Tips for first-time startup investors

1. Mentally write your investments off

Facts and figures on startup success and failure are flying around. Some say 7 out of 10 fails, some say 9 out of 10. This market is still in its infancy, and putting together sensible statistics is quite challenging. However: assume that the chance is higher that a startup will fail than that it will succeed.

Good returns on a startup portfolio come from getting a few big hits in your portfolio, combined with a fairly solid base of mid-level successes. Those successes could take a while to realize, and the hits are relatively rare and extremely unpredictable. The failures will come more quickly, and they can hurt emotionally.

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. So if a company goes under: you have mentally written it off already, and the disappointment is mild.

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

People who are considering a startup investment are usually familiar with normal shares and bonds. 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 loans have several advantages over regular shares or loans.

Now pay attention to the next paragraph:

Basically, a convertible is a loan that 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 % discount on that price. Often there is also a cap on the maximum share price that can be used for conversion, so if the share has really gone ‘through the roof’ the investor still gets them cheaply.

Well if you didn’t understand what was written in the last paragraph, it is probably a good idea to educate yourself more.

Leapfunder offers online training sessions. Those get great reviews, and many investors have gone before you. It is useful to get tips from your investor friends and from the web. You can learn by doing, and soon you will probably start to think convertibles are perfectly normal.

3. Enjoy your due diligence, and take your time with it

So you come in contact with a startup, you have met the team, and they have done their short 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. Is the IP properly in the company, are there debts, is there a Good Leaver/ Bad Leaver agreement, are the smaller shareholders well pooled, etc?

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!

Naturally, Leapfunder also offers online training sessions that will help you learn everything you need to know.

4. Set up a good information flow after the investment

If you are used to investing in shares of listed companies, then you are used to being 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 we 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, you would wonder if they could better spend their time on their 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.

5. Be ready for a long-term relationship

We advise investing 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 theoretical possibility that you can sell your startup investment before the company achieves an exit, but the chances are low. There isn’t an active market in second-hand startup shares, so it would be very lucky to find a buyer.

Another thing: we would like to emphasize is that the success of your investments won’t just depend on picking good companies. It is also about what you add to the company after investing. Are you able to support the company from your network, and personal experience? Being an investor ideally 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. There is so much luck involved, and the timelines are so long, that it is unlikely that you will be able to pick the ‘hits’. By having a broader portfolio, your risk 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 should be able to spend time, and attention, on each of your companies.

Usually, it is a good idea to start investing relatively small amounts for a few years. Once your confidence grows, you can offer larger investments.

Often some of your best investments are follow-up investments into later funding rounds of your favorite portfolio companies. You have a lot of extra information once you have been a shareholder for a few years: that will allow you to put additional capital into your best performers. That’s how you can start to concentrate your portfolio on your winners.

7. Take the attitude of a beginner: ask for advice and follow angel training

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 lookout 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 that offer angel investment training. (Leapfunder does.) 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 we have written, we sincerely hope we haven’t scared off any (potential) investors. It is important for us 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 relationship 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.

Don’t underestimate the subtleties of startup investing.  Even if you had a startup yourself, investing in a startup is different than running one. Even if you are a financial investment professional, and know all about stocks and 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”. We 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.

If you have any questions: contact us at info@leapfunder.com.

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