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How To Invest In Startups – Part 1

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    This article is written by Yigit Ihlamur (@yihlamur), co-founder and general partner at Vela Partners, an AI-enabled venture capital firm. 

    As a venture capital firm, Vela Partners is frequently approached for advice about startups. How does someone build a successful startup? How does someone invest in a promising startup? Many articles try to answer the first question, but few take a stab at the second, and, consequently, the process of investing in quality startups remains frustratingly mysterious to many. 

    In this two-part guide, I will explain how to get started in startup investing. By the end of this guide, you will have learned the following skills:

    1. How to build a startup investing budget 
    2. How to determine your target market 
    3. How to build your startup funnel
    4. How to create an investment decision-making process

    But before we get started, it’s critical to understand that investing in startups is speculative and should not be done at the expense of more conservative investments found in your company’s 401k plan. Make sure you are maxing out your 401k and have adequate savings before engaging in startup investing. 

    The Differences Between Investing in the Stock Market and Investing in Startups

    Investing in the Stock Market

    When people say they are going to invest in the stock market, they are referring to buying an ownership stake (shares) in a publicly-traded company listed on the New York Stock Exchange, Nasdaq, or other stock exchanges. These publicly traded companies are regulated by the Securities and Exchange Commission (SEC) and are required to publicly report their earnings on a regular basis.

    For the most part, these companies tend to be mature, earn revenue (hopefully making them profitable), and follow proven business models. 

    It’s easy to purchase through online brokers such as Charles Schwab, Robinhood, Etrade, etc. All it takes is cash in your brokerage account and the company’s ticker symbol to easily purchase shares in the company. Each publicly traded stock has a designated abbreviation that represents the company. For instance, Facebook’s ticker symbol is FB, and Amazon’s ticker symbol is AMZN. An added benefit of purchasing publicly traded stock is that most of the listed companies you’ll find are liquid, meaning you can easily buy and sell them when you want to. However, your return on investment won’t surpass investing in “successful” startups. I say “successful” because the failure rate for startups is quite high, upwards of 90% of startups fail.

    And finally, with publicly traded stocks you can easily sell your investment when you want, whereas with startups your investment isn’t liquid so if you want to sell the startup you have invested in, you will have to wait probably 7-8 years, assuming the company is even viable. 

    Investing in Startups

    Unlike established publicly traded companies,  most early-stage startups are still discovering their business models. A business model is a method for how a company will go about creating products and selling them to customers. Being that a startup’s business model is a work in progress, usually these companies haven’t yet earned any revenue. By investing in startups, you are taking on much more risk because their business models are unproven and no one really knows if their potential customers will be willing to pay for their product at a price that will make the startup successful.

    The benefit of investing in a startup is the potential to earn a higher return than you would for investing in a publicly-traded company. When you invest in a startup, you have the ability to invest at a discounted price that doesn’t take into account the potential value of the company when it becomes profitable. Whereas if you invested in a mature company with strong revenue and healthy profitability, you are purchasing shares of the company at full price or potentially at a premium because the business is proven to be profitable.

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    Another benefit of investing in startups is that with large publicly traded companies you have very little impact on how the business functions, but with startups, you have the opportunity to meet the founder and provide them with valuable advice and introductions to people in your network that can help the company achieve its goals. Not only is it financially rewarding to invest in a successful startup, but it is also satisfying to know that your help contributed to the overall success of the company. 

    How do you pick the right startups to invest in?

    There is no one right answer, and no one knows the leading indicators of startup success. If someone did, then there would be one firm dominating the market. But there are ways you can minimize the risk involved in investing startups if you build your own process to evaluate as many startups as possible, build a disciplined qualification process to separate the great from the good, build a large enough portfolio to account for outlier potentials, and remain patient. Most investments will fail, a few will break even (or do slightly better), and one or two will succeed spectacularly.

    So with that being said, let’s get started with the first step in building your startup investment process.

    Step #1: Build a startup investing budget

    Although this asset class is probably the riskiest and most illiquid one out there, its return profile is the most promising. As a starting point, allocate a budget as you do for your 401K. This should be an amount that you won’t touch for a long time. Choose an amount that is low enough to not materially change your life should you end up losing it. In other words, only use funds for startup investing that you don’t mind losing.

