Investing in startups
It is the highest risk asset class – 9 out of 10 may fail. It is the least liquid asset that you will have – you can’t sell it very easily. And it is the longest that you will need to hold – on average 10 years. But obviously there is a counterbalance to all that: With very good companies you can earn a 100X return, if you spent 100,000 you can make 10 Million. But obviously you can loose it all.
- Make sure you can easily afford to loose it all
- Make sure you know everything you can and more about startups
- Make sure you can afford investing $50,000+ in at least 25 companies each
- Investing in startups is not only investing money but a lot of time each.
With that said, getting 2 out of 25 to win big ($20 Million+) is a greater return than most other asset classes.
High Risk
The high risk of startup investment has multiple facets:
- Startups are managed by young people with no experience. However they are able to completely think out of the box and that makes them so successful.
- Selecting startups from industries the investor has no experience with is a huge added risk
- Not being aware of the dynamic a cap table may develop over time is yet another risk. An otherwise brilliant company may get stuck if they gave up too much too early.
- The investor needs to make sure that one or two of their portfolio companies can make an IPO. Otherwise there is almost no way to see a return.
How to find them?
Finding very good startups is not easy. You may see some presenting at pitch events. Others may approach you directly if you are very exposed as a successful investor in the entrepreneurs scene. A good way however is to collaborate with an Angels Group. Those groups have typically a good gravitational pull. Another plus of angel groups is the ability to co-invest with others and learn from others, do joint assessments and conduct the due diligence together.
It’s highly recommended however an investor looks for co-investors with similar investment strategies to alleviate the risk of different opinions when it comes to exits or business strategies.
Selecting an investment
When selecting startups to invest there are a few rather well defined success pattern but not very well communicated. Here are the most common profile attributes, successful investors are looking for:
* Founders must be a smart team of complementary founders. I.e. diverse in technology, business and finance, sales and marketing. Solopreneurs, meaning founders with more than 50% equity dominating a company are banned by most professional investors
* Team – team – team, being the most important factors to build a successful company. Great teams can make the best out of a bad product. Bad teams can’t even get a good product to market.
* Large markets. Small markets may not need investments at all, other than making the founders more comfortable. Huge markets need investments and are the only way to get a decent return. Companies who focus on large markets are the only businesses that actually provide a significant value not only to founders but also to the society.
* Unique, ideally disruptive business models. Classic models, where there is a price ticket at a product, standard support and standard sales processes having a very hard time to compete against existing vendors no matter how cool the product is and how fascinating the technology my be.
* New startup investors tend to put a high focus on technology. But even the best and most powerful technology has no chance of getting even near to success if the team cant get it to the large markets as mentioned above. The go-to-market mindset is one of the most critical. Even of the go-to-market strategy is rather amateur style, a grand mindset to get to markets is critical.
Assess the company
Before you engage in any meetings, check if it fits your investment strategy. Do you understand their market and technology? Did they do a thorough market validation? Only of all is a go, engage as an investor. Otherwise you maybe able to help as a mentor.
When assessing the investees, again it’s all about the team. A good way is to make different meetings with different focus rather than hearing everything at once with no depth. Experienced investors start with getting to know the team, their overall mindset. Are the teams having substantiated yet bold long term perspectives? Do they have a good sense for the customer needs, do they think in partnerships or is it all about themselves.
Another meeting maybe about how to bring the product to market, What was the market response so far. How did it influence the product? What will it take to get the product to large markets? A third meeting should satisfy their urge to share details about the product. If you are not an expert,learn everything about it and become very knowledgeable – otherwise don’t invest. And a final meeting about all the financials, capital needs, financial outlook etc.
It’s not a donation
Startups are typically young people who need all kinds of help, far beyond capital. As a serious investor you should not invest unless you can provide significant support to the companies you invest. The only exception is if you are a co-investor and all other investors are ok with just putting in money. To the contrary, all to often investors pay to play – but not to seek a return on investment. We call it “donations”. While this happens with all good intentions, it really doesn’t help a lot and is more often than not counter productive. Investors who don’t care that much and take startup investing as a gamble are bad investors. Startup Investors need to have the urge to get a return – not because of greed but because that energy is needed to make a startup a company and be able to succeed on global markets with fierce competition.
