Show of hands: Who here doesn’t want to invest in the next Facebook or Google?
Didn’t think so.
The people who invest in startups have supplanted hedge fund managers as the investment rock stars of our age. What makes startup investing so thrilling is that unlike the passive investing common in the stock market, angel investors have the opportunity to provide ongoing value with their experience… and networks.
Whether you’re just kicking off your career as a venture capitalist or starting out in angel investing after making your money in other businesses, investing in startups can be a very lucrative activity. In fact, data has shown that well-positioned angel portfolios can return 2.5X over a 4-year period. Returns like these easily trounce stock market returns (and historical returns of most other asset classes).
However, investing in startups can be tricky... So what are the best practices in startup investing? To avoid the pitfalls and accelerate up the learning curve, here are eight steps to getting familiar with startup investing:
1. Understand How to Make Money Investing in Startups
It’s not about being lucky or particularly skilled at picking a company that goes on to return 100X. Very few successful investors have shown that they can do that consistently. Angel investing is about process. It is about diversification. To win at the angel investing game requires understanding how important investing in numerous startups really is because you’re going to build a broad portfolio of startup investments.
Think about it like this: unlike the stock market (where the risk of an investment going to zero is almost nil), angel investors frequently write-down some of their investments in early stage companies. According to the Bureau of Labor Statistics’ Business Employment Dynamics, on average, only 50% of small businesses make it to year 5. Another handful of investments can return 2X or 3X on your original investment. But there will be one or two investments in your portfolio that should drive the overall returns of your angel activity. That’s why the Kauffman Foundation’s seminal research on angel investing, the largest study ever of its kind, found that to achieve a yearly average of almost 30%, angel investors need to have at least 15-20 investments in their portfolios.
2. Determine Your Investment Strategy
Once you’ve decided to get active in angel investing, it’s time to determine what type of investment strategy you’re going to use. Before you make your first investment, try to figure out the following:
- How many deals you’re going to invest in: If diversification is the key to successful startup investing, then you’re going to want to target something like 15-20 investments for your portfolio, as previously mentioned. The research shows that angel investors can eke out even more returns when they invest in a greater number of companies.
- How much money you’re going to allocate to each deal: You’ve got to decide whether you’re going to give equal weight to all your investments as part of your diversification strategy or invest more money in the deals that you believe warrant it. Either way, make sure you leave over a significant portion of your allocated capital for follow-on rounds. Many of your companies will need to raise money later on and you’ll have the ability to prevent your stake from getting diluted.
- What types of deals you’re interested in: Determining what type of deal you’re interested in may sound simple but it will greatly influence your deal flow and ultimately, your returns as well. Are you interested in investing in an idea with a great team assembled around it or do you prefer more mature startups with a working product and maybe some revenues? Or maybe, you want a smattering of both. Your choice of startups matters as valuations can vary widely depending on where you’re investing along the startup maturity curve.
- Whether you’re going to be a sector specialist or an angel investing generalist: The Kauffman data show that there is value in niche-ing down and specializing your investing in a particular sector. If your background is in enterprise software, it probably makes sense to do some investing there, as you know how to connect the dots better than an outsider would.
- Join or build an angel group: Angel groups that invest together generally perform better than individual investors at the margins, according to the Kauffman data. They help attract and consolidate deal flow and give investors a sounding board when they’re looking at deals. Most cities have these groups and you can join on. Even if you don’t join your local angel group, you can always create a formal or informal confederation of investors who bring some value to the table. Investing in numbers does help — remember, your portfolio companies are most likely going to need more money down the road and having more talent at the investor table will help. Angel investing is a team sport.
3. Build Your Sources of Quality Deal Flow
One of the major nuances of angel investing is that unlike the stock market, where an average investor has complete access to invest in all securities, good private deals are still hard to come by. No matter all the advances in technology, getting access to good deals still requires work. And it’s a virtuous cycle: as an investor builds a track record, you end up getting better access to future deals as you build a brand for yourself.
A great way for new angel investors to jump start their deal flow generation is to join an equity crowdfunding platform, like the kind we’ve built at OurCrowd. These platforms provide instant access to a wide variety of deals in numerous sectors. Different platforms provide different types of access: where some are actually an unfiltered marketplace of all kinds of startups raising money, OurCrowd provides a curated list of opportunities that pass our due diligence process. Online investing platforms like this give individual angel investors entry to some of the same deals top institutional investors are investing in. That’s powerful and a great way to accelerate building a good deal flow pipeline.
