How profits are made from startup investments

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Understanding Startup “Exits”
Investing in private startups is different from investing in public securities markets.
One of the big differences is that publicly traded securities are “liquid”, meaning you can easily buy and sell most of them on national exchanges. You can choose to take a profit, or a loss, on your investment at almost any time.
When you invest in a private startup early, the securities you purchase are usually not liquid. Early on, you can’t sell them easily both because there is no market but also because it is usually restricted by law. However, this is not necessarily a bad thing.
Publicly traded securities can fluctuate wildly. When it comes to trading, our emotions work against us. We sometimes sell too early, or buy too late.
As noted investor Charlie Munger (co-founder of Berkshire Hathaway) said:
“It’s waiting that helps you as an investor, and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.”
When you invest in startups, it’s a long-term investment by default. The “waiting” part becomes automatic. Investors are usually committed until the company fails, there is an IPO, or it is acquired.
Exit Scenarios
An “exit” is when a company you invested in either goes public (IPOs), or is acquired by another company.
Let’s go over acquisitions first. Acquisitions can occur any time after a startup launches, but the best ones often occur once a company has built a substantial business (3-5 years after founding, or more).
Acquisitions can reward early investors significantly, depending on the price paid for the company, and the valuation (price) investments were made at.
Let’s look at a real example.
Venture capital firm Sequoia Capital invested $60 million in WhatsApp starting in 2011. When Facebook bought WhatsApp for $19 billion in 2014, Sequoia made $3 billion, for a roughly 50 times return.
Of course, WhatsApp is a rare case. Many startups fail, and return nothing to investors (or pennies on the dollar). This makes investing in startups a high risk, high reward endeavor.
In addition, acquisitions are usually much smaller than WhatsApp. But they can still be profitable. If you invest when companies are worth $5-25 million, even a $100 million exit can be a positive outcome.
IPO: Initial Public Offering
For many early-stage investors, the ultimate goal is to invest in companies that eventually grow large enough to have an Initial Public Offering (IPO).
During an IPO, a company sells shares to the public through investment banks and stock exchanges such as the Nasdaq and the NYSE. Being a public company means anyone can become a shareholder.
IPOs are a big step for companies. It means their shares will be publicly traded, and their value will be decided by market participants (buyers and sellers). Financial reporting requirements are strict, and almost every detail becomes public.
For investors who got in before the IPO, it can mean a chance to sell their shares and cash in their early stakes.
However, some private investors choose to hold onto shares even after the company whose shares the investor holds has IPOed. You don’t necessarily have to sell your whole stake. Private investors who held onto companies like Facebook, Square, and Google have done very well post-IPO.
Depending on when you invest, it can take 5, 8, even 10 years or longer for a company to IPO (if ever). Startup investments require long-term thinking. It’s also important to note that in some cases, early investors have to wait 90-180 days to sell shares after the IPO (lockup period).
The profit, if any, early investors see during an IPO depends on two primary factors.
• The price the investors paid
• The IPO price (valuation)
Let’s go over a (hypothetical) example of what could happen when a private startup investment goes public.
Say you invest $1,000 in a startup at a $10 million valuation cap. Let’s say this company didn’t raise any more money while private, and went public with a market capitalization (valuation) of $1 billion. If you were able to sell shares at that price, your return could be up to 100x.
However, it rarely works out quite so neatly in the real world. There is usually some “dilution” of shares due to employee stock grants, executive awards, and new investors coming in. So if a startup company increases 100x in valuation, it may translate to a net gain of 40 or 50 times net return for investors in that first round of funding (approximately, returns vary). So if you had invested $1,000 in this case, it could be worth $40,000 to $50,000.
Of course, this is merely a hypothetical example. Real startup exits vary widely and returns are not guaranteed; some result in a total loss, and others can be very profitable for early investors.

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