Investing in startups is not a wet finger and you know it. Wondering how much you want to invest? Where to find startups? How will you balance your portfolio? If you don’t know the answers to these questions, don’t worry, you’re not alone. Many investors want to become business angels and invest in startups, but don’t know where to start. Here are seven tips for your first ticket.
Only invest money you can lose
Startup stats are legion. Some say that 7 out of 10 startups die prematurely, others grow to 9 out of 10. Some say that accelerator-backed startups are more or less likely to fail, others say that startups with a blue logo have a much higher success rate than those who have red. in their logo… unless it’s reversed? This market is still in its infancy and it is very difficult to gather reliable statistics. However, I venture to conclude that the risk of failure for a startup is higher than its success. This means for investors that for any new venture, they are more likely to lose their investment than to make money. Good returns on a portfolio of startups come from a few big successes. These hits can take a while to happen and are relatively rare. So the first advice you should follow: only invest money that you can lose. You must be ready to mentally amortize your investment when you start.
Learn how to use financial instruments designed for startup investing
There are a number of financial instruments that you must learn to use. Convertible bonds or convertible loans have several advantages over ordinary shares or loans. But be careful! A convertible bond is a loan that earns interest over time and is eventually converted into equity. The conversion takes place during the “qualifying event”: generally the first major fundraiser. During this conversion, the “convertible” investors obtain the shares at the price used in this investment round. Of course, they invested their money much earlier and therefore get a pre-agreed percentage reduction on this price. There is also often a cap on the maximum price of the stock that can be used, just in case the stock has really exploded.
If you do not understand what is written in the last paragraph, it is probably a good idea to find out more by going online or finding someone who can explain it to you. If you do not know what is meant by interest, discount, cap and qualifying event (which proves go to the market), you may be missing some basic knowledge that you will probably need at some point. If you don’t understand the mechanics of seed investing, you may be disappointed. Interest, discount, cap and qualifying event are the basics. Then come the details!
The question investors often ask is: “what percentage of shares will I potentially receive when I convert my convertible bond?” Suppose the investor invested 100,000 euros and at the time of the conversion the valuation of the startup was 1 million euros. It is tempting to think that you will receive 100,000 divided by 1,000,000 = 10%. However, this is false. When convertibles are converted into shares, the startup must first issue new! The sum must therefore be increased by the number of new shares to be created, i.e. 1,100,000. The total share that the investor will receive will thus be 100,000/1,100,000 = 9.09%.
After that, new investors must still acquire shares: their investment was likely the qualifying event – the fundraising – that triggered the conversion. These additional actions will reduce your additional percentage. You don’t know how much because it depends on the size of this investment round. If you expected 10% but got 9.09% or even less, you will be disappointed.
Pay close attention to details
So you get in touch with a startup, you meet the team and they make their presentation in two minutes. Let’s say you are extremely excited about the business idea and the team and your instincts tell you to invest in this startup. It’s time to slow down. Put your enthusiasm aside and look at the details.
Some details you should always look at:
- How is capitalization formalized? Are there a multitude of small or inactive shareholders? Does the business have any debts that it may not be able to repay?
- Is there a co-founder/shareholder who is no longer active and whose shares must be redeemed?
- Are all relevant IP addresses and URLs owned by the company? If it has IP licenses: are they of sufficient length and scope?
You may not have heard of some of these terms before and it may sound like witchcraft. You can find an experienced attorney to help you, but again, a modification bill can pop up at any time. One way to avoid high costs is to seek out other business angels who have already faced the same problems. Surround yourself with investment-savvy friends you can ask for help. Maybe you can make it a habit to invest with them. Expanding your network is important! Every company is different and every startup has its specifics that you need to understand.
Stay informed about the day-to-day life of the startups you invest in
If you are used to investing in shares of listed companies, you are used to checking online for a stock’s daily price and all the latest news. With seed investments, this is not possible. A more practical way of thinking is needed. Startups work hard and every moment spent with investors to inform them wastes precious time on their activity. At the same time, the startup must establish a relationship with its investors. You can’t build trust overnight. So I advise startups to send out weekly newsletters. If they are smart, they will use these newsletters to ask for advice or additional support. If you are a savvy investor, you will be ready to provide this support.
However, not all startups have communications or finance experts capable of delivering well-rounded financial and strategic presentations. If they could, I wonder if they should spend their time on the business instead. If you have specific questions: ask them. As long as you come up with good ideas and are 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 informed.
Be ready for a long-term relationship
I only recommend investing in startups if you find it exciting and fun. If you want to make money fast, you should probably reconsider your decision. The start-up investment is long-term. Most startups have one cash flow negative for the first two years, meaning they lose more than they win. They burn investments in the hope of one day being able to make money and start a profitable business. Then they can reward their first investors with an exit.
There is always a chance to sell your seed investment before the company makes an exit, but liquidity is low. There is not yet an active trading platform where supply and demand for seed investment positions are offered. Also, if you have shares in a startup, you often cannot immediately sell them to anyone. It is common for legal entities to be organized in such a way that you must first sell your shares to your co-investors. I will not go into too much detail in this article. But again: if this is all new to you, find a way to learn more about this topic.
I would also like to point out that the success of your investments does not depend only on the selection of good companies. It is also about what you contribute to society after investing. You can support the company from your network and personal experience. So after investing, don’t get too passive. A startup is about having a mindset focused on discovering and exploiting opportunities. As a new investor, you can do the same. If you meet a potential supplier or customer, mention that you know of a startup that might be of interest to them. Being an investor actually means being an ambassador.
Diversify your portfolio
Don’t put all your eggs in one basket. I often see investors who commit small amounts to 5-10 companies. For any business, the risk of failure is relatively high, regardless of its quality. By having a bigger wallet, you avoid the “all or nothing” side. Of course, you should not invest in too many startups, you should be able to keep up with their news. When you start with your first portfolio of investments, you can choose to invest 1000 euros in 5 to 10 different startups. This way, you can gain more experience and see if you’re making a profit without putting out a huge amount of capital. Once your confidence increases, you can invest more in your favorite companies.
Seek advice and take business angel training
Seed investing is a skill you can learn. Always be looking to learn more and try to educate yourself. Regardless of the topic, chances are you can find an expert who knows more than you. You may have friends who have already invested, there are also places that offer angel investment training. If you get to know more business angels, you can share your potential investment opportunities, learn from how others see things, and eventually decide to invest as a syndicate.
Reading what I’ve written, I sincerely hope I haven’t scared away any (potential) investors. It is important for an investor to be aware of the mechanisms and risks associated with seed investments and that the reward does not always translate into a financial return. Investing in startups can be rewarding because of the direct relationship you have with it. You can actually learn a lot from a startup, have a direct impact and see your investment grow. Also, don’t underestimate the intricacies of startup investing. Even if you had a startup, investing in another one is very different. Even if you are a financial investment professional and know everything about stocks, bonds, investing in startups is something else entirely. Make your first (small) investments and see what happens. Maybe it’s not for you. The only way to find out is to do it.
This article was originally published on Medium in English by Leapfunder.