3 Things To Think About When Investing In Startups

Recently I was out to dinner with a group of friends and one of them said to me: “Hey man I’ve invested in this incredible startup. You should really check it out and consider getting in.” This is a line that I have been hearing with increasing frequency over the last year and it is usually followed by some variation of “I’m so excited” or “they are doing something totally awesome”. As an investor in a tech startup I must admit that I too have fallen victim to such exuberance in the past but now with a bit more experience my attitude to such things has begun to change from one of blind optimism to one of realism or perhaps dare I say it (gasp) skepticism.

Why should we be skeptical when evaluating the merits of investing in a young company? We all know the entrepreneurial success stories that the media reports about ad nauseum; the Ubers, the WhatsApps, the AirBNBs, the Facebooks, the Twitters that went from zero to hero valuations at breakneck speed making their early investors wealthy in the process. In addition, it has become easier than ever for us to invest in such early stage companies through the proliferation of such ventures as well as online crowd funding platforms. In fact, the glamorous tales attached to these stories have become the stuff of legends immortalized by the news media and even Hollywood. Pay attention to the media and you could be led to believe that these golden boys are being minted everyday and thus the last thing you want to do is miss the next boat to adventure, freedom and prosperity. Time to jump aboard….right?

Make no mistake investing in a startup can be very lucrative as returns can go as high as 100 times your initial investment. But you can also lose your entire initial investment. So before you drink the Kool Aid and get into “the game” be aware of the following:

1) Are you ready and willing to lose every penny of your investment?

The bottom line is that making a startup successful is extremely difficult work. Contrary to the small statistical samples of success touted by the media, studies undertaken by Harvard Business School indicate that 3 out of every 4 venture backed start-ups fail to return investor capital. The numbers for tech startups are even worse at a 90% failure rate. Therefore, it is important to remember the precarity of any early success founders use as investor bait. For start-ups things can change very quickly and when things go wrong you probably won’t get any notice. Some common issues to be wary of are: What if the competition launches a new and better product which threatens the early traction the company has attained? (Not to mention that it has never been easier to launch a tech company given the availability of cheap developer tools and platforms.) What if Google or Facebook enter the space? What if another recession hits? What if one of the startup’s anchor clients decide to leave the platform? What if the company has a bad month of sales and can no longer meet expenses?

These very real possibilities beg the question: What kind of investor are you? As Dan Martell one of Canada’s top angel investors would say: “If you don’t have $150,000 you’re willing to put on black in Vegas and roll the dice, then you shouldn’t be angel investing.” To invest in startups requires a very high-risk tolerance and if you are not ready to write off your entire investment then look elsewhere.

Risk mitigation tips:

If you still want to invest I suggest investing no more than 10% of your money in startups and not investing it all in any single startup. Instead, it is quite possible, given the proliferation of online platforms, to invest equally in over 5 ventures enabling one winner to make up for any losers.

2) Are you going to need your money any time soon?

In investing parlance there is a crucial concept called liquidity. What this refers to is the degree to which an asset or security can be bought or sold on the market without affecting its price. In the case of startup shares there will be little or no liquidity and thus if you want to sell your shares you probably can’t or if you can only at a steep discount. Most likely, the only way you can get out is after the company has a liquidity event (IPOs or acquisitions) or exit (someone buys the shares hoping to make a profit during a round of financing).

The crucial takeaway is that these events take time to occur (often 3-5 years and sometimes even 10, if ever). Furthermore, be aware that although most companies die around 20 months after their last round of financing raising $1.3 million, many start-ups limp on for years, out of the public eye but still attached to the intravenous of early investor money. This is tied to the “hypomania” that many entrepreneurs suffer from that can be characterized by immense self-confidence, recklessness and over-optimism.

Risk mitigation tips:

Bone up on your behavioural psychology and spend time evaluating the personality of the founders. What kind of people are they? What kind of exit do they envision and how feasible is it? Also be prepared to lock up your investment for the next 5-7 years.

3) Be honest with yourself about your own business experience and expertise

We simply can’t know everything about everything and to be a successful startup investor it is essential to have a solid understanding of the business that you are investing in. This is the crux of good investing as without a good working knowledge of the performance metrics that matter in the particular industry or market niche within which the startup is operating you are setting out to learn a potentially painful lesson.

Risk mitigation tips:

If you are dead set on investing in a startup, first, try to create a list of what you know. Do you work at an advertising company, an online retailer, a medical technology company or a social media company? You may find that you know more than you think. Do your research and try to connect what you know to a startup that is trying to make something work in an industry you understand. This will help you make better decisions and may also allow you to help the young company grow once you have invested. Finally, if you haven’t the slightest idea about how to value a company I would strongly suggest taking an online course or at least reading a textbook on valuation and corporate finance.

Simply put, investing in a startup can certainly be a rewarding learning experience yet it is important to be prepared and to approach “the next big thing” with a healthy level of skepticism.