When you're looking at things to fund you have a lot of choices - the investment ecosystem is very broad - you could invest in a startup or an SME (small and medium-sized enterprises). Identifying whether something is an SME or a startup is heavily conflated by the fact that Government and startup peak bodies often use the terms interchangeably but they're very different. The investment experience, potential returns and risk profiles are very different for startups and SMEs. That’s why it’s important to understand whether you’re investing in a true startup or a great small business.

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The difference between a startup and an SME is growth potential

An SME might be profitable but it will generally give a smaller return over a long period of time. Most SMEs are profitable and lower risk - that's a core part of what makes a good SME - so it’s easy for an investor to see how you can put in some capital, scale it three or four times and have a great company.

Typically, an SME may reach $10 million to $20 million in revenue but it’s not growing 100% year on year or going from 10 to 100 people in a year. Its profits are often reinvested in the business through its cash flow.

When investing in an SME, you're looking for a sustainable business model. It's about building for profitability, cash flow and understanding the marginal economics of the business rather than building for an exit. It’s easy to invest in an SME - they’re unit economic positive, generate cash flow and are profitable. An investor can have a portfolio of SMEs and get a good return, but it's a very different experience to investing in startups.

On the other hand, early stage startups lose money hand over fist. They’re growing teams rapidly and the risk profile of the business is huge - it either becomes a $100 million revenue business or it dies. When investing in a startup you’re less focused on profitability and more on growth.

One way to identify if you’re investing in a startup or SME is to talk to the founders about their vision. If they want to win at all costs to build a business with over 100 people that has offices around the world that’s a startup founder. If they want a business that pays them a good income, has maybe 30 employees and delivers great value to its customers then that’s a small business.

The investment experience, potential returns and risk profiles are very different for startups and SMEs. That’s why it’s important to understand whether you’re investing in a true startup or a great small business.

Both startups and SMEs can pivot

If you’re on a classic startup journey you may find that the business isn’t acquiring customers or revenue at the rate you anticipated. In this situation it may make sense for the business to pivot and become an SME.

An SME can also pivot into a startup. This happened with a business I ran - I thought it would turn over $1 million a year and built it with that assumption in mind. But the space exploded, consumer demand increased and competitors left it alone. So we ended up shifting from an SME model to a startup model.

When you’re researching or seeking advice about an investment, it’s important to understand whether the information is designed for SMEs or startups because the consequences for your investment are very different. It’s also important to decide what type of businesses you want to invest in. Having that clarity can help you filter the advice you receive and identify the best investment opportunities for you.

Hugh Stephens is an Angel Investor.

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