Take these 8 steps to become an all-star startup investor

Show of hands: Who here doesn’t want to invest in the next Facebook or Google?

Didn’t think so.

The people who invest in startups have supplanted hedge fund managers as the investment rock stars of our age. What makes startup investing so thrilling is that unlike the passive investing common in the stock market (see our Ultimate Stock Market Investor’s Guide to Investing in Startups), angel investors have the opportunity to provide ongoing value with their experience… and Rolodexes.

Whether you’re just kicking off your career as a venture capitalist or starting out in angel investing after making your money in other businesses, investing in startups can be a very lucrative activity. In fact, the data show that well-positioned angel portfolios can return 2.5X over a 4-year period. Returns like these easily trounce stock market returns (and historical returns of most other asset classes).

However, investing in startups can be tricky. For example, it’s very likely that some of the startups you invest in will end up folding (less than 50% of startups never reach their 5th birthday).

What are the best practices in angel investing? To avoid the pitfalls and accelerate up the learning curve, follow these 8 steps to invest in startups:

 

1. Understand how to make money investing in startups

So, how do you get these returns that trounce the stock market? It’s not about being lucky or particularly skilled at picking a company that goes on to return 100X. Very few successful investors have shown that they can do that consistently. Angel investing is about process. It is about diversification. To win at the angel investing game requires understanding how important investing in numerous startups really is. You’re going to build a broad portfolio of startup investments.

Think about it like this: unlike the stock market (where the risk of an investment going to zero is almost nil), angel investors frequently write-down some of their investments in early stage companies. On average, only 50% of small businesses make it to year 5. Another handful of investments can return 2X or 3X on your original investment. But there will be one or two investments in your portfolio that should drive the overall returns of your angel activity. That’s why the Kauffman Foundation’s seminal research on angel investing, the largest study ever of its kind, found that to achieve a yearly average of almost 30%, angel investors need to have at least 15-20 investments in their portfolios.

2. Determine your investment strategy

Once you’ve decided to get active in angel investing, it’s time to determine what type of investment strategy you’re going to use. Before you make your first investment, try to figure out the following:

• How many deals you’re going to invest in: If diversification is the key to successful startup investing, then you’re going to want to target something like 15-20 investments for your portfolio. The research shows that angel investors can eke out even more returns when they invest in a greater number of companies.
• How much money you’re going to allocate to each deal: You’ve got to decide whether you’re going to give equal weight to all your investments as part of your diversification strategy or invest more money in the deals that you believe warrant it. Either way, make sure you leave over a significant portion of your allocated capital for follow-on rounds. Many of your companies will need to raise money later on and you’ll have the ability to prevent your stake from getting diluted.
• What types of deals you’re interested in: Determining what type of deal you’re interested in may sound simple but it will greatly influence your deal flow and ultimately, your returns as well. Are you interested in investing in an idea with a great team assembled around it or do you prefer more mature startups with a working product and maybe some revenues? Or maybe, you want a smattering of both. Your choice of startups matters as valuations can vary widely depending on where you’re investing along the startup maturity curve.
• Whether you’re going to be a sector specialist or an angel investing generalist: The Kauffman data show that there is value in niche-ing down and specializing your investing in a particular sector. If your background is in enterprise software, it probably makes sense to do some investing there, as you know how to connect the dots better than an outsider would.
• Join or build an angel group: Angel groups that invest together generally perform better than individual investors at the margins, according to the Kauffman data. They help attract and consolidate deal flow and give investors a sounding board when they’re looking at deals. Most cities have these groups and you can join on. Even if you don’t join your local angel group, you can always create a formal or informal confederation of investors who bring some value to the table. Investing in numbers does help — remember, your portfolio companies are most likely going to need more money down the road and having more talent at the investor table will help. Angel investing is a team sport.

3. Build your sources of quality deal flow

One of the major nuances of angel investing is that unlike the stock market, where an average investor has complete access to invest in all securities, good private deals are still hard to come by. No matter all the advances in technology, getting access to good deals still requires work. And it’s a virtuous cycle: as an investor builds a track record, you end up getting better access to future deals as you build a brand for yourself. For some pointers in improving your dealflow, you’ll definitely want to check our our article about the ways top angel investors improve their deal flow.

A great way for new angel investors to jump start their deal flow generation is to join an equity crowdfunding platform, like the kind we’ve built at OurCrowd. These platforms provide instant access to a wide variety of deals in numerous sectors. Different platforms provide different types of access: where AngelList is really an unfiltered marketplace of all kinds of startups raising money, OurCrowd provides a curated list of opportunities that pass our due diligence process. Online investing platforms like this give individual angel investors entry to some of the same deals top institutional investors are investing in. That’s powerful and a great way to accelerate building a good deal flow pipeline.

4. Research well and pull the trigger on your first investment

Once you’ve developed a steady stream of good deals and have a model for the type of investment you’re going to make, that’s the time to zoom in on an opportunity you like. Experts extol the value of an investor checklist; at OurCrowd, we screen for 5 criteria we’re looking for before we invest in a startup. Apply your screens appropriately to the investment candidates you’re considering to see if they match your requirements. Download the same company scorecard we use to make our investments.

