This week we are celebrating the Jewish holiday of Passover, which commemorates the liberation of the Israelites from slavery in ancient Egypt. The 10 plagues that Moses, with a little help from on high, launched on the biblical Egyptians have been spun into numerous allegories, lessons, and instructions. And, being the Israeli high-tech investing fanatics we are, our first thoughts were with the connections to startup investing.
Startup investing isn’t easy — sometimes you’re blessed with miracles (i.e.- exits and IPOs), but along the way to the Promised Land of Profits, you’re frequently plagued by problems. There is no guaranteed recipe for success, but here are some tips for avoiding bad investments.
So, without further ado, here are the 10 rules of what NOT to do when investing in startups.
The 10 Plagues of Startup Investing:
- Investing in just 1 startup: The data here don’t lie – picking the right startup is tough. So, diversification is even more important when investing in young, private companies than it is when investing in startups. How much can investors make investing in startups? The Kauffman Foundation groundbreaking research on startup investing demonstrated investors made 2.5X on their investments — that’s a great return but it’s only true when investors have built portfolios of over 10 holdings. Moral of the story? Invest in multiple startups.
- No support from other investors, mentors, or board members: Investing is definitely a team sport and it takes a village to raise a successful startup — that means, a company needs the support of early investors, its board of directors, and advisors. Make sure companies you’re looking at have the continued support of a strong set of evangelists.
- Not fully understanding your rights: It’s important to understand the ins and outs of your investment. Like, what happens to your holdings at the next round of investment? Do you get to top-up your investment or are you going to get diluted down? The nitty-gritty of the details of your investment are held in the term sheet. Read the term sheet. Understand your rights so you can be prepared to optimize your investment down the road.
- Investing in a small, niche market: Like Israeli social driving app, Waze, which was purchased for over $1 billion by Google in 2013, startup investors should be aiming for the fences (read 6 tips on how to invest in the next billion dollar exit). That’s partly because you should expect some of your investments to fail and some to merely return your investment. The 1 or 2 investments that succeed wildly need to be big enough wins to provide returns to the rest of your portfolio.
- Investing in things too difficult to understand: Warren Buffett only invests in companies he understands. That’s why he doesn’t invest in technology (or bitcoin, for that matter). Peter Lynch, famed Fidelity mutual fund manager, wrote in his famous investment book, One Up on Wall Street, that investors should be prepared to invest in simple-to-understand businesses (he gave the example of pantyhose).
- Investing in companies with little traction: Traction is the lifeblood of a startup and startups are designed to grow fast. Depending on where a company is in its growth curve impacts how quickly a startup is growing. We look for early traction with a product to get more comfortable with a potential investment. Traction can come in different forms: sales, users, partnerships, etc.
- Forgetting investing is a process, not a destination: We see over 100 potential deals per month as we whittle them down to make 1 -3 investments. That’s a huge funnel of deals that we look through as we find just a couple of investable companies. We approach our dealflow as a process with a team of professionals manning specific stages of our research process. Individuals don’t need teams of research analysts to find good investment candidates, but it’s imperative to have an investment model and a process to find high-quality investment targets.
- Investing in a deal structure that isn’t investor- and company-friendly: Making an investment in a startup is like marrying it. Though exits can happen earlier, startups don’t typically exit for years. Having the right incentives for investors to continue backing and investing in the company is good pre-requisite. But, so is having a good deal structure that leaves enough of the company in the hands of the founders to ensure they’re incentivized to keep building and scaling their “baby”.
- Thinking backing a Kickstarter campaign is the same as investing: Have you been following the Oculus Rift story? The virtual reality hardware company ran a successful crowdfunding campaign on Kickstarter. Thousands of backers backed the technology with donations. But when Facebook bought Oculus Rift for $2 billion dollars at the beginning of April, backers were upset. Backing a project on Kickstarter — though it’s a good sign to generate traction — isn’t investing in the company. For that, you need an equity crowdfunding platform like OurCrowd.
- Betting on poor founders: Investing is a team sport. The founders are a company’s lifeblood. As much as good ideas and good execution matter, investing in winning founders is probably the best recipe for success for angel investors. Famous private equity investors are known to say that it’s better investing in an A team with a B idea than the inverse.
Passover offers participants the yearly opportunity to relive the transition from slavery to redemption. Startup investors can stand to learn from the same story.
OurCrowd would like to wish all a very happy Passover!