When to invest? Early stage vs. growth VC funds

A common misconception is that venture capital funds only invest in very early stage, speculative investment opportunities; however, in reality venture capital funds pursue a range of different strategies both in terms of thesis, and stage (or maturity) of investment.

Whilst some larger funds invest across a wide range of stages, most funds specialise at a particular stage of a company’s lifecycle:

  • Pre-seed/seed stage: Often minimal or no traction, when a founder has an idea, may have built their MVP and is looking to take it to market
  • Series A: Usually when a business has demonstrated product-market fit (customers are willing to pay for a service / the business is making money – likely >£1m ARR), and is now looking to continue a rapid growth trajectory
  • Series B/C, pre-IPO: The business is growing, has reached a good size (>£3m-5m ARR), has demonstrated go-to-market fit (i.e. a repeatable and scalable sales function) but either isn’t profitable yet, or needs to raise funding to fuel accelerated growth or expansion into new markets

Investing in early stage start-ups can be a high-risk, high-reward endeavour. The potential upside of investing in a successful early stage start-up can be substantial, with scope for significant returns on investment. The risk of failure, however, is also high, and many early stage start-ups do not make it to later stages of development. We know that in general, 90% of start-ups fail and research shows they have just a 0.00006% of becoming a Unicorn (valued at $1bn+).

Going early

One of the main pros of investing in early stage start-ups is the potential for high returns. Start-ups that are in the early stages of development often have a low valuation, and as they grow and become more successful their value can increase significantly. Additionally, early stage venture capital investors are likely to negotiate a board seat and preferential terms, as well as acquiring a significant ownership percentage of the company (15-25%) which may enable them to support and influence the direction and growth of the company.

The primary downside of investing in early stage start-ups is the high risk of failure. Many start-ups fail early on and investors can lose their entire investment. Additionally, early stage start-ups often require a great deal of time and resources to get off the ground, which can require significant investment, even before a company is revenue-generating. VC funds mitigate the risk of failure when investing by building large portfolios, factoring these odds, into their portfolio construction as well as often taking a preferential share class which angel investors may not have access to.

Backing the emerging stars

Investing in later stage businesses (for example Series B onwards), on the other hand, can be less risky but also have less potential upside. Later stage businesses have a proven track record and have already established themselves in the market. These businesses have also shown the ability to generate revenue and are more likely to be profitable. The risk of failure is also lower, as these businesses have already proven themselves.

Funds investing at Series B onwards can still achieve strong returns, and will typically invest 2-5 years before an IPO or other expected exit. Subsequently, the other advantage to investing at this stage is a shorter hold period, or path to exit. Whilst total return may be lower, the combination of lower risk profile and shorter path to liquidity can be very attractive for investors.

It’s worth noting that whilst the upside potential for an individual business may be lower by investing at a later stage, the potential for a fund might still be very strong. This is because the ‘loss ratio’ is typically lower. An early stage fund with a handful of successes will need these successes to cover the money lost on other businesses, whereas a later stage fund will typically have fewer outright failures that need to be subsidised.

Portfolio construction

There is no right answer, and different funds ultimately pursue strategies that suit their strengths when looking to maximise fund performance. Some seek big winners early, whereas others look to invest when they have more information on the businesses to diligence. Both strategies have a place in a well-constructed investment portfolio, but different investor personalities may prefer early or later stage for different reasons.

At Sprout, we aim to bring our community a selection of leading VC funds across a variety of strategies, including some early stage and some later stage funds. We look forward to sharing more information on these funds, and how each of them seeks to deliver returns to their investors.

Stay tuned for more information on these funds as we announce more partnerships in the coming weeks.