A guide to developing your startup investing strategy
The best strategy to startup investing is to make many small investments. Look for startups that show promise between the founding team and the market they are pursuing. If there are no red flags, this startup is worthy of a small bet. The trick is making enough bets to cover the risk so that your investment portfolio has a decent opportunity of scoring a huge return on the one or two startups that turn out to be a winner.
Startup Investing 101
Startup investing is a high-risk and high-reward venture. Maybe that’s why the associated investment industry is called venture capital. The reward part is obvious: we’ve all heard of success stories of startups. Everyone would love the opportunity to invest early into the next billion dollar business (known as “unicorn” because it’s so rare). The risk part needs to be stated as well: startups typically fail to return money to investors. So if you’re thinking about gambling on a startup, then you’re probably wondering where to start when considering what startup to invest in.
Early stage companies are nearly impossible to evaluate. This is why the U.S. Government places regulations on who can invest in startups (historically accredited investors, but this is expanding thanks to the Jobs Act and new 2020 legislation).
There are a lot of online resources to help investors answer the question “how do I get started investing in startups?” Start by reading through the Education Center at FundersClub (5 chapters!) and the FAQs on Wefunder.
What’s a smart investment approach to investing in startups?
Potential investors craft their approach on which startups to invest on an assortment of criteria. The most seasoned early stage investors explain that they know in the first 30 seconds of seeing a startup pitch if they are going to invest or not. They basically consider three areas:
The Founder Approach
Some angel investors will explain that making a good investment is all about judging the founder or founding team: have they successfully built a company before? Well, every successful entrepreneur had to build their first successful startup so if you only place bets on serial entrepreneurs then you’re missing out on most opportunities.
The Market Approach
Venture capitalists harp on the importance of the market. It’s known that when a startup gets ahead of a nascent market then they have a chance to define and own the market (typically maintain about 75% of the business!). Predicting what will be a new, hot market takes research.
The Product Approach
As much as seasoned investors like to talk about considering the founder or the market, the truth is everyone gets excited about a killer product. That’s not to say every great product will generate a successful business. Yet product is sort of everything at the early stage. This is what will get customers excited too. Consider that the only press coverage a startup gets is either around their innovative product or a funding round. So evaluating the product (or having someone else who is a potential customer evaluate the product for you) is a critical step.
The Best Approach
Regardless of how you balance such approaches, the only tried-and-true startup investing strategy is the shotgun approach. Making lots of small bets means making an investment decision on a single, new startup is less risky. Getting a return on investment is hedged by the amount of different investments made.
Investment platforms for crowdfunding (like WeFunder) and angel syndicates (like AngelList) provide investment opportunities across a wide range of startup companies. Equity crowdfunding platforms take advantage of new rules in place so that early investors do not have to be high net worth individuals yet startups can take many small investments easily. The minimum investment can be as little as $100.
Here are some frequently asked questions:
What’s an example of a startup with a proven founder with a unique product pursuing a new market?
Unitonomy comes to mind! Charley Miller is a proven innovator who co-founded Touchcast. Unitonomy is cornering the culture management software market and how AI will augment knowledge workers. Their lead product is Glvvv, which solves emailing yourself. http://unitonomy.com/invest
When does an investor make money or get their return on investment?
This can depend on the nature of the company but for early stage investors they typically make money when the company is involved in an acquisition by a larger company or the company goes public with its stock and lists on a public stock exchange.
Do I have to be an accredited investor to invest in startups?
Startups typically raise money in private offerings pursuant to certain exemptions from registration under federal and state law. Private offerings come in many shapes and sizes but the most typical form that startups use requires that investors are accredited. That is not always the case and the landscape is changing to some degree with the new laws mentioned above that have increased the frequency of certain fundraising platforms such as crowdfunding that facilitate startups raising capital in a manner that is more suitable to investors that are not accredited.
How do you perform due diligence when the startup has no revenue yet?
Even without revenue there is plenty of diligence that can be undertaken. The startup likely has some amount of funds that are being expended in operations so financial diligence regarding the company’s expenditures and burn rate is still important. Additionally, regardless of revenue, all other aspects of a typical business are worthy candidates for diligence such as contracts, founder and employee credentials, market outlook, competitors and the business plan to name a few.
How often do startups fail?
Frequently. Startups that attain sustainable profitability is certainly the exception, not the rule. Markets are competitive and the high failure rate of startups is evidence.
Should cash-flow and revenue be evaluated when assessing a startup?
Yes, cash-flow and revenue are critical to every business and startups are no exception. Startups often have a period of time before generating any revenue but even at that stage an investor can evaluate the company’s projections for when it expects to generate revenue, how much cash the startup has available to fund pre-revenue operations and the burn rate for that cash.
What is the difference between a SAFE and a convertible note?
Strictly speaking, a SAFE is a warrant to purchase stock in a future issuance by the company while a convertible note is debt with the right to convert into equity upon certain specified events. In both cases the result is often equity obtained at a future time based upon the pricing of the applicable future equity round.
What’s the difference between a tech startup and a small business investment?
That often depends on who you ask but the most common distinction is probably the company’s objectives. Startups are typically focused on very high, explosive growth, often with the goal of creating that growth through some kind of new technology and/or market disruption. The goal of a small business is typically steadier growth and profitability with a longer term, sustainable time horizon in mind.
Is Kickstarter an equity crowdfunding platform for startup investing?
No, Kickstarter does not provide equity to the users that donate to Kickstarter projects. Rather, Kickstarter is a funding platform for creative projects with the project backers typically receiving a reward related to whatever the project produces.
Do I have to invest in the next Amazon, Google or Uber to make a lot of money?
No. Amazon, Google and Uber are prominent examples of startups in which early investors were nicely rewarded. However, the more common path for a successful startup is an exit (either the acquisition of the company or going public with its stock) with much less fanfare that still pays significant upside to early investors.
Who are some of the top investors to follow for guidance or ideas on startup investing?
Here’s a lucky 13 list of early stage investors (some VCs and some angel investors) to jumpstart your Twitter feed. These folks are a diverse set to give you a balanced report.
- Cindy Bi (@cindybisv)
- McKeever Conwell (@macconwell)
- Todd Goldberg (@toddg777)
- Merci Victoria Grace (@merci)
- Christoph Janz (@chrija)
- Andreas Klinger (@andreasklinger)
- Shervin Pishevar (@shervin)
- Katie Jacobs Stanton (@katies)
- Lolita Taub (@lolitataub)
- Monique Villa (@moniquevilla)
- Hunter Walk (@hunterwalk)
- Fred Wilson (@fredwilson)
- Joanna Wilson (@thegothamgal)
What’s more lucrative: investing in startups or real estate?
That’s impossible to answer because there are so many variables. There’s typically more upside potential in investing in startups but also more risk in comparison to real estate. One might want both in their investment portfolio.
Do venture capital firms invest in early stage startups?
VC firms do invest early but it depends on the venture capital firm. Early stage startups used to be the domain of angel investors but more investment funds of various types appear to be dipping into early stage startups more frequently. Some VC firms even want to be “the first check” at the idea stage. More often venture capital comes in at the seed or series A stage for startups that have proven product-market fit and need funds to scale.
What is the difference between pre-seed, seed and series A financing?
There are no hard definitions to these funding stages. If you talk to enough founders and investors, everyone will provide a slightly different scope. Generally anything pre-seed is considered to be a startup that has yet to take their product to market, anything seed is a startup with their first form of proof that are onto something valuable, and series A is when a startup has proven product-market fit and is ready to scale their offering.