Betting on a Horse or Its Rider: How to Start Investing in Startups

Alex Golod, an American investor with Belarusian roots, co-investor, and mentor at Starta Ventures, spoke about how to start investing on your own and choose the right startups.

Early-stage startups are one of the riskiest asset classes to invest in. The growth opportunity they create involves investing in the early stages of a company’s development and can result in profit by the time of “exit”, or liquidity event. Through this strategy, the angel investor has a higher earning potential than if they were to simply invest in a diversified portfolio on the stock market. However, angel investments carry significant risk, which is reflected in the higher profitability of successful investments and the large share of losses for unsuccessful ones.

In the US market, at least 20,000 angels have invested in over 71,000 deals, totaling $25 billion. In the United States, angels invest in more diverse teams, with investments in women-led startups growing 21% in 2019.

First steps in the venture capital market

First, to minimize risk, you need to think about portfolio diversification immediately. If you want to be an Angel and invest only in two or three startups, the risk is generally too high. When you reach 8–10 companies in your portfolio, and, preferably 15–20, the chances of success increase. Statistics show that up to 50% of business angel investments turn out to be unsuccessful; that is, they fail to provide a positive return on investment, or even go to zero. However, for a diversified successful portfolio, the investment return can range from 20–25% or even higher on an annual basis.

The second critical consideration is choosing how to enter the world of venture capital investments, whether that be as an individual angel, with a group (syndicate) of business angels, or with a fund. Funds attract more money from outside with a capital volume many times greater than that of business angels, and an average return of 25%-35% on invested capital, per year. On the other hand, funds are somewhat of a black hole to investors, commonly known as Limited Partners (LPs). LPs do not control the fund’s individual investments and have to give fund management free reins on the majority of investment and administrative decisions. Deals are normally closed here within 6 months but can take anywhere between 3 months and a year, since no two deals are identical. The fund also helps individual investors to develop a better understanding of the market and specific industries.

Currently, there is an increasing number of investors choosing independent investment options to allow full control of investment decisions. This trend is much more pronounced during early investment rounds, including Friends & Family, pre-seed, and seed rounds.

Angel group members invest their own funds routinely at a clip of 5% to 20% of liquid capital, and the time it takes to close the deals varies widely. There is no pressure to invest annually in some of these groups. I am a member of the Chicago ArchAngels group. We have roughly 40 members, but only 15–20 members are active in terms of both investments and participation. For “passive” investors there are no mandatory minimums or obligations to invest, but there are annual membership fees.

Some of the advantages of angel syndicates include the power of collaborative thinking, robust networks, and the ease of portfolio diversification. In addition, investors can find opportunities in the areas and domains where they are not knowledgeable enough to make their own decisions.

How to become an Angel Investor

There is a lot that goes into becoming an angel investor, but for simplification purposes let me highlight the 3 major paths to becoming one. Many people turn to angel and alternative investments after progressive and successful entrepreneurial journeys. After building and selling their own companies, it is somewhat of a natural progression to become interested in angel investments. These kinds of angels are not limiting themselves to investing their money, they also offer advice and connections to startups.

The second way is applying your past management and corporate experience in a specific industry to invest and help startups in the same domain and industry. For example, in our Chicago ArchAngels group, many healthcare professionals choose to invest in healthcare-related startups. They are mostly interested in medicine, pharma, and biotechnology startups due to their expertise in this domain.

The third group is high net worth individuals interested in angel investing as an “expensive hobby”. Some people like to try their luck in Vegas, while others prefer to invest in a risky startup. Normally, these investors have their financial house in order, and their bases covered before they turn to angel investments. There is an element of gambling in their investment decisions, hence my comparison with Vegas.

As a side note, there are certainly other investment categories and approaches, such as Family Offices, but we will not cover them here.

Choosing a startup for investment

It goes without saying that it’s not too smart to invest randomly in startups, as they require plenty of research and due diligence. Likewise, you don’t want to invest in a startup simply because your friends or relatives asked you to pitch in. First of all, you must be an expert in a specific field, or at least have some understanding of the industry and the market. It takes time, but you can develop the required knowledge by researching, analyzing, and observing market trends. For example, I focus on B2B startups with a focus on technology. This investment thesis is not necessarily so much about understanding “deep technologies” but more about understanding specific industries and domains that I follow, and consider promising.

Secondly, the major factors in choosing the startups you invest in include, team, market, and product, in no particular order. There is a saying in the investment community that originated from the racetrack lingo: “ You can bet on a horse or a rider”. I tend to favor the rider. Several years of personal experience have vividly demonstrated that a lot depends on the personality and character of the founder. Sometimes the idea is excellent, the market is promising, the product is thoughtfully developed, and there are no logical objections against investing, but something doesn’t feel right. Namely, this is the lack of chemistry and understanding with the founder. In this scenario, it’s better to hit the pause button, take a closer look at the founder’s background and track record, and perhaps, refrain from investing. Once again, I am talking from my personal experience and failures.

An illustration of an “investable” startup for me is StringersHub, a Starta Ventures portfolio company, with an experienced founder, Yakau Buta who is focused on all the right key indicators and metrics. StringersHub is an online platform that connects stringers (professional videographers and eyewitnesses) and media worldwide. The platform currently has 25,000 users. StringersHub has raised $500k in investments from Starta Ventures, Insta Ventures, and business angels.

There is a totally opposite approach for choosing startups centered around finding the best ideas, concepts, products, and services, without emphasis on the founders and their personality. Some investors believe that they can bring any idea to market on their own, even if the founder is not experienced or a strong visionary leader. Venture studios are known for popularizing this approach.

I personally think that, as an investor, you want to see the founder’s passion, fire, ambition, and drive to succeed. If it is not palpable, it might be a red flag for me. Along the same line of thinking, another red flag is when a founder doesn’t give up their full-time job while building the startup, even after a year of trying to do both. This multitasking is a recipe for disaster. If a founder himself is not ready to take on 100% risk, it would be unreasonable to expect the investor to share this risk with a founder. Track record, successful exits, and founder’s expertise within his domain are also vital.

If you have limited or no experience in a specific industry, your due diligence process looks a lot different, so seeking assistance can be key. You can attract experts in the field such as partners, accelerators, and your fellow angel investors who can help you gain critical knowledge about the market, the product roadmap, and competition.

Tips for those entering the world of venture capital investments:

• Be prepared to study the subject and delve deeper into the industry and domain. You cannot start investing money “at random” or at the request of a friend or relative. This could very well lead to failure.
• Start with a vertical or horizontal familiar to you. For example, if you have previously worked in the insurance industry, insurtech startups might be natural for you.
• Evaluate startups based on three criteria: team, product, and market. All three factors are critical to gain a 360-degree view of a company.
• Diversify your portfolio. The fewer companies you invest in, the higher the risk, however, you need to limit the number of investments you have to avoid being spread too thin. As an active investor, I prefer to have anywhere between 15 and 20 investments at any given time.
• Angel and alternative investments are some of the riskiest asset classes on the market. I consider it excessive to invest more than 10–15% of liquid or investable capital into these classes.
• If you do not have enough time or sufficient knowledge on a specific subject, it is best to co-invest with a venture fund, angel group, or other syndicates.