    How much capital you should allocate varies based on your risk profile. Young professionals may have a higher risk appetite, fewer commitments in their lives, and a longer time horizon for returns. Their allocation of capital for the startup asset class may be much higher than a professional with a few kids at school. Your net asset allocation to startups should be between 5% and 10%. You can increase this allocation as you build more confidence over time. 

    The next step is to determine what your diversification strategy will be. Based on our studies at Vela, we estimate that ~5% of a typical venture firm’s portfolio brings an outlier return (100 times return on investment, or more). This means that 1 out of 20 startups may bring more than 100x return on your capital; even if 19 of your portfolio companies go bankrupt, the return on your capital will be large enough. Let’s think of this scenario. If you invested $1 for 20 companies, your return in this scenario would be $80 ($1 * 100 – $20). With this in mind, the suggestion is to invest in at least 20 companies. 

    The other aspect of diversification is the rhythm of investing. Should you invest in 20 companies in a period of one month? Probably not. You should invest in at least 20 companies over a period of some time to avoid the time bias or in other words seasonality. For example, at Vela, we invest in 20+ companies over a period of 3 years. 

    Step #2: Determine your target market

    Now that you know your budget and how many startups you will aim to invest in, you can calculate how much you can invest in each startup. It is time to determine your target market.

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    If you do not know who your target market is, that’s okay. Put yourself into exploration mode for the next 3 months and do some market research: 

    1. Update your calendar for a regularly scheduled time to learn about startups. It should be at least a few hours per week.
    2. Read about startups and the investment theses of other venture capital firms.
    3. Attend startup events and “demo” days.
    4. Ask other startup investors if they can share the pitch decks they are looking at. You can connect with startup investors at SVIC’s Facebook group. 
    5. Review at least 100 startups. The more startups you review, the better. Only by reviewing dozens of startups will you learn the patterns that signal which startups are critically flawed.
    6. After each startup investigation, score it on the promise or quality of its various dimensions, including its team, market, and idea. 

    After reviewing more than 100 startups, you will realize that you have no interest in investing in certain markets. This is good; in time, you will dismiss companies and categories immediately without having to think too much about it, allowing you to focus on the ones you like. 

    Determine what dimensions you care about most. Some example dimensions are team, market, location, innovation, and traction. Scoring startups this way will help you articulate what kind of startups you prefer to invest in. 

    Here are the most common dimension-driven strategies:

    1. Team-driven: Startups that were founded by friends, ex-colleagues, under-represented communities, ex-Googlers, etc.;
    2. Market-driven: Startups that pertain to a specific market (e.g. SaaS, finance, developer, retail, etc.);
    3. Location-driven: Startups you can visit face to face;
    4. Innovation-driven: Startups with a focus on an innovative market or technology (e.g. quantum computing startups, machine learning startups, etc.);
    5. Traction-driven: Startups with more than $10K monthly recurring revenues and less than $5M in valuation.

    To Do:

    1. Open a Google Doc to create an investment journal to track your startup investing journey and to answer the following questions and save links from your research.
    2. Determine what your startup investment budget will be.
    3. How many hours per week will you dedicate to startup investing? Make sure to schedule recurring time on your calendar to review startups.
    4. Update your social media profiles to make it clear you are interested in investing in startups.
    5. Determine which kinds of startup dimensions (team-, market-, location-, innovation-, or traction-driven) you enjoy and explain why.
    6. Who do you know that invests in startups? If you know someone who does, reach out to them to learn about their experiences. 
      • Try starting a conversation within the SVIC community to connect with other investors.
    7. Scour the internet for information on startups and review venture capitalist websites and blogs to learn how they analyze startups.
    8. Review startup pitch decks to get a better flavor for what is included in a standard pitch deck.

    Well, that’s a wrap for part 1 of this guide. In part 2 of the guide, you will learn how to find deals and how to decide which startups to invest in. If you enjoyed this article, please share it! Also, please let us know your thoughts by leaving a comment in the comment section below or within the SVIC community

    Thanks to Jordan Thibodeau and Joe Ternasky for reading, reviewing, and editing this article.

    The content here is for informational purposes only. All views contained herein are my own and do not represent the views of Vela Partners LLC (“Vela Partners”) or any Vela Partners affiliate.

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