Early-Stage Venture Capital: The Next Great Alternative Investment Class

Article written by Jason Jacobsohn, Nick O'Brien, and Chris Sorensen

In the high-risk, high-reward world of venture capital (VC), early-stage funds are emerging as a compelling option for individuals seeking high-yield alternative investments. Early-stage funds play a critical role in the entrepreneurial ecosystem by providing essential initial funding for promising startups. These funds tap into the massive upside potential of early-stage equity and can provide investors with substantial returns while also granting them inside access to companies at the forefront of innovation.

Despite the recent slowdown in VC, it continues to represent one of the highest-returning private capital investments. According to data reported to PitchBook, the average annual return for global VC funds has been 14.92% over the past 10 years. Furthermore, early-stage funds have exceeded this, achieving a 10-year average annual return of 15.65% [1].

PitchBook-Global VC Funds Data by Fund Type | As of April 11, 2024

The Early-Stage Advantage

Early-stage funds often outperform later-stage funds due to a variety of factors, including a higher risk-return profile and the significant added value that investors (funds) can provide to startups. However, success in early-stage investing requires investors to possess a range of crucial skills and experiences. These include having access to high-quality startups and the ability to identify companies with high growth potential early on, even before there is obvious evidence of potential success.

Below are some primary drivers that skilled investors can utilize to provide outsized returns compared to larger, later-stage funds.

Early Access to High-Potential Startups: Early-stage funds must identify high-potential startups during the formative stages of their development, often before they have “traction” or established product-market fit. By being the first in the door, investors can secure significant equity stakes in disruptive startups with potentially exponential growth. A successful early-stage investment can yield returns of 10x, 50x, or even 100x. Funds with a diversified portfolio of well-vetted investments can capitalize on these returns while mitigating risk for their investors.

Investor Value-Add: Early-stage investors typically provide significant “value add” to their portfolio companies. They leverage their network and expertise to contribute to the growth and success of their investments. This involvement enhances the likelihood of a startup’s success and ensures alignment between the investors and entrepreneurs, ultimately leading to higher returns on investment.

Lower Valuations: One of the greatest advantages early-stage funds have is the ability to negotiate favorable deal terms and invest at lower valuations compared to later-stage funds. Getting in at the ground level increases the chances of exponential returns as the startup scales its operations and grows in value.

Reduced Competition: The pre-seed and seed investment landscape is less crowded compared to the later-stage funding market. Reduced competition allows funds to be more selective in their investment choices, which can increase deal flow. This enables early-stage funds to focus on building diversified portfolios of high-quality startups with plenty of room to grow.

Diversification: Early-stage funds invest much smaller amounts than later-stage funds and can typically diversify their portfolio better. This approach allows investors to spread risk across many small investments. The potential for one exit with exponential returns hedges the risk of the entire portfolio and positions early-stage funds to capitalize on as much growth as possible.

Lower Minimum Investment: Large VC funds typically have very high minimum investment requirements and are therefore only available to institutional investors. In contrast, early-stage funds have lower investment requirements, providing more people access to the high-growth potential of startups. This creates a broader pool of investors with diverse backgrounds who can collaborate with portfolio companies to guide decision-making and growth.

Additional Insights

  • Examples: Companies like Facebook, WhatsApp, Dropbox, and Groupon are all major VC success stories that were once early-stage investments. These startups provided their early investors with billions and showcase the potential of early-stage funding.
  • Risk Analysis: While the potential for high returns is significant, the risks are equally high. Ideal investors are typically those with a high-risk tolerance and a long-term investment horizon.
  • Trends & Outlook: The VC business cycle has been on the defense since all-time highs in 2021–2022 and pre-seed/seed rounds are at their lowest relative share over the last 10 years. However, investors are sitting on more than $300 billion in “dry powder” and demand for capital is near all-time highs [2]. Although 2024 may remain on pace with 2023 deal volume, an investor-friendly supply-demand dynamic is building with tremendous potential. This should decrease valuations and increase negotiating leverage, which could make 2024–2025 an ideal time for early-stage investing.

The Bottom Line

These advantages and insights are what allow smaller, early-stage funds to not only compete with but often outperform larger, institutional-backed funds. These are also some of the reasons why investments in the pre-seed stage have surged by over 300% in the past five years. This explosive growth underscores the significant potential of early-stage funding and the vital role it has in fostering innovation.

[1] Venture Capital, private equity and M&A database | Pitchbook. PitchBook. (n.d.). https://pitchbook.com/

[2] PitchBook Venture Monitor Q1 2024. (n.d.-a). PitchBook. Retrieved April 13, 2024, from https://files.pitchbook.com/website/files/pdf/Q1_2024_PitchBook-NVCA_Venture_Monitor.pdf#page=1.

Propellant Ventures is a Seed-stage venture capital fund that invests in the growth of Chicago and the greater Midwest across a broad range of powerful, diverse, and leading-edge B2B industries such as healthcare, future of work, supply chain, fintech, and edtech.

Posted on

April 30, 2024

Early-stage funds often outperform later-stage funds due to a variety of factors, including a higher risk-return profile and the significant added value that investors (funds) can provide to startups.