Investing in the right startup company
“Nine startups out of ten fail.”
Is it a misconception or a myth? Because until recently, I believed that Napoleon was ugly short and that motivated his domineering behavior. I also strongly believed that the Great Wall of China is visible from space. Well, the first is a derogatory social stereotype. The second is a space myth.
But the startups failure rate is very high (not exactly 90% everywhere, and every time). The number might not be accurate to a tee but it’s a fact.
Just like urban myths, startups success stories tend to transcend the limit between the “factual” and the “Walt-Disney-like”. Have you ever heard of this tiny startup led by a brilliant outlier that overcomes great odds - and terrible stepmothers – to bloom into a publicly traded multibillion company? Thinking Amazon? Microsoft? UBER?
Well, let’s not forget the odds here.
Caution is needed and happy endings don’t quite happen often in the sharp-edged world of business. Success stories like Sequoia Capital’s 12,000% return from their investment in WhatsApp (acquired by Facebook in 2014 for 19 Billion USD) are sure exciting but scarce. The transformation to make-it-to-happily-ever-after takes a lot of capital, effort and risk.
In line with the Wald Disney stories, investors are commonly called “angel” investors.
To quote Andy Wu, assistant professor of business administration at Harvard Business School:
“Angel investors are a key component in the entrepreneurial ecosystem, providing indispensable capital that kick-starts the journey of tens of thousands of startup firms in the United States every year,”
According to a national study published in November 2017, the Angels said an average of 11 percent of their portfolio yielded a positive return. So much for the 9-out-of-10 odds.
This article sheds light on the strategies to make a great bet in the startup-investing arena. It goes without saying that, just like any other investment in stocks, IPOs or even cryptocurrencies, loss and reward are intertwined and one should only invest the money he or she can afford loosing.
Pick The Right Industry
It’s ground zero. Picking the right industry with a rational mind that filters hopes and dreams from cold-hearted facts is where everything starts for investors.
For instance, the startups with the highest success rate in the USA were Finance, insurance, and real estate. In fact, 58% of them were still operating after 4 years.
Direction is paramount and some great startups fail because they operate in industries with terrible market conditions (politics, society, international trends, all of these have a butterfly effect).
Another important factor is the experience of an investor in the field. It’s more than an intuitive choice. A seasoned doctor understands the risks of the healthcare industry more than an eager banker. In fact, statistics prove this claim loud and clear. A study called “Returns to Angel Investors in Groups” shows clearly that higher investment multipliers and investment returns were connected to investors’ industry expertise. Hence, an investor will curb failure risk by picking a “hot” industry that he knows best.
Avoid the All-In Approach
Once the right industry selected, it’s time to pick up the right horses for the track. Diversifying once portfolio is a way of dealing with the terrible odds of success. To this extent VCs, Investment Banks, Accelerators, and experienced Angels usually pick many startup companies even if they clearly see a huge competition potential between them.
Like we already established, more often than not startups return less than the initial investment amount. Hence, picking a winner that yields a huge ROI oftentimes makes up for picking many other doomed-to-fail startups.
Another diversification strategy is to invest in many startups across many industries with business strategies that are completely different. Furthermore, it’s wise to diversify the stage at which one would invest. It’s highly recommended to invest in some early-stage, some mid-stage, and some late-stage startups.
This reminds me of a general rule of thumb when investing in the Stock market – to curb unsystematic risk. A general consensus puts the sweet spot at 30 to 50 stocks. For startups, the “Returns to Angel Investors in Groups” study shows clearly the improved odds with diverse portfolios. In fact, while 48% of single ventures provided a 1x return, the number went up to 61% multiple ventures portfolios.
Due Diligence Is Key
This might be self-explanatory but due diligence also means that we shouldn’t invest in a startup because a dear friend, or a high profile investor is making the same move.
As it turns out, the same study listed above puts an accurate number on due diligence: it’s 20 hours. Investors that spent less than 20 hours investigating their portfolio items got an overall ROI of 1.1x. Those who spent more than 20 hours got a whopping 5.9 times their initial money. So much for the “Time Is Money” proverb.
On Being Continuously Involved
The post involvement after investing implies a close monitoring and advising of the burgeoning project until it fully penetrates the market and starts scaling. Angel investor should be willing to give off their time and share hindsight by mentoring the team, helping it establish business relationships through their own network and financially assessing its situation.
Being committed to monthly meetings on top of weekly reports assessment will help both investors and startup founders correct the project’s direction, detect any pain points early enough to intervene and foresee next steps/milestones. A great approach is to secure investors board seats in the startup to maintain a degree of post-investment involvement.
Getting the sought after ROI requires a combination of the above approaches to begin with. With that, one should comprehend that the drivers of success are more complex than mere talent and good fortune.
An amazing book by Malcolm Galdwell called Outliers identifies other equally important drivers of success such as the “10,000 hours” road to expertise, the opportunity, being born in the right place at the right time span, concerted cultivation, family background, a sense of entitlement and the list stretches even further. It’s not as intuitive an answer as one might have indeed.
There is magic in these beehives we call startups. There are abundant with energy, determination, will and emotions. This is what makes this new world so exciting for millennials and so misunderstood for Wall Street.
Pictures: Pixabay, Unsplash
Key words: Investment, Startups, Equity, ROI
Mehdi MEZNI - 2020
