Startup Investing Basics. If You Know Nothing, Read This

A lot of great content about the fine art of investing in startups and catching unicorns has already been published. It is too broad of a topic to cover in just one blog post or even a series of posts. So before we go on and write a full blown series, we thought we’d start with something that’s easy to digest and provide a few rules of thumb for investing. In future posts we’ll dive in deeper into the subject of investing and also provide references to our favorite startup investing resources.

But until then…

The first thing you need to know about investing in startups is that it’s hard.

Simply put, it is difficult to pick and choose the right companies to invest in. Most professional investors, angels and VCs have a low rate of success and in many cases, they don’t even make excess returns on their portfolios. However, when investors do make the right pick, they can generate massive returns. For example, A16Z invested a mere $250K in Instagram. That quarter of a million yielded $78 millions (!), or a 312X return on investment. Benchmark invested $12 million in Uber and got $7 BILLION (with a B) in return, which is 512X return on investment. There are many additional examples like these two, but there are even (many many) more examples of failed investments. Startup investing is a business of anomalies. One good pick can make up for many bad ones and generate significant profits for one’s portfolio.

Market and Growth.

Let’s start with the most basic question: What is a Startup? By definition[1], a startup company is a newly emerged business that aims for hyper-growth[2]. Meaning, the goal of every startup company is to generate a significant amount of value (which can come in many shapes and forms) in a pretty short time. Thus, startups carry significant business risk, which leads to a high rate of failure. But when startups succeed, they can generate massive returns for their investors. To put this in sport terms, startups don’t aim for a hit to get them to second base, but for a home run. And with such aggressive hitting, their chances of striking out are high.

Not every new small business is a startup. The two main conditions that a new business must meet to be considered a startup are:

  1. It operates in a big or about-to-be big market
  2. It has potential for hyper-growth

For example, opening a new mom-and-pop bookstore isn’t a startup. This business is limited in reach to customers who live nearby so its market is rather small, the intention of the founders is probably some money in their pocket every month vs. a significant increase in the value of the business, and since such business grows by opening additional brick-and-mortar stores, which requires significant (and mostly linear) resources, it probably doesn’t fit the hyper-growth mold. In comparison, opening an online bookstore could be considered a startup since it has the potential to serve a huge market pretty much on day one and it can grow very fast. (Note: due to some competition I’m not sure you should open an online bookstore or invest in one ????)

Our first rule of thumb is: look for a big market with real potential for hyper-growth.

Risk and reward: a timing thing.

The funding stages of a typical startup are:

  1. Seed Round
  2. A Round
  3. Growth rounds
  4. IPO/exit (if all goes well)

If things go well, the company’s valuation should increase over time with each funding round. At the seed stage, the company still has a ton to prove and validate. At this stage startups typically have nothing to very little on all the product, revenue, and customer fronts. Therefore, investing at such stage carries the highest risk. Highest in this case is very high, and investors in this stage have a good chance to lose everything they invested. But with that risk, comes potential reward. Investing that early means low valuations. For example, back in 2008 AirBnB’s seed valuation was only $1.5m. Nine years later, it was $31b. Assuming aggressive dilution of 80%, that’s a 400,000% return in nine years.

Investing in early stage startups, even before they go in hyper-growth mode, has the potential to generate these massive returns. In a perfect world, these are the investments you should aim for. Our second rule of thumb is: the earlier you invest, the higher the risk and potential return. If you find an idea you believe in, waiting is not necessarily a good thing.

Tell me about your greatest weakness.

Every idea has flaws, every market has (potential) competition, and every successful company goes through rough times. Lyft/Uber had a ton of regulatory resistance and AirBnB was not an overnight success. But those who recognized the potential of the idea, the market, and the teams involved were rewarded. It’s very easy to find multiple reasons why a company might fail, but that’s not always the right question. As an investor, you should ask yourself why this company is going to succeed.

Our third rule of thumb is: invest in strengths, because you can always come up with weaknesses.

Diversify.

Even the best investors lose their money on the majority of deals they invest in. That’s where diversifying comes in. Early-stage investors invest in many deals they like, and hope to get a few home runs that will more than cover the losses in the strikeout deals. Even if you really like one early-stage company, you should probably invest in multiple startups. That doesn’t mean that you should invest more than what you have or intended to – just use the same amount and allocate it to several deals. If you have $100K for startup investments, invest $20K in 5 different companies, instead of $100K in one company.

Our fourth rule of thumb is: spread the risk and invest in several companies, not one.

Even with diversification, early-stage investing is very risky and you should invest only what you can afford to lose. It’s also a long-term illiquid investment as it takes an average of 10+ years for companies to go through a successful exit (if they do at all) and during that time, it can be challenging for investors to sell shares, so don’t forget to take that into account.

Summary.

To be a great investor you’ll need access to investment opportunities and the ability to pick the right ones. Knowing how to “speak startup investing” can also help. We will continue to write about these topics in future posts. Until then, we recommend YC Startup Investors School. It’s a great resource that can help you navigate the unique world of startup investing.

Good luck!

 

[1] https://en.wikipedia.org/wiki/Startup_company

[2] According to this HBR article, hypergrowth is the steep part of the S-curve that most young markets and industries experience at some point, where the winners get sorted from the losers.

7 thoughts on “Startup Investing Basics. If You Know Nothing, Read This

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