Advice for Investing in Startups

Una version de este post aparece en español con el titulo Lo Que Debes Saber Antes de Invertir en Startups. También fue una charla (video).

As startups and tech investing has gone mainstream with things like AngelList, Shark Tank, The Social Network, the proliferation of accelerators and incubators, and the celebritization of founders and VCs, more money has flowed into the industry.

Most non professional investors interested in startups are starting to dabble in early stage companies as angel investors. Friends often send me deals they’re think about investing in, asking for advice.

Here’s a concrete example of a typical question from a successful entrepreneur friend looking to invest:

I am starting to look at some investments in startups that have proven initial product-market fit and revenue traction with positive gross margins. I have found some great opportunities [and] I am only targeting businesses that meet my personal criteria. My biggest concern is how I should evaluate the businesses from a valuation perspective. Is there any guide suggested on this?

I personally am finding companies that claim to have a higher valuation than my own company which has greater revenues and faster growth rates, etc. So, that puts off a bit of an alarm in my head but I realize it’s normal in the VC world. I don’t really know how to value a VC backed start up.

I decided to share my answer:

Here’s a few quick thoughts from what I’ve learned running a small seed fund.

I’m standing on the shoulders of giants with this post and am not adding much new info. Read Brad Feld’s article Suggestions for Angel Investors; It’s the best, primers I’ve seen. Look for other investors who have shared their investment strategies like Samuel Gil, Roger Ehrenberg, Brad Gillispe on the VC end of the spectrum and Fabrice Grinda, Dave McClure, Paul Graham and Tim Ferriss in Tools of Titans on the angel end of the spectrum. There’s many more great examples, google them.

I highly suggest reading Brad Feld and Jason Mendelson’s Venture Deals before investing, as it’ll help you understand the legal structure, terms and definitions so you don’t get screwed.

Here’s my advice

1. Invest as if you’ll never see the money again

Never invest money in startups that you cannot 100% afford to lose. Even if you can afford to lose your investment, don’t invest if you’re not comfortable losing your investment. Notice the difference between being able to and being ok with losing your investment.

Startup investing is extremely risky. It’s even more risky when you’re getting started. Mentally write off your startup investments and you’ll sleep better at night.

2. Decide the total amount you’ll invest and stick to it

Many people who go to Vegas create a budget of how much they’re ok losing at the tables and have a hard rule to quit when they hit their number. Set aside a personal fund that you’ll invest over time. It’s easy to chase deals and invest more than you set out to, crossing over into even higher risk territory.

3. “Be promiscuous” – Brad Feld

Investing in startups is a quantity game. You’re very likely to lose money if you only invest in a few startups, as its incredibly hard to pick winners. This doesn’t mean you should “spray and pray”, investing in tons of deals you know nothing about because you likely don’t have access to enough good deals to make this strategy work, but if you plan to invest in 1-2 companies, the numbers say you’ll likely lose.

4. Make rules and stick to them

Some questions to ask yourself to help set your rules:

  • What’s the maximum valuation you’ll invest in?
  • What niche/industry will you invest in?
  • Will you lead rounds? Or only co-invest?
  • How much will you invest in each deal?
  • What is the total amount you’ll invest of your net worth?
  • Will you invest in companies that you can add value other than money? Or just money?
  • What’s the minimum return you’re looking for on each deal if it goes well?

Different people have different strategies. For example, Tim Ferriss will only invest if his investment can return his entire “fund” set aside for all of his investments if the company does well, along with meeting the rest of his criteria.

My fund only invests in startups that have their tech team in Latin America, but target the US market or B2B startups that operate in Latin America. We try to be the first check into a company. We’ll always invest $25-$75k as our first investment and can follow on with up to $250k. We’ll only invest in companies where we can provide value other than money.

When we’ve broken our rules in the heat of the moment, we’ve lost (or will lose) money.

5. Valuation is important

Pretty obvious, right? Many people get this wrong.

We only invest in a company that meets all of our standard criteria, but also where the valuation can give us at least a 15x upside if everything goes right. For example, the best Latin American startups only targeting the Latin America market generally exit for $10-$25m, with a few outliers of $50m. This means that we need to invest at $750k to $1.5m valuations for our Latam B2B investments to make sense.

In an average startup portfolio distribution of 10 companies, ~6-7 companies will fail, 1 will return the original investment, ~1-2 will make a small return and you need the last company to return at least ~6-7x just to break even, not to mention make money.

6. Realize that $1b and $100m valuation companies are very rare

From Aileen Lee’s post, from 2003-2013, there were only an average of four $1b companies created per year. The pace has increased to 25-50 per year through mid 2016, but many of these companies have had massively lower valuations since then. There have only been one to three $100b+ companies per decade. Will you find one of the rare $1b companies and beat out the pros?

According to multiple VCs I’ve met, there are only ~6-10 new SaaS companies that reach $12m Anual Recurring Revenue (ARR) each year. These generally end up with ~$100m valuations when they raise money. Will you find one?

Conversely, there are many new companies each year that end up valued in the $20-$50m range, making it much more likely you’ll invest in one.

What does this mean? If you’re investing in a SaaS company at a $5m valuation, you’re getting 20x returns (minus dilution) if you’re in one of the top 6-10 companies per year. Does that make sense as an angel investor? If you’re more likely to invest in a $20-$50m company, which means you’ll get 4-10x returns, minus dilution, does that make financial sense?

The chances that you’re getting in the best deals are likely pretty low.

As Roger Ehrenberg put it:

Remind yourself that massive adverse selection is at play. The best angels (read: the most experienced, most value-added, most connected, most highly respected) see the best deals. The others see, well… This is why if you are new to angel investing that you should hook your star to angels far more experienced and skilled then you, respectfully ask for small amounts of capacity in their deals and try to only focus on deals where you can add something to the syndicate, e.g., a few domain-specific connections, a few business development contacts, etc.

7. Invest a set amount

Brad Feld invested $25k as an angel. We use a range of $25-75k. Set a rule and stick to it. Avoid the emotional pull to invest extra money in your first few deals.

8. Invest in rounds led by experienced angels or micro vcs

You’ll avoid having to do all of the legal due diligence, paperwork and will have the chance to learn from someone with more experience.

9. Think about AngelList or Founderlist (in Latin America)

You can follow professional investors and get access to more deals by joining a syndicate.

10. Balance your portfolio

I personally use Taleb’s barbell philosophy, where I invest a small % of my money in very high upside, high risk opportunities (startups + options) and invest the rest in stable, low risk, lower return opportunities. Most recommendations I’ve seen advocate investing a maximum of 5-10% of your net worth in startups

For example since I’m heavily investing in startups, which are nearly binary outcomes ($0 or big returns), I make sure to balance risk with cash flow investments: stable, traditional businesses, SaaS companies that will never have hyper growth, but throw off profits, unleveraged real estate, and other income generating investments.

Photo credit: David Yu