Last Thursday, a tech start-up called Square (NYSE: SQ) went public.
For investors who got in early, when the company was still young and private, champagne corks should have been flying—
After all, Square’s IPO gave the company a value of nearly $3 billion.
So why the heck were so many early investors crying?
How did they lose money on this deal?
“Seed-Stage” Versus “Later-Stage”
The explanation has to do when those private investors got involved.
You see, when you invest in private start-ups, there are two main ways to do it:
With the first way, generally called “seed-stage investing,” you’re investing in a company before it’s proven itself:
At this stage, a company might have nothing more than a couple of engineers with a big idea, or maybe it’s built an initial product and has a small level of sales.
With the second way—often called “later-stage investing”—you’re investing in an entity that may already have millions of users, and millions of dollars in revenues.
But beyond the obvious differences between these two types of companies, there’s a more subtle distinction:
One of the most critical concepts in private market investing is something known as “valuation.”
Simply put, valuation is a private company’s value—its market cap.
Generally speaking, seed-stage companies have low valuations (i.e., they’re inexpensive to invest in), while later-stage companies have high valuations (i.e., they’re expensive to invest in).
But no matter what you’re investing in—from start-ups to stocks to real estate—to make money as an investor, you need to “buy low and sell high.”
And unfortunately, when you’re investing in later-stage start-ups—especially in today’s frothy environment—it can be challenging to “buy low.”
To see an example of this, let’s look at Square.
In December of 2009, while it was still a young company, Square raised money from private investors. At the time, it was valued at $40 million.
By January 2011, the company had made significant progress, so when it raised its next round of funding, its valuation increased to $185 million.
The company continued to make progress and raise capital from private investors—and as it did, the valuation it commanded continued to soar…
In fact, by October 2014, it was valued at $6 billion.
But as Square’s IPO value made perfectly clear, $6 billion was far above the right price for anyone who wanted to “buy low and sell high.”
The Winner Is…
You see, Square went public last week at a market cap of $3 billion.
At that level, later-stage private investors who got in at the $6 billion valuation lost about 50% of their money.
But as you can see in the below chart (from funding platform EquityZen), investors who got involved at earlier stages enjoyed huge gains from the IPO:
Investors from the January 2011 round made 11.5x their money.
And investors from 2009 made 40.6x their money—that’s enough to turn a $5,000 investment into about $200,000.
There might be an occasional exception—Facebook comes to mind—but once a private company is already worth billions of dollars, the only investors with a clear path to profits are private, seed-stage investors.
Certainly, late-stage private investors in companies like Square are getting burned…
And things are even worse for public-market investors: as we wrote about recently, the average IPO in 2015 has provided a negative return on its first day, falling 3.5%.
If you’re looking for big returns, you need to get in early…
And that’s why you need to start looking at seed-stage investment opportunities in the private markets.
As you probably know, these markets have been off-limits to ordinary investors like you for more than 80 years—but because of new legislation known as the JOBS Act, in just a few months, ALL investors will soon be able to invest in these deals.
To help you understand the variety of seed-stage deals you’ll be able to invest in, from technology start-ups to food & beverage companies, we recently wrote a detailed research report.