The Ultimate Stock Market Investor’s Guide To Investing In Startups
I published this recently on OurCrowd's blog and thought Tradestreaming readers would appreciate reading it here, too. :::::::::::::::::::::::::::::::::::::::::::::::::::: Most investors ‘come of age' learning the mechanics and strategy of investing through their involvement in stock markets. That makes sense: stock markets are typically comprised of the largest and most stable companies within a geography, with enough interest that investors can relatively easily buy and sell shares. Individual shares and mutual funds populate many long-terms investors' retirement portfolios. And it's the stock market, we've always been told, that deserves investors' dollars and attention. But as new technology enables investing in newer, different types of assets, stock market investors are beginning to look beyond just investing in the stock market and more towards investing in alternative assets: like real estate, commodities, and more often, startups. For the sake of this article, we're going to focus on investing in small, growth-oriented private companies (startups). Small companies are the lifeblood of the US economy, driving growth and providing new jobs to the workforce. It's the allure of large, outsized returns by investing in the next Google, Facebook and Apple that is captivating investors right now.
How stock market investors evolve to angel investorsSo, how's a stock market investor to invest in startups? How do stock market investors transition successfully to becoming an angel investors? While there are shared commonalities between investing in startups and investing in stocks, there are certain nuances that can make the difference between generating market-beating returns or suffering disappointing losses. Here's how investors with experience in stock markets should best think about investing in startups:
DiversificationDiversification is a key concept in investing and whether you’re a stock market investor or angel investor, diversification is going to impact your investing results. At a high level, diversification is the only free ride we have as investors: by not putting all our eggs in one basket, we not only lower the risk in our portfolio – we actually improve our performance. This is backed up by some (pretty intense) math as part of the Modern Portfolio Theory. For investors putting money into the stock markets, the prevailing rule of thumb is that a properly-diversified portfolio contains 15-20 securities spread across different industries (which perform differently in various economic environments). The idea is that by putting your money into different investments, some will perform well, while others struggle, lowering an investor’s exposure to general market risk and increasing returns in the process. Of course, too much of a good thing can go the opposite way; there is a point where an investor can be over-diversified. Angel investors also have to deal with risk. But for angel investors, the issue is more acute. If 3 out of 4 startups fail, managing risk becomes paramount for someone investing in startups. As opposed to investing in publicly-traded securities which rarely flop, startups have a much higher attrition rate. Experienced angel investors understand the portfolio dynamics unique to this asset class: typically, a handful of their investments fail, a few have small returns, and just 1 or 2 have such large, out-sized returns that they pay for all the losses (and then some). The data show that to get those sexy returns that headlines boast of (2.5X over 4 years), you’re going to need to invest in at least 10-15 startups. Returns continue to improve with angel portfolios of up to 50 investments. We call this the portfolio approach to investing in startups.
Follow-on roundsInvestors in the stock market have learned that one of the best ways to increase their returns over the long term is to consistently reinvest their dividends. That means, any cash that’s generated from an investment should get ploughed back into the company, increasing ownership over time by taking advantage of any fluctuations in stock prices. The research proves that dividend reinvestment really works to build wealth: From 1988 to July 2013, $10,000 invested in the S&P 500 would have grown to $68,200. But reinvesting dividends would have almost doubled that return, jumping to $120,600. That’s improving returns 2X as much by merely reinvesting. The story is a bit different with startup investing. Just because you find a hot tech company in which to invest $10,000 doesn’t mean you’re done tapping into your wallet. Startups typically need to raise more money in the future (called follow-on rounds). Early investors typically get the opportunity to re-invest in their portfolio companies along the way to exit. Meaning, when companies need to raise future rounds of capital, you should have the opportunity to invest again (hopefully, if things are going right, at a higher valuation). If you don’t exercise your right to reinvest, you run the risk of getting massively diluted as your portfolio companies raise larger rounds in the future. To invest profitably in startups, it's important to understand the entire lifecycle of an investment in a startup. Take a look at the following Slideshare we created to address the entire lifecycle of startup investing: An angel investor sits in a good position: you get to invest early, while later on gaining access to ensure your equity stake doesn't get diluted as valuations go up. As 500Startups’ famed investor, Dave McClure, counsels angel investors simply: Invest in a company BEFORE it achieves product/market fit and then double-down AFTER through follow-on rounds. As an angel investor, definitely keep some money as dry powder to continue to invest in the best-performing companies in your portfolio as they conduct follow-on rounds of funding.
Liquidity constraintsMost of the time, in a major market, stock market investors don’t think too much about liquidity. If you’re buying Apple ($AAPL) or Google ($GOOG) stock, you click a button, and boom! The stock automatically appears in your portfolio. The transaction is nearly instantaneous and the price an investor pays is pretty much the price the seller of the stock receives. The same dynamic mostly holds true whether you’re buying a large cap stock, exchange-traded fund or mutual fund (which price at the end of every day). Liquidity is not a thought that most stock market investors are concerned with while transacting in common instruments. That’s definitely not the case if you’re transacting in a small-cap company with little daily trading volume. The Bid and Ask price — basically, the price the buyer is willing to pay for a stock and the price at which a seller is willing to sell — can be significantly different. More than that, a single investor transacting in an illiquid stock can severely impact the price level by trying to buy or sell just a small amount of stock. This lack of liquidity has to be taken into account when making an investment in an illiquid investment or while considering when to exit one. Private companies, like startups, can be one of the most illiquid types of investments an investor makes. There isn’t really a market for shares in small startups and that means when an angel investor makes an initial investment, his or her holding period really is forever. Even purchases are a bit more complicated than just clicking a button — there is more paperwork and contractual agreements that go into investing in a private company. And unless that company gets bought, IPOs, or goes bust, the investor is most likely going to hold the investment forever. So, David Cummings’ advice is sound:
“The next time you think about making an angel investment, remember the lack of liquidity challenge and make sure that the money isn’t needed for a long, long period of time.”