One of the many strengths of the tech industry is its vibrant startup culture.
Tech startups are often recently established and can be private or publicly traded. These small-scale operations are usually in the development or early implementation phases, and they are generally on the hunt for funding from venture capitalists and angel investors as they work to commercialize their products.
Some of the most successful tech startups are now among the world’s most recognizable tech companies, including Meta Platforms (NASDAQ:FB), Airbnb (NASDAQ:ABNB), Snap (NYSE:SNAP), Snowflake (NYSE:SNOW) and DoorDash (NYSE:DASH).
While the technology sector is highly volatile and investing in tech startups can be a risky venture, getting into an early stage company can prove financially fruitful if investors bet on the right horse.
For example, someone who purchased 589 shares of Snap, the parent company of Snapchat, when it launched its initial public offering (IPO) in March 2017, would have made an initial investment of US$10,013, with each share worth US$17. As of March 12, 2021, that investment would be worth an impressive US$36,924 — that’s a compound annual growth rate of 38.5 percent.
However, it bears repeating that the tech sector is highly volatile — as of September 7, 2023, with signs of a recession on the horizon, that same investment would be worth half as much (US$5,707) as the initial investment. Tech stocks generally take a hit during recessions, but this sector also stands to gain the most once a recovery is underway.
What to look for in a tech startup?
The harsh reality of startup investing in any industry is that 90 percent of these companies fail within a decade. However, investors can mitigate that inherent risk by practicing serious due diligence. Among other factors, investors should seek out companies with a clear sense of identity, the potential to lead in their specific market niche and a strong management team.
Because the tech industry can change so rapidly, it’s essential for companies to articulate a clear vision of who they are, who they want to support and who they are targeting as competitors. Technology is a closely interwoven ecosystem, with many companies working in tandem to create amazing end products. Without a clearly defined identity, companies can cause disruption — but not the good kind.
However, tech startups don’t just need a clear sense of identity. They also need a bold vision of the impact they will make on their target market. For those looking to invest in tech startups, this potential for market leadership is a key factor to consider. The first and best company in a specific niche has a clear advantage over other competitors.
Companies with innovative value propositions that are targeting a new area of the market, or an unmet need in an existing sector, can become future market leaders.
Investors should also consider management as part of their due diligence. Look for teams stacked with individuals with proven track records for building successful companies in the past, and who can apply models they’ve used previously at their current company. A well-rounded team will exhibit unique and extensive expertise that gives a competitive edge, and will include professionals in the areas of finance, marketing and operations.
Investing in tech startups requires knowing the tech market
To know if a startup company is truly addressing a valuable, yet underserved niche in the technology sector, investors need to understand the tech market itself.
The tech sector centers on “the manufacturing of electronics, creation of software, computers, or products and services relating to information technology,” according to Investopedia, and includes “consumer goods like personal computers, mobile devices, wearable technology, home appliances, (and) televisions.” It also covers business-to-business products and services related to enterprise software, logistics systems management and the collection, protection and analysis of critical data.
All of these business-to-consumer and business-to-business goods and services are so vital to the global economy that it’s easy to see why the technology industry is considered one of the most attractive sectors for investors. The leading tech growth segments in recent years have been social media, blockchain, cloud-based computing, fintech, mobile apps, the internet of things (IoT), artificial intelligence (AI), medical devices, gaming and cybersecurity.
The cloud-driven everything-as-a-service segment of the market is forecast to do especially well. According to Fortune Business Insights, the global cloud computing market is set to grow at a compound annual growth rate (CAGR) of 20 percent between 2023 and 2030 to reach nearly US$2.43 trillion. This growth will be driven by innovation and widespread adoption of internet-of-things-as-a-service, software-as-a-service and platform-as-a-service technology.
Meanwhile, the firm expects revenues in the AI segment of the tech industry to grow at a CAGR of 21.6 percent to reach US$2.03 trillion by 2030. As it explains, ‘(With) the introduction of ChatGPT, companies have been engaging and investing in AI technologies to respond to these AI driven tools. These initiatives and implementation of AI technologies have been increasing the demand for the artificial intelligence market.’
Fintech is another multibillion-dollar market. Market Data Forecasts estimates that this segment of the tech space will reach a market value of around US$324 billion by 2026.
