skyscraper to start-ups ranging from currency-payments service Revolut to financial-analytics firm CreditVision (Level39 does not invest in the start-ups, but the programme helps further the image of Canary Wharf as a hub for innovation). Even firms such as Diageo and John Lewis also have their own incubator programmes.

Avoiding the VC trap

The third source of funding is VC funds. These mostly avoid the seed-financing stage, since they are put off by the risk/return profile (of the €4.3bn invested by VC funds in 2016, just €400m was in seed financing).

Instead, they focus more on start-ups that need capital for growth. But despite some widely shared stories of VC funds that were early investors in future tech giants, the reality is that this part of the asset management industry has a disappointing track record compared with both listed equities and private-equity funds that focus on buying out larger companies certainly once the risk profile and volatility is taken into account. VC funds achieved a net internal rate of return of 6.1% per year over the last ten years, compared with 5.6% for the FTSE All-Share index, 7.6% for the FTSE Small Cap index, and 15% for large private-equity buy-out funds.

Nor are VC funds necessarily well regarded in the tech industry, where their claims of bringing expertise and connections are seen as overblown marketing: "90% really add no value, and I truly believe 70% of them reduce the potential of a company", claimed Vinod Khosla, cofounder of Sun Microsystem, in an interview in 2015.

And Peter Thiel, the PayPal co-founder and venture capitalist, has criticised the "spray and pray" strategy that leads many VC portfolios to be a collection of lottery tickets, with the fund manager expecting one big success to deliver acceptable returns for the whole portfolio and pay his fees. "Venture returns don't follow a normal distribution overall," he writes in his book Zero to One. "They follow a power law: a small handful of companies radically outperform all others."

Poor returns led many private-equity firms to sell their VC portfolios and exit this segment in the late noughties. Others are now rethinking their strategies and investing into accelerators, taking the view that this gives them a high degree of diversification, saves time conducting due diligence and negotiating terms, and means that they enter earlier in the investment process at lower valuations. An accelerator typically makes 12 investments per year, about five times higher than the rate of a venture fund, and typically invest at lower valuations (through common stocks rather than preferred stocks for VCs).

Some venture funds are beginning to provide the type of support services for start-ups associated with incubators and accelerators. Hopefully, the rise of incubators and accelerators will drive many VCs to improve their business model and performance. In the meantime, I would suggest looking at the listed incubators and accelerators, which often offer better buying opportunities.

Six start-up funds to watch

Investors in start-ups have to be more careful and patient than investors in any other sector: the average holding period of investments will often be many years. Risks are high and many rising stars will turn out to be stardust.

While the rise of crowdfunding platforms has made it possible for individuals to invest in start-ups more easily, identifying good prospects requires insight and experience. Traditional metrics of value such as price/earnings ratios, book value or free cash flow used to evaluate mature companies are of little use. So if you are interested in start-up investing, a good place to begin would be to evaluate and monitor the performance of the listed incubators and accelerators.

In the UK, these include IP Group (LSE: IPO) and Touchstone Innovations (LSE: IVO), which are set to merge following a hostile takeover bid from the former earlier this year. IP Group, a FTSE 250 component, has 100 portfolio companies valued at £663m, and has partnerships with universities in the UK and more recently in Australia. Touchstone, which was created in 1986 by Imperial College to commercialise its innovations, is invested in 112 firms valued at £382m.

Another well-known firm, Allied Minds (LSE: ALM), invests in technology and life science, partnering with universities across the US. The company has not exited any investment so far and has recently written down seven of its investments by $167m. A new CEO has been named, but I would only consider this share once it shows progress on its portfolio or signs of a successful exit.

Rocket Internet (Frankfurt: RKET) raised €6.3bn in an initial public offering (IPO) in 2014 the largest German IPO since 2007. Run by CEO and largest shareholder Oliver Samwer, the firm copies the business models of successful US tech companies to implement them in Europe. Rocket has had some high-profile hits with Delivery Hero and HelloFresh, and has €1.7bn of cash remaining.

The share price has collapsed, in part because some investors are unhappy that it does not publish valuations of portfolio companies. However, the firm is now valued at less than the sum of its parts and a break-up of the portfolio seems a likely outcome, so this may be a good time to buy.

Elsewhere in Europe, LVenture Group (Milan: LVEN) runs an accelerator aimed at digital start-ups. Lastly, NetScientific (LSE: NSCI) is a healthcare investor in five firms that are starting to generate revenues. CEO Franois Martelet, a doctor who was part of the healthcare team that advised French presidential candidate Franois Fillon, views himself as a builder of companies rather than an incubator, and has assembled a focused portfolio that seems very promising even in my non-specialist view.

The chairman is Richard Sykes, formerly CEO of Glaxo and chairman of the merged GlaxoSmithKline. NetScientific listed three years ago; while the shares have disappointed, the price seems to have stabilised and better prospects lie ahead.