7 tips for first-time startup investors

Have you considered investing in early stage startups? But you don’t know how to do it? There are questions you need to think about: How much do you invest? Where do you find startups? How do you balance your portfolio? If you don’t know the answers to these questions, don’t worry, you are not alone.

There are many investors who want to become a business angel and invest in startups, but don’t know where to start. In this blog post, I will give some tips to get you going. But before I do, I would like to talk a little bit about the history of startup investing: where are we coming from, and where are we going, in the world of startup investing.

So where do we begin? Well, only a few years ago startup investing was only for a lucky few. There were basically two reasons why this form of investment was very rare. First reason: it was very costly to invest.

The transaction costs you had to make — by hiring a lawyer that would help you develop contracts, for example — were quite high. The cost and difficulty of putting together a transaction meant that it would only be worthwhile if you were able to invest > € 100k. That’s a big amount, especially when you have to build a portfolio of five to 10 companies with investments that big.

That meant Angel investment was only for the successful entrepreneurs, or for the former CEO’s and CFO’s of the world, who had a lot of money on their hands at the end of a career. But that was not the only problem: even when you have all the money in the world, where do you find good startups? It was quite difficult to find startups, even for enthusiastic investors. There just isn’t a single place where they all hang out. If you don’t see enough potential deals then it is difficult to build a good portfolio. Of course, at the same time, it was difficult for many good startups to find investors. On the whole, it is fair to say: this market didn’t work very well.

Nowadays these barriers have been reduced: there are online investment platforms that use standardized contracts and offer instant access to a range of companies. Because of this, Angel investing is now available to everyone. On these platforms interesting startups can be easily found: everyone comes together on the same website. Investing can start from as little as € 1,000, since transaction costs are negligible.

With a website like this, everyone can get passionate about investing in early stage startups. You can find yourself working alongside enthusiastic entrepreneurs who want their company to become the new Google or Facebook. Let’s face it: that’s pretty cool. Investors find that it gives a lot of energy to help early stage startups to reach their goals. You might say: we are in a golden age of startup investing.

Below I have some tips you might find useful. But there is one thing I would like to emphasize: Be careful when investing in startups. Although everyone can invest now: startup investing is not for everyone. You will find yourself dealing with complex financial products and highly risky investments; make sure you don’t invest money you can’t afford to lose.

Enough introduction: let’s now go on to the seven tips when dealing with startup investing.

1. Mentally write your investments off

Facts and figures on startup success and failures are flying around. Some say seven out of 10 fail, some say nine out of 10. Some say that startups in accelerators are less/more likely to fail, some say that startups who have blue in their logo have a much higher/ lower success rate than startups with red in their logo, and so on…

This market is still in its infancy, and putting together sensible statistics is quite challenging. However, I dare to conclude that the chance is higher that a startup will fail than that it will succeed. This means for investors that for any startup company they have a higher chance of losing their investment than making money.

Good returns on a startup portfolio come from getting a few big hits in your portfolio. And those hits could take a while to realize, and they are relatively rare. So the first advice anyone should give you: please only invest money that you can miss. You should be willing to mentally write off your investment when you start.

2. Learn to use the financial instruments that are designed for startup investing

People who are considering a startup investment are usually familiar with how normal shares and bonds work. However, in the world of startup investing there is a range of unique financial instruments, which you will need to learn how to use. In particular, convertibles are becoming the norm. Convertible equity or convertible loans have several advantages over regular shares or loans. Now pay attention to the next paragraph:

Basically, a convertible is a loan which accumulates interest over time, and is eventually converted into shares. The conversion happens at the so-called qualifying event: usually the first major equity investment round. At this conversion, the convertible investors get the shares at the price used in this investment round. Of course they invested their money much earlier, and so they get a pre-agreed percent discount on that price. Often there is also a cap on the maximum share price that can be used, just in case the share has really gone ‘through the roof’.

Well if you didn’t understand what was written in the last paragraph, it is probably a good idea to educate yourself more by going online, or to find someone who can explain it to you. If you don’t know what is meant by interest, discount, cap and a qualifying event, then you may lack some basic knowledge that you will probably need at some point when you decide to invest in startups.

If you don’t understand the mechanisms of startup investing, you risk the chance of being disappointed. The interest, discount, cap and qualifying event are the basics of a convertible. Even if you have mastered the basics, then come the specifics! I will elaborate one example below to show what the impact of a ‘specific’ can be:

The question investors in convertibles often ask is: what percentage of the shares will I potentially receive when my convertible converts? Let’s say the investor invested € 100,000 and at the time of the conversion, the valuation of the startup is € 1,000,000.  It’s tempting to think that you will receive 100,000 divided by 1,000,000 = 10 percent. However, this isn’t correct and I let explain why.

When convertibles convert into shares, the startup needs to create new shares first! So the total should be increased with the number of new shares which have to be created, meaning 1,100,000. So the total percent share the investor will receive is 100,000/1,100,000 = 9.09 percent.

After this the new investors will still need to get shares: their investment was likely the qualifying event that caused the conversion. These further shares will reduce your percentage further: you don’t know by how much, because that depends on the size of that investment round. If you expected getting 10 percent but in the end you get 9.09 percent or even less, you will be disappointed.

3. The details of due diligence

So you come in contact with a startup, you have met the team, and they have done their two minute elevator pitch. Suppose you are extremely enthusiastic about the business idea and the team, and your gut feeling says you have to invest in this startup.

