Startup investing: key strategies to avoid making rookie mistakes
Category: Understanding startup investment
Entrepreneurs have a wide variety of financing alternatives available, which vary depending the stage their startup is at. Each investor as their own investment criteria which they follow to decide in which startups or sectors to invest, always looking for an exit to make money on their investments.
We’ve touched on all of the above topics over the past few weeks, but one missing piece of the puzzle so far are the investment strategies used by investors to back startups and technology companies.
Startup investing: Time, amount and profitability
In previous occasions we’ve mentioned that a significant number of startups and entrepreneurs don’t understand that not any project is worthy of investment money for various reasons: growth projections, scalability, market conditions, etc.
Business angels, Venture Capitalists and other financing vehicles only operate for one reason, and that is to make money for themselves and their Limited Partners.
Startups have high mortality rates associated and some studies claim that 80% of investments fail, in the sense that they don’t generate profits for the parties involved. That’s why most investors -be it big funds or business angels- diversify their risk level by backing numerous companies, hoping a handful of them will generate enough profits to compensate the failed investments.
There are three main implications to take into account here:
- Profitability: for an investment strategy to work, 20% of the investments not only need to compensate failed ones, but also need to be profitable for the investors. Which means that those 20% need to be VERY profitable.
- Amount: it’s important to make many small investments for the strategy to work, so that if any of the early investments is successful there is enough money to invest in future rounds.
- Time: investors back companies because they want to get returns as soon as possible, but this period of time is certainly not short: it usually takes 3 to 5 years for a US investor to exit a company, 4 to 6 in Europe and 5 to 7 (or more) in Spain.
It’s important for investors to determine their own investment strategies by valuing -more or less- the above aspects.
It’s worth noting that while business angels usually need to create big portfolios of companies for their strategies to work -they invest small tickets in very early stage companies-, Venture Capital firms tend to invest at a later stage. Although this is quickly changing as the capital available in the market increases and as VC firms approach seed investments.
To invest means to manage risks
Investing properly is not an easy task and implies taking big risks. That’s why the majority of investors have two ways to minimize risk.
1. Risk control
The first way to control risk is by negotiating the valuation of a startup: higher valuations means more risk associated, thus needing to invest more to increase the value.
A different way of managing the risk associated is by using clauses in term sheets, such as:
- Vesting: agreement which implies that founding team needs to stay X years at a startup to receive a certain number of shares.
- Liquidation preference: it implies that in the case of an exit or liquidation, investors have the right to receive X times their initial investment before anyone else in the company.
- Anti dilution: in the case of a later round, the premoney valuation of a startup can never be lower than the postmoney valuation of the previous round in which certain investors backed the company.
- Lock-up: it establishes limits to stop founders from selling (or leaving) the company before a certain period of time has passed.
2. Selection and valuation
Managing risk is part of every investor strategy, but so is the process of evaluating a startup. Investors need to analyze a series of internal and external factors that might end up heavily influencing the future of a company.
Here are some examples:
- Startup is investable: which implies that it has high growth projections and a possible outcome (exit, acquisition, etc).
- Team: a team of founders and early employees that complements each other and fully committed to the project.
- Market: if an investor (or founder) wants a company to grow fast in a short period of time, there needs to be a big market with real clients willing to buy your product or service. And what’s even more important, that market needs to be growing.
- Competitors: it’s often said that if there’s no competition there’s no market. What investors want is for startups to understand the market they are in and their advantages vs. their competitors. And execute based on such characteristics.
- Business model: most investors only back scalable and profitable business models.
- Traction: with a few exceptions, most investors will only back companies that have certain market traction (clients, users, etc).
- Projections: investors want to know how a company plans to evolve its business over coming months and years, to value whether it’ll be able to generate enough profits over time.
- Exit: investors back companies to obtain a return and the way to achieve that is via exits or dividends.
All of the above varies from ecosystem to ecosystem, and while certain aspects apply to more mature markets such as Silicon Valley or London, others make more sense in up and coming ecosystems like Spain or Eastern Europe. If you have any more tips or suggestions, let us know in the comments!
One of the best ways to reduce the risk associated with the first investments is through syndicated co-investments, where a top business angel with an extensive record of startup investments leads a round other co-investors can back up.
We are launching syndicated co-investments soon. If you are interested, please join us and add your investor profile.