There are significant differences between investing in start-up companies and investing in publicly traded stocks or real estate assets. The most important difference is that investing in start-ups entails a greater risk of losing the entire investment. None the less, in an Exit event (company acquisition or IPO), such an investment can provide unprecedented returns.
Upon choosing to invest in a start-up company, there are a few critical steps one can take to mitigate the risk involved
1. Diversified investment portfolio
Assuming that the average investor does not have infinite capital, there is a clear advantage for splitting the capital among several start-up companies. We believe the magic number is 20. This course of action will help disperse the risk and increase the chances of an Exit event, which will further atone for potential losses in the investment portfolio. Choose the companies carefully, because there are many factors beyond the company’s ability to execute which influence the likelihood of success. Market forces and pure luck also play a role. Always remember that when dealing with long-term investments (investment horizon of 5-8 years for an Exit event), patience is key.
2. Access to attractive deal flow in relatively early stages
In Israel, while there are only a small number of experienced angel investors and VCs, there are a colossal number of companies looking to raise funds. It is quite difficult for a private investor with limited time to research start-ups and meet with entrepreneurs to understand where to invest. One can use filtering factors such as; venture capital funds, equity crowd funding platforms and of course, personal acquaintances with industry leading super angels. These factors are almost the only entry ticket for private investors to join investment rounds in these kinds of companies. Additionally, in early stage investments, the valuation of the transaction is relatively low, bringing high risk but large potential returns.
3. Study the entrepreneurs thoroughly
Many lead investors always say that the most important factor in start-up investments is the human asset: the talent. It is important to go over the entrepreneurs’ resumes. Are they serial entrepreneurs (previous exits)? Do they have a long-term vision? Are they a solid team (have worked together before)? Moreover, make sure that the founders complete each other in all areas of expertise (technology, management, marketing, etc.).
4. Scrutinize the Market/Competitors/Business Model
Scrutinize the industry and understand the field in which the company’s product/service operates. Ensure that the market is large enough, understand who the company’s competitors are (maybe there is a potential for acquisition) and what is the company’s competitive advantage. Establish that the product/service meets the needs of the target audience. Moreover, one must assess the company’s Business Model and make sure that the company has an effective monetization strategy (cash flow model) that will supply fuel for the company long term.
5. Study the investment round details
First and foremost, in order to calculate the expected stock holding percentage in the company, you will need to know the pre money valuation (company’s valuation before the investment) and the total round of investment (i.e. let’s assume a pre-money valuation of $4M and total round of investment of $1M). The combined value should be divided by your investment amount, which will give you the holding percentage in the company (i.e. as per our example, assume that out of the $1M investment round you are investing $50k, in this situation you will hold 1% in the company).
It is also important to check the legal documents of the company to understand which type of share is being granted. In the event of an exit, money will first flow to the preferred shareholders and then to ordinary shareholders. In addition, check whether as an investor you are eligible for data/information rights regarding the company’s progress and future participation rights in the event of further investment rounds.
6. Option for a future investment in the company
Startup companies go through several investment rounds during their lifecycle. First, the seed stage (usually the proof of concept stage), then more advanced rounds such as A, B, C, in which the company has already secured a product and revenues. It’s likely that the company will conduct another round of investment. In order to keep your shareholding percentage and avoid dilution you may want to invest additional funds. Angel investment rounds are usually worthwhile if you believe in the company and its ability to succeed. Participation in more advanced rounds is often difficult as the valuation of the company may be very high. In any case, it is common to expect a 20-25% dilution following investment rounds you choose not to participate in. It is important to note that investing in start-ups needs to come from available capital. I would not advise to take a second mortgage on your house for this purpose.
7. Research the company’s existing investors
In a case where investors have already invested in the company, it is suggested to run a background check and see if they can provide any added value to the company other than the capital invested. The ideal opportunity is to join a financing round alongside experienced angels or VCs who hold a proven track record. For example, successful exits, expertise in specific verticals and industries in which the company is working, and performing as mentors and advisors for the company and entrepreneurs post investment. Another significant contribution of investing alongside leading angels with extensive experience in the industry is the fact that they’ve already preformed their due diligence on the company in question. If they decide to invest in it, it is safe to assume that the company is fundable, and all the legal matters are in place.
8. Finally, what does the company intend to do with the funds raised?
How is the money going to be spent, what are the development and marketing goals and how does the company intend on reaching them? How are the funds going to be distributed between development and marketing and the milestones in which any major actions are going to be taken? It is recommended to invest in companies which engage in areas familiar to you as an investor so you can evaluate the company strategy in a more professional way.
The start-up nation is thirsty for angel investors – spread your wings and go for the kill.
Business Development Associate at iAngels, serial entrepreneur and an attorney specializing in high-tech.