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Growth Potential

3 Categories of Startup Growth Potential

If return on investment is your primary reason for angel investing, then you should assess a company’s long-term growth potential before buying its shares. Invest only in startup companies with high growth potential, among other positive characteristics such as strong management teams and revenue forecasts.

(ROI is not always an investor’s primary motivation—we’ll discuss other, equally valid, motives in a future column.)

Types of Startup Companies

Evaluating growth potential is highly subjective, more dependent on the founders’ vision and goals than on quantitative measures. We suggest that you conduct a thorough review of each issuer’s offering documents, operating history, marketing strategies, financial forecasts and team profiles; then sort the companies into three categories: lifestyle, middle-market and high-growth-potential.

Lifestyle Companies

Lifestyle companies provide good incomes for their founders, but do not pursue growth aggressively. The founders are not inclined to take big risks that may jeopardize their (and their families’) long-term security. They are reluctant to give up control to people outside the family, preferring to keep their companies closely held, rarely seeking financing beyond community bank loans and early-round crowdfunding.

Lifestyle companies are usually not destined to be acquisition targets (at least not until the founders retire) or IPO candidates, so they wouldn’t be considered prime angel investment opportunities—unless your motivation is related to community development or social factors rather than to ROI.

Middle Market Companies

Middle-market companies pursue growth aggressively until their annual revenues are $50 million to $2 billion, and then level off or continue to seek modest growth. These companies should provide equity investors with income in the form of dividends, and gradually increase in share value when they mature. They may also be prime opportunities for strategic investors. They may be acquisition candidates eventually, but not soon enough for equity investors looking for near-term divestment. And you can expect them to remain private (not file an IPO).

In 2013 only 8 percent of middle-market companies expected to go public at any time in the future, according to a Deloitte survey.

High-Growth Companies

High-potential entrepreneurial companies pursue fast growth aggressively. The founders want the company to be big—maybe very, very big—not only so they can earn a fortune but also because sometimes it’s necessary to get big in order to achieve economies of scale and maintain market share in a hypercompetitive environment.

The founders of high-potential entrepreneurial companies typically thrive on risk taking, innovation, and the excitement of growth. Exit strategies are paramount: They aim to be acquisition targets or IPO candidates, representing jackpot-grade exit events for early investors.

Education, Experience, Judgment

To judge the potential of a startup, you need education and/or experience in the field where the startup operates. Reliable studies have shown that returns on investments made by angel investors are positively correlated with the number of years of experience in the industry in which the investment was made.

Today, in hindsight, it is easy to categorize the 1976 version of Apple Computer as a high-potential entrepreneurial company. It is quite another thing to have been Mike Markkula in 1976, visiting the scruffy founders Steve Jobs and Steve Wozniak in the garage where they had just built the Apple II prototype, and recognizing this as a high-potential startup worth investing in. Wozniak recently pointed out that if you had asked average consumers in 1976 if they would like to have a personal computer, they would have responded, “What’s a personal computer?”

It helped that Markkula had a master’s degree in electrical engineering and had worked as a marketing manager for Fairchild Semiconductor and Intel, where he earned millions on stock options before he met Steve and Steve. In other words, Markkula had the education and experience, not to mention keen judgment of character, which enabled him to recognize Apple’s potential. He invested $80,000 in the company in return for one-third of the equity (he also loaned Apple $170,000). That transaction valued the company at far less than $1 million. When Apple went public three years later, the company’s value soared to $1.778 billion, and Markkula’s share was worth something like $200 million.

Leverage the Wisdom

One advantage of investing via equity crowdfunding platforms is that you can collaborate with other investors—leveraging the wisdom of the crowd—to assess growth potential. If you lack experience in a particular field, you may be able to rely on crowd members who have it. Be sure that the platform shows investor profiles, so you can verify their experience.

 

— David M. Freedman, based in Chicago, has worked as a financial and legal journalist since 1978.

— Matthew R. Nutting practices corporate law with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of Equity Crowdfunding for Investors, published by Wiley & Sons in June 2015.

About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

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