This is the time to take it slow. Put away your enthusiasm and look more closely at the details. Some details that you should always look at:

• How is the cap table formalized, or are there loads of small or inactive shareholders?
• Does the company have debts which they may not be able to repay?
• Is there a co-founder/shareholder who is no longer active and needs to be bought-out?
• Is there a shareholders’ agreement containing a strong anti-dilution, or liquidation preference?
• Are all the relevant IP and URLs owned by the company? If they have IP licences: do these have a sufficient length and scope?

You may not have heard of some of these terms before: it might sound like sorcery. You can find an experienced lawyer to help you but, again, a bill might be presented. A way to prevent high costs is to go and find other angels who have dealt with the same problems before.

Surround yourself with investment friends whom you can ask for help. Perhaps you can get into the habit of investing alongside them. Expanding your network is pivotal! Every company is different and every startup has their own details that you need to understand and get a good understanding about.

Generally, a fast way to get information about a startup is reading their Information Memorandum. Not all startups produce an Info Memo. But if they have written one, and they had someone experience or a professional help with it, then this is often a good starting point. Otherwise, you will need to collect the information yourself.

4. Set up a good information flow

If you are used to investing in shares of listed companies, then you are used to be able to check the daily share price of a stock and all the latest news online. With startup investing, this is not possible. A more hands-on mindset is needed. Startups work hard and every moment they spend talking to investors to give updates means that they lose valuable time which they could spend on their business.

At the same time, the startup has to build up a relationship with their investors. You can’t build trust in an instant. So I advise startups to send updates once a month from the beginning. If they are smart they will use the updates to ask for advice, introductions, and support. And if you are a smart investor you will stand ready to give that support.

Please remember: even if they send monthly updates, the quality of the updates can differ per startup. Not all startups have communication or financial experts in house that can send perfectly polished financial and strategic presentations. If they would, I would wonder if they could better spend their time on the business. If you have concrete questions: ask them. As long as you are offering good ideas and being genuinely constructive your emails will be appreciated.

In general: startups communicate a little differently. It is very important for you as an investor to stay updated. Before you decide to invest, you can ask the startup to send over an example update and make arrangements about updates that you are comfortable with.

5. Be ready for a long term relationship

I advise to invest in startups only if you think it is exciting and fun. If you want to make money fast, you would probably need to reconsider. Startup investing is a long-term thing. Most startups are cash flow negative for the first couple of years, meaning they lose more than they make. They are burning up investments, hoping to one day be able to earn money, and create a profitable business. Only after that, they can reward their early investors through an exit.

There is always a possibility to sell your startup investment before the company achieves an exit, but the liquidity is low. There isn’t yet an active trading platform on which supply and demand for startup investment positions is offered. Also, if you have shares in a startup you often cannot immediately sell off your shares to anyone. It is common for the legal entities to be arranged so that you first have to offer your shares to your fellow investors. I will not go too much in detail in this blog post. But again: if this is all new to you, please find a way to get more knowledge on this topic.

Another thing I would like to emphasize is that the success of your investments won’t just depend on picking the good companies. It is also about what you add to the company after investing. You are able to support the company from your network, and personal experience. So after investing don’t become too passive.

A startup is all about having a mindset which is set on discovering and exploiting opportunities. You, as an investor in a startup, can do the same. If you come across a potential supplier, or a potential client, mention that you know a startup which can be interesting for them. Being an investor actually means being an ambassador.

6. Diversify your portfolio

The headline news is simple: spread your portfolio. Don’t throw all your money at one startup. Often I see investors committing smaller amounts in five to 10 companies. For any company, there is a relatively high risk that the company will fail altogether, no matter how good it looks. By having a broader portfolio your portfolio won’t be ‘all or nothing’ like it is with just a single investment. Of course you shouldn’t invest in so many that you can’t keep track of them. You can start small.

When you are starting with your first startup investment portfolio you can chose to invest 1,000 euros in five to 10 different startups. That way you can get more experienced, and see if you enjoy it, without exposing an enormous amount of capital. Once your confidence grows you can offer larger follow-up investments to your favourite companies.

7. Ask for advice and follow angel trainings

With everything in life, if you haven’t done it before, you will probably not immediately do it perfectly. Startup investing is a skill that you can learn. Always be on the look-out to learn more, and try to educate yourself. For any topic it is likely that you can find an expert that knows more about that particular matter than you do. Perhaps you have some friends that have invested before and which you can learn from.

There are also places which offer angel investment trainings. These can be found online with an angel investment platform, but also at startup accelerators, for example. If you get to know more angels, you will be able to share your potential investment opportunities, learn from each other’s way of looking at things, and perhaps decide to invest as a syndicate.

Overall

Reading through what I have written, I sincerely hope I haven’t scared off any (potential) investors. It is important for me that an investor knows the mechanisms and risks involved in startup investing, and that the rewards don’t always have to come in the form of a financial return.

Investing in startups can be rewarding because of the direct relation you get with the startup. You can actually learn a lot from a startup, have a direct impact, and you can watch your investment grow. Also, don’t underestimate the subtleties of startup investing.

Even if you had a startup, investing in a startup is different than running it. Even if you are a financial investment professional, and know all about stocks, bonds, investing in startups is a very different thing. While talking about entrepreneurship startup guru Eric Ries once said: “a startup is an experiment, you have to do it, measure the performance and see what happens.”

I would claim that startup investing works the same: make your first (small) investments and see what happens. Perhaps it is not for you, perhaps it is your life’s calling. The only way to find out is by doing it.