Valuation
Valuation is based on certain “Key Performance Indicators” such as forward looking revenue, relative to past revenue, or number of users and the connected growth rate. A common value for a startup valuation is 5 to 8 times the forward looking revenue for the next 12 month. And since revenue would be too weak as a stand alone value there is a list of circumstances that either help to maintain the multiple or discount it. For instance is the team truly a team of brilliant people, is the market huge enough to get into 9 digit revenue levels and go international, is the marketing and market attention already compelling, is there a well grounded and research based long term vision and so forth. Very similarly a user based valuation. Even with no revenue a startup that has already 5 million users can be valued on the value of such a user base. Depending on market size and segment, a user maybe worth up to 50 cent. in that case the technical due diligence and user review is critical.
Outside Silicon Valley, valuation seems to be a magical value. Some investors work hard to push the valuation down. Others make their investment decision depending on the valuation, yet others have no idea how to deal with valuation in the first place. To overcome that situation, it is important for investors to help those who are simply less experienced.
Roundsize
There are ranges that experienced investors see over and over again. Like a software startup that needs less than €/$ 20,000 needs to be explored if the outreach is really made realistically. European Startups coming to Silicon Valley typically ask for €/$ 3 Million in their first or second seed round. Nobody knows where this number comes from but it seems communicated among european entrepreneurs. In other words round sizes vary big time. Unfortunately far too many investors focus on “typical numbers” rather than getting a deep and full understanding what it takes for a company to get to the next level and to the next level thereafter. Most typical rounds however range between € 100,000 to €1 ,000,000 in Europe, $ 200,000 and 2,000,000 in Silicon Valley, and $10,000 to $ 1,000,000 in Asia depending on the country.
Partizipation
Investors need to quickly learn the participation and dilution dynamics. As an early investor you may put together with 4 others 200,000 into a startup that has a post money valuation of 1,000,000. In this case you own 5% of the company, all 4 of you 20% and the startup keeps owning 80%. That’s a typical seed round. But also the very max the startup should give out. If they give more you, as a good investor should warn them. Most startups get killed by inexperienced entrepreneurs, working with inexperienced investors and seeing a rapid end already after an A-Round – if they even get there.
Already with the next round investors either keep investing and my keep their percentage ownership or get diluted. But even tough it may feel a bit sad to get down from, say 5% to 2%, the real good news is that the 2% is now worth more than the earlier 5%. It also means there is the much needed growth in value and thirdly it shows that other investors are interested now at a much higher valuation. So all good news.
Co-Investing
Solo investors, very much like solopreneurs, are usually not successful. We highly recommend to never invest alone and only invest with co-investors. If a solopreneur either due to lack of skills or due to greed cannot attract co-founders is very much the same as when you and the entrepreneur cannot attract other investors. Whatever it may be – something is wrong.
Co-investors live by the four eye principle, ideally are complementary and can share the work when doing the early assessments, contract discussions, due diligence and thereafter mentoring and nurturing the team.
Investment Decision
The actual investment decision needs to be made with great discipline and in accordance to the investment strategy that was setup by the investor and its very personal objectives. Opportunistic investments despite the fact that one has no idea about the business but it sounds so great is a very bad idea. Having decided to invest in companies with a high potential that is can become a company and bring it to an IPO, it would be a very bad investment decision, if the majority of co-investors are very open to sell early of the right opportunity presents itself. They key to good investment decisions is having an investment strategy in the first place. Those strategies are rather individual yet, everything but a secret.
Due Diligence
The due diligence is the process to go through everything possible that proves what the company was telling the investor and making sure that everything is inorder. There are typically three distinct reviews in a due diligences.
1) Legal Due Diligence
Reviewing that the business is registered, taxes are reported and paid. No undisclosed legal cases are filed.
2) Business Due Diligence
The first and most important act is interviewing a few customers.
3) Technical Due Diligence
Investors either do it themselves or find an experienced engineer who can review the product and see if it is professionally built, it does what it is supposed to do, is scaleable or of that is a future plan, there is a technology or technique to make it scalable. Also in the technical due diligence is a good chance to conduct database reviews to see the sequence of signups, customer usage pattern, even with most hardware products.