In addition to the quantitative screen, most angel investors have built informal expert networks they tap when researching an opportunity. For instance, if you’re looking at a medical technology startup, go to respected authorities in their fields to get their feedback. This gives you not only a 3rd party expert perspective on the opportunity but also enables you to get inside the head of a perspective buyer or user of this technology. That’s valuable in understanding the barriers to entry and the distribution challenges a young company may face.

While many deals share certain characteristics in terms of how they’re structured, every deal has its own unique nuances. The contractual agreements that service angel investments are called term sheets and you’ll want to understand the mechanics of how term sheets work. The different variables include whether you’re purchasing a company’s equity (either directly or in the form of preferred equity which comes with some interesting bonus preferences) or structuring the investment as a convertible loan (it’s a loan that can be converted to equity if certain requirements are met). Take the time to understand the pros and cons of these preferences and structures, so that you scale the learning curve quickly and efficiently. This is important because the term sheets define your upside and your future participation in future funding rounds, as well as what happens if everything goes south. Check out our awesome list of resources for investing in startups for more information and expert advice.

5. Provide value beyond your capital

Startup investing is perhaps the most hands-on type of investing out there. Many early stage companies want to raise funds from smart money, investors who have the ability to contribute their advice and connections in addition to their capital. If you are smart money, you have the opportunity to truly move the needle for your portfolio of investments by making warm intros, helping with product development, and even assisting in a buyout negotiation. That’s not to say every entrepreneur you invest in is going to want your help, but you’ll certainly have the opportunity in increase the value of your investment with your intellectual and human capital, alongside your investment capital.

Research has shown that angel investors who interacted with the venture a couple of times per month experienced an overall multiple of 3.7X in four years. On the other hand, investors who participated a couple of times per year experienced overall multiples of only 1.3X in 3.6 years. So, your communication and expertise do contribute to overall better returns over the long term.

6. Double down on good follow-on opportunities

Dave McClure of 500Startups and a battle-tested angel investor himself has great advice for angel investors. He recommends investing before product/market fit and doubling down after that’s achieved in a follow-on round. Angel investors have the amazing opportunity to really get in on the ground floor at really low valuations (the other side of that coin is that these are the most risky and illiquid of investments) before a company has proven itself. If it does and achieves some type of traction, you’ll probably have an opportunity to re-invest (at a higher valuation) in a future investment round.

Here’s McClure on the angel investing dynamic:

This is really the key to my investment thesis: Invest BEFORE product/market fit, measure/test to see if the team is finding it, and if so, then exercise your pro-rata follow-on investment opportunity AFTER they have achieved product/market fit.  It’s sort of like counting cards at the blackjack table while betting low, then when you’re more than halfway thru the deck and you see it’s loaded with face cards & tens, then you start increasing your betting & doubling-down.

Technology has truly changed everything, creating huge exits in record time for entrepreneurs and the investors who back them. Angel investors are shouldering some of the risk in the startup ecosystem and in return, are given a ringside seat to watch how things progress.

7. Exit, stage left

Identifying and getting access to good deals are the beginning — but the work doesn’t end there. You’ll still need to get your research (and luck) right to be able to exit your investment. In angel investing, that includes primarily a merger/acquisition or an IPO. The data clearly shows that for a variety of reasons, more and more companies are either delaying or simply skipping going public. That leaves M&A as the primary mechanism to realizing value in your investment.

Crunchbase provided some interesting data recently on the exit market for startups (circa the end of 2013):

• The average successful US startup has raised $41 million and exited at $242.9 million. 
• The average successfully acquired U.S. startup has raised $29.4 million and sold for $155.5 million, for investor profits of about 7.5x (if you assume 100% investor ownership of the company, which is never the case).
• The average IPO-bound startup raised $162 million before going public. Thanks to a few recent large IPOs, the average raised amount soared to $467.9 million, for a 2.9x investor return (of course, venture investors will never sell all their shares on the IPO date).
• Data from our 2014 infographic about the M&A/IPO market in Israel demonstrated the technology startup industry in Israel is on pace for a record year (both from IPOs and M&A).

Review our roadmap for exiting startup investments to see how successful investors are able to realize the value of their investments in private companies.

8. Rinse, repeat

Success in the angel investing game is about process (and, well, a little luck). Creating a vibrant and quality deal flow is the hub around which the rest of your investment activities should rotate. Whether you break out on your own and hit the pavement in search of the next Facebook or you join an equity crowdfunding platform like OurCrowd, getting your deal flow right is the most crucial step. Not only does it increase the quality of the types of opportunities you see, it also helps to ensure you’ll see more opportunities. And getting more opportunities is a necessary component of angel investing.

Some of your investments will return money, others will go bust. But the one or two that you get right — really right — can provide large, outsized returns, like the kind you’ve read about regarding early investments in Facebook, Google, Whatsapp, and Uber.

[xyz-ihs snippet=”ZackMiller”]