Other top emerging technologies to watch in the near future include autonomous vehicles, natural language processing, bioinformatics and 3D printing.
Getting into a tech startup pre-IPO
Investing in a tech startup before it reaches the IPO stage gives individuals an ownership, or equity, position in a company that can then potentially be sold for a profit once the company hits the market or is acquired by a larger company. For the most part, much of a tech company’s value is created at the private level, before going public.
Private market investments can bring returns that are difficult to obtain from investing in publicly traded companies. ‘Private market returns, meanwhile, are outpacing public returns over every time horizon, while alternative funds provide access to the broad global economy and the fullest range of asset classes,’ according to management consulting firm Bain & Company. ‘These advantages explain why private markets continue to grow relative to the public markets.’
But how can investors get in on the ground floor? Investors should look at angel groups or online platforms for early stage investors. Investing expert Tim Lemke has said that online platforms offer investors a way to diversify their portfolios and feel good about supporting companies they believe in. A few he recommends are Seedinvest, Wefunder, Republic (founded by alumni of AngelList) and MicroVentures (an early funder of many top companies, including Twitter).
Tech startup venture capital funds
The biggest downside to investing in a private company is the lack of liquidity. Unlike public shares on the stock market, equity in a private company is not something that can traded or easily sold.
Another route into the tech startup market is investing in publicly traded funds backed by venture capitalists. These venture capital funds provide exposure to companies that are not publicly listed. Here are a few:
Private venture capital funds also offer investors a way into tech startups pre-IPO, including:
Greylock Partners focuses on early stage companies in the consumer and enterprise software sectors and was an early investor in Airbnb and Meta.Lightspeed Venture Partners supports early and growth-stage startups in the consumer, enterprise, technology and cleantech sectors. The firm was the first outside investor in Snap.
Participating in tech startup IPOs
IPOs offer investors the opportunity to get in on a tech startup as it starts trading on the open market.
“IPOs are usually discounted to ensure sales, which makes them even more attractive, especially when they generate a lot of buyers from the primary issuance,” Investopedia explains.
Until recently, many tech companies chose to stay private for longer, either delaying their IPO launches or forgoing them altogether. However, in recent years tech companies have been keen on IPOs.
Research from Baker McKenzie shows that 2020 and 2021 were record years for global IPO raises. The financial and technology industries top the list in terms of both volume and capital raises. Three of the biggest IPOs for 2020 included Airbnb for US$3.49 billion, DoorDash for US$3.37 billion and Snowflake for US$3.9 billion. The winning technology IPOs in 2021 were centered on electric vehicles, ride-hailing apps and fintech, including Rivian (NASDAQ:RIVN) for US$11.9 billion, Grab (NASDAQ:GRAB) for US$4.5 billion and Nubank (NYSE:NU).
While the tech IPO landscape fell off the map in 2022, there are signs of a comeback in Q4 2023, reports CNBC. In late August, grocery delivery startup Instacart, data and marketing automation company Klaviyo and chip designer Arm filed to go public.
“Other teams will watch the reception of these and it could encourage some of those management teams to stop waiting around for yesteryear and just get it done,” said Lise Buyer, founder of IPO consultancy Class V Group.
Click here to learn more about how to participate in an IPO.
Tech startup exchange-traded funds
Exchange-traded funds (ETFs) offer a low-cost and lower-risk route to investing in tech startups.
For investors interested in small-cap tech companies, there is the Invesco S&P SmallCap Information Technology ETF (NASDAQ:PSCT). PSCT tracks a broad index of small-cap growth companies in the infotech sector, with a focus on the software, internet, electronics, semiconductor, communication and hardware segments.
While PCST’s top holdings include more established tech companies, the Renaissance IPO ETF (ARCA:IPO) focuses on newly listed companies. IPO’s top five holdings are Airbnb, Snowflake, DoorDash, and Palantir Technologies (NYSE:PLTR).
Another ETF that tracks the performance of recent IPOs is the First Trust US Equity Opportunities ETF (ARCA:FPX). FPX also has a healthy mix of mature companies, which helps to diversify its risk profile. Its portfolio includes Uber Technologies (NYSE:UBER), ON Semiconductor (NASDAQ:ON) and Airbnb.
Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.