4. Research Well and Pull the Trigger on Your First Investment
Once you’ve developed a steady stream of good deals and have a model for the type of investment you’re going to make, that’s the time to zoom in on an opportunity you like. Experts extol the value of an investor checklist; at OurCrowd, we screen for the 5 criteria we’re looking for before we invest in a startup. Apply your screens appropriately to the investment candidates you’re considering to see if they match your requirements.
In addition to the quantitative screen, most angel investors have built informal expert networks they tap when researching an opportunity. For instance, if you’re looking at a medical technology startup, go to respected authorities in their fields to get their feedback. This gives you not only a 3rd party expert perspective on the opportunity but also enables you to get inside the head of a prospective buyer or user of this technology. That’s valuable in understanding the barriers to entry and the distribution challenges a young company may face.
While many deals share certain characteristics in terms of how they’re structured, every deal has its own unique nuances. The contractual agreements that service angel investments are called term sheets and you’ll want to understand the mechanics of how term sheets work. The different variables include whether you’re purchasing a company’s equity (either directly or in the form of preferred equity which comes with some interesting bonus preferences) or structuring the investment as a convertible loan (it’s a loan that can be converted to equity if certain requirements are met). Take the time to understand the pros and cons of these preferences and structures, so that you scale the learning curve quickly and efficiently. This is important because the term sheets define your upside and your future participation in future funding rounds, as well as what happens if everything goes south.
5. Provide Value Beyond Your Capital
Startup investing is perhaps the most hands-on type of investing out there. Many early stage companies want to raise funds from smart money, investors who have the ability to contribute their advice and connections in addition to their capital. If you are smart money, you have the opportunity to truly move the needle for your portfolio of investments by making warm intros, helping with product development, and even assisting in a buyout negotiation. That’s not to say every entrepreneur you invest in is going to want your help, but you’ll certainly have the opportunity in increase the value of your investment with your intellectual and human capital, alongside your investment capital.
6. Double Down on Good Follow-On Opportunities
Even at the initial point of allocating funds for startup investments, investors should consider ‘doubling down’ when shaping their overall startup investment strategy. Most startups will raise multiple rounds of investment throughout their lifecycle. If the company is performing well, they will raise future rounds at a higher price point, or valuation (also known as “up rounds”). You want to make sure your preemptive rights are well established at the time of your investment, and you want to be able to back that up when it’s time to double down in the next round.
For more on how OurCrowd chooses when to double down, watch The Secrets to a Winning Portfolio.
7. Exit, Stage Left
Identifying and getting access to good deals are the beginning — but the work doesn’t end there. You’ll still need to get your research (and luck) right to be able to exit your investment. In angel investing, that includes primarily a merger/acquisition or an IPO. Unlike equities listed on public exchange like NASDAQ and NYSE, which have a robust market of buyers and sellers, startups are long-term, illiquid investments. Investments can remain illiquid for many years, while early investors need to remain patient and hopeful for an M&A or IPO. For example, Mobileye was a private company for almost 15 years before it went public on the NYSE, at the time the largest U.S. IPO by an Israeli company. Less than three years later, the company was acquired by Intel for a record $15.3B.
Much ink has been spilled pointing out a trend whereby startups are staying private longer for a myriad of rationales.
Here are some other quick thoughts to consider while waiting for your investments to pay off:
- Successful angels usually invest between 25-50% of the total money they plan on putting in the company in the first round of funding, reserving significant “Dry Powder” for follow-on rounds (Staging Capital: Angel Follow-on Theory).
- Startup investors hope for the best while expecting the worst. The worst generally means losing your entire investment.
- Even companies that raise tens and hundreds of millions of dollars, and become “unicorns”, still die (Unicorns That Lost It All).
- 80% of returns are concentrated in less than 20% of portfolio companies, according to Horsley Bridge.
- Successful angel investors generally focus more on finding and developing ‘rocket ships’ than performing CPR.
8. Rinse, Repeat
Success in the angel investing game is about process (and, well, a little luck). Creating a vibrant and quality deal flow is the hub around which the rest of your investment activities should rotate. Whether you break out on your own and hit the pavement in search of the next Facebook or you join an equity crowdfunding platform like OurCrowd, getting your deal flow right is the most crucial step. Not only does it increase the quality of the types of opportunities you see, it also helps to ensure you’ll see more opportunities. And getting more opportunities is a necessary component of angel investing.
Some of your investments will return money, others will go bust. But the one or two that you get right — really right — can provide large, outsized returns, like the kind you’ve read about regarding early investments in Facebook, Google, WhatsApp, and Uber.