Mentorship
Startup investments are also called “smart money”. The best entrepreneurs look for more than just cash. Top entrepreneurs know that startup investors are usually entrepreneurs themselves who made so much money that they can easily afford a few total losses. And those are the most sought after investors as they bring much more than just cash – but the experience building great companies. Mentoring investors bring “smart money”.
In today’s world most first time entrepreneurs have barely seen enterprises from the inside. Many had great ideas at school and just couldn’t wait to start a company. They have no experience, cannot have it and one of the reasons they have such a potential is the fact they look at problems with a very idealistic mind. And that needs to be preserved – yet supported as they will hit roadblocks.
Reporting
Reporting from startups cause epic discussions. The main endpoints of those discussions are let the work and forget reports on one end and make sure they themself know if they are on track and ask for weekly reports. Our experiences have shown that the lose end with no reports is extremely risky, and the tight end with weekly reports never killed a company if the reports are kept of meaningful size and relevant content.
Reports are a key instrument to navigate a company in completely unknown waters with no chart. A GPS and a depth sounders are literally magic tools in that case. Monthly reports with weekly calls is one way to balance the reporting discussion.
The better entrepreneurs learn and understand that reports represent the most critical feedback system on a path into the unknown they will appreciate reports the most.
Follow-on Investments
Highly successful startups grow extremely fast. The consequence is that they consume cash accordingly. And as long as it is growth financing it is all good. In order to help the company with their timing, investors are asked to help plan follow on rounds early on. Typically 6 month after funding. Rather than going fundraising when cash is short, it’s good to jointly initiatie the follow on financing at least 6 month before they run out of money.
Investors can easily socialize the idea early on with their peers and pre-select candidates. Investors can also carefully watch growth data and work with the management to keep or better increase the pace.
Most of the times angel rounds are followed by venture rounds. Old style VCs tend to push angels out. For some angels it’s good because it means paiday and exit. For more serious angels it’s a pity because the real return on investment relative to the early risk is after the first 5 to 10 years. BUt that can be navigated.
Troubleshooting
During the first ten years, a fast growing company is usually one to three times nearly bankrupt, looses at least twice the most strategic customers, maybe one co-founder and/or top team mates. Also those companies may get smashed in a legal fight or the technology gets suddenly outdated. Other problems include sudden market shifts or technological dead ends. Another situation that happens with more than 99% certainty are serious scalability problems. All that is not good, not nice, and one hopes to avoid it all – but the come with 100% certainty. If not – the team is care to risk averse and gets in trouble because of that. Trouble is therefore guaranteed. Angel Investors should turn in a different type of angel and be helpful. Help should be more psychologically than financially. The company needs to prove to get out of it on their own. Obviously there maybe cases that additional finance is necessary to keep the company afloat – but entrepreneurs should never get used to solve problems with extra cash.
Exits
While in Silicon Valley, entrepreneurs would get kicked out when they present an exit strategy before they even had their first successes, in Europe they get trained by Universities to have an exit strategy. The reason is nit quite clear but we can’t blame the startups. Obviously we expect a startup to have no exit strategy but take their business all the way to the top, even without a Plan-B. Investors on the other side need to have exits as part of their investment strategy.
One exit opportunity is when VCs step in as investors and wash out the early angel investors. If that is part of your investment strategy its good. If your investment strategy is “hold” and you want to keep the investment for the next 7 years, no matter what, than you need to have a dialog with potential angels early enough.
Investment Strategy
When creating an investment strategy for startup investments, ask yourself why are you doing it. Is it to work with very cool people, or to maximize a return, or to simply give back, or to possibly get a job later on, other reasons or any combination. Be very clear with yourself AND your investees. When dealing with money, there is no wrong, only wrong goals and wrong expectations. Ask yourself what happens when the first three startups you invested 100,000 each all go out of business – what does it mean to you? How many investments do you want to make? How much do you you want to invest in each company? How much time can you spend with each investment? What investment horizon do you look at? What return do you hope to get? What type of startups in which industry you want to invest? Be very clear about the company profile you want to invest in and what are parameters where you do not invest.
Consider: 8-9 out of 10 companies fail. Typical investments range from $25k to $100k per investor. Typical time between investment and a good liquidity event is 10 years. For a good risk handling 10 investments is the minimum. No more than 5% of your overall liquid assets should be used to invest in this high risk asset class.