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

published 19 October 2017

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.

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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?

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.

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.

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%.

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.

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.

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).

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.

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.

Frederic is an investment analyst. He started his career at JP Morgan in Paris. He has more than ten years of experience investing in private equity and also worked with the 3i debt management team investing in private debt. He is an ACCA member and a CFA charterholder. He graduated from Edhec Business School.