The combination of public market alpha opportunities decreasing and legislation making investing in startups more interesting to more people, means startup investing is on the rise. While there is a plethora of information regarding investment management, there is a lack of it specifically pertaining to startups. With that in mind, I put together a quick list of things to consider in order to help bring new investors up to speed quickly.
- You can’t just invest in any company you want. Unlike the public markets, startups companies aren’t always taking money. You have to find a company that is actively raising funds and then find a way to get into that deal.
- There is opportunity in the trade as well as in the investment. In the public market, the trade is established and the only variables are time and price. In the private market, there is value in the trade: negotiating shareholder rights, pro-rata follow ons, etc. Read my post “The Investment and The Trade.”
- The buy-side is easier than the sell-side. With crowdfunding, the JOBS Act and AngelList, it is getting easier to get into deals. Getting out is a different story. While the sell-side is starting to shape up, there is no dependable standard on existing an investment position in a startup yet.
- You probably wont know what you investment is worth. In the public market there are constantly trades happening, which provide price discovery. In the private market, price discovery only happens when a company raises another round or is acquired. This means that it is hard to tell how your investments are doing.
- No one will give you advice (legally). Most financial services firms shy away from allowing their advisors to give guidance on startup companies. They do this because the firms don’t have adequate information or coverage on startups to stand by a recommendation to invest or pass. This creates a gap in financial advice. As investors increasingly turn to startups and the private market as a way to generate true alpha opportunities, they are left to their own methods of evaluation.
- The good deals are hard to get into. The paradox is that the best company can likely raise money from whomever they want, leaving the lesser known investors to the perceivably less valuable deals.
- Just because you invested in the startup doesn’t mean you get to see its internal ongoings. There is something called Major Shareholder rights, and if you don’t negotiate it (as a small investor) you may not be entitled so see things like financial updates.
- You may not own the percentage of the company that you think you do. It’s wise to negotiate pro-rata rights — that is, the right to by more shares in subsequent rounds in order to maintain your ownership percentage.
- Most of the time, you won’t really be able to help the company succeed. A lot of Angel Investors try to pick investments where they think their sepcific experience can help move the needle for the startup — a logical way to invest. The reality is, though, that most of the time, there are way more factors at play which will marginalize such a phenomenon.
- It’s nothing like Shark Tank. As cool and easy as Shark Tank seems, it’s really nothing like real startup investing. Deals don’t get made in 10 minutes, they take weeks. With the best companies there is less room for negotiation and most of the time, Angels can’t move the needle as do the Sharks on TV.
- Diversification is expensive. In the public markets, you can diversify by buying a mutual fund with about 1k. While investment minimums are coming down in the private market, you still need about 10k to get into any deal. Standard diversification would say you need to own 15+ companies to diversify away non-systemic risk; in private market investing, that is at least 150k.
- Diversification is less effective. Private market companies are less proven and therefore by definition, much more risky. While owning 15+ companies does diversify non-systemic risk to an extent, it still doesn’t ensure that one of your deals will outperform others. It’s quite possible that all 15 of those deals don’t do squat.
- It shouldn’t be all about making money. There is no doubt that there is a true shift of the efficient frontier when you add startups to your asset allocation. In fact, it may be some of the only true alpha addition left in the market. That said, it’s still risky, and having more in mind then just making money will help you on your journey. Understanding how your investment is having impact on communities or industries is important.
______________________________________________________________________
About the Author
This article was written by Brandon Gadoci.
