As previously stated, investing in startups is a high risk and high reward business. Any decision you make to invest should not be taken lightly; and you should ensure that you have done as much Due Diligence as you can before signing money over. That said, it can be extremely lucrative with investors receiving enormous multiples in return for their initial investment.

But how do these returns come about? 

Investing in startups is not like investing in large publicly listed corporations not only because of the risk involved but also because the stock is not public – startups are private companies and so equity can only be bought by dealing directly with the heads of the company.

When you invest in return for an equity share in a private company, you are issued with shares, the value of which will rise (or fall) as the company progresses and its valuation changes. But you cannot get rid of your shares at any moment as you might do with a publicly listed company.

So how and when can you get returns?

Gains from investing in startups may be realised in several ways:

IPO:

The most successful startups may achieve IPO, i.e. their shares will become publicly listed and you will then be able to dispose of your shares whenever you like.

A recent one to hit the news was the flotation of Twilio, a cloud communications company which allows software developers to programmatically make and receive phone calls and send and receive text messages using its web service APIs. 

Here’s the article from CNBC : http://www.cnbc.com/2016/06/23/twilio-ipo.html 

Sale/Acquisition:

The startup may be acquired by another company via trade sale or merger. At this point, your equity portion realises its value based on the total value of the acquisition. For example if Company Y buys Company X at a valuation £250 million, and you have a 1% equity stake in Company X, then you will be paid £2.5 million after the sale has occurred. This is a very simple example, but you get the idea.

This happens to very successful startups, to moderately successful startups and even underperforming startups as larger competitors want to buy out the competition or get hold of intellectual property etc. The success of the startup will obviously dictate the valuation at which it is bought.

Check out the examples below:

In 2012, Facebook founder, Mark Zuckerberg, announced that Facebook would be acquiring photosharing app Instagram for $1bn (£629m (at the time)) just two years after it launched in 2010.

 Link: http://www.bbc.co.uk/news/technology-17658264

On a smaller scale, I wrote a post last year on the Angel Investment Network blog about Velocity, the first international, fully comprehensive digital hospitality solution, who acquired Uncover, an app for late bookings, a year after we helped raise money for their seed round. They had 135,000 users, but that was enough for Velocity to deem them worth acquiring considering their obvious synergies.

Link: http://www.redleafpr.com/media-centre/client-news/corporate-pr/2015/nov/velocity-acquires-uncover/

Dividends:

Startups can, if they choose, issue dividends to investors, but this is quite abnormal. Normally, you would expect surplus cash to be re-invested into further growth. Equally, angel investors do not tend to invest in startups looking for dividend payouts down the line; they’ve invested and taken the risk in the hope of high returns (hopefully at least 10x their initial investment and hopefully much more!). Returns of that size will only come about through trade sale, acquisition or IPO. Skimming dividends off will be detrimental to the company valuation and thus negatively affect the final return after a successful exit.

Selling shares to other investors:

In some circumstances investors may be able to sell their shares to other investors, but the actual mechanics of this are extremely problematic and will depend on each individual case. The other problem with this is that trying to sell off your shares will appear like a vote of no confidence in the company so it’s hard to imagine any takers.

In summary, successful exits come in two forms: when the company goes public and when the company is bought up. Only in these circumstances will an investor realise the value of his shares and hopefully get a huge return on his initial investment.