As an investor or a head of an investing company, it can be lucrative to look for fresh startups. After all, any startup can be the next big thing, raking in hundreds of millions in profit in their first few years and allowing you to get an exponential return. Compare this with the S&P 500 companies, where there’s relatively little upward movement. Sure, most companies are steady earners and “safe picks,” but they’re unlikely to be able to convert millions into billions after they have already gone through the breakthrough phase.
But with all the potential success, there’s always a risk of the startup being a non-starter. After all, many companies fail to make it past their first year. So, how do you choose which startup to invest in, and which one to pass on? Let’s dig into the dynamic landscape of startups, what makes them so attractive, and the best tactics to follow.
What Makes Startups So Attractive to Investments?
Startups are, by their very nature, small companies that are only in their initial growing and settling stages. However, within that description lie a few crucial factors that savvy investors know to look for, which make them particularly interesting for angel investments. After all, if they weren’t interesting, very few startups would get off the ground.
High Growth Potential
Startups need to break into emerging industries, using innovative technology, concepts, or designs in order to make them stand out. Their competition is generally significantly larger and has much more capability to fund novel services.
But big companies are also hamstrung by their size. Corporations live and die by their reputation and existing offers. If something goes wrong, there’s significantly more at stake for the company, and more importantly its shareholders, to lose. This can make them resistant to change or adopting new concepts. And once a company establishes itself in the industry, its exponential growth is practically over.
By contrast, startups start from the very bottom and can grow much more rapidly. Giants like Slack, Zoom, Clubhouse, and Canva all managed to reach over 750,000 users within their first year. Airbnb broke into the accommodations scene, with thousands of listings within a year. This type of growth gets noticed, and investors are constantly looking for the next best thing.
This potential for growth is also somewhat of a self-fulfilling prophecy. If a startup manages to impress a few investors, it has a much higher chance of gaining traction with other investors. This will typically lead to the company having more than enough funding to start extensive marketing campaigns. With a solid business idea and developed plan, that alone can be enough to fuel growth.
Excellent Return on Investment
With explosive growth comes excellent stock valuations and yearly profits, both of which give investors their money back and then some. Regardless of the type of investments that you actually give to a startup, one way or another, you can recoup some of that money relatively quickly if the company takes off.
This is further emphasized in the early investing rounds. Small companies trying to secure loans, funding, or even connections with manufacturers or supply chains don’t have much to offer except equity stakes. And with relatively few large investment companies or angel investors out there, they are strapped for choice in funding. This puts a startup on the back foot of any negotiations, giving investors an opportunity to secure relatively high equity stakes at surprisingly low prices or favorable loan terms.
Looking Into the Future
As a general rule, startups need to innovate to be anywhere near successful. After all, if they offer a service similar to an existing giant, there wouldn’t really be a point of the new company in the first place. In the same vein, startups often need to be ambitiously bold when it comes to presenting new concepts.
Investors who are looking for the next best thing in any industry should generally look toward the attempts startups are making at shaking things up. A small company can have a large impact on its industry or even the world as a whole, and a savvy investor can become a part of history by staking their claim in the company through an early investment to make it all possible.
The Opportunities (and Risks) That Come With Investing in Startups
With all these potential benefits in mind, there’s always a downside around the corner. Yes, startups can be incredibly rewarding if you manage to invest in the right one. However, it takes skill, experience, extensive knowledge of market trends, and a bit of a gut feeling to separate the wheat from the chaff. Here are some key factors to keep in mind if you decide to pursue angel investing.
Patience Is Key
Here’s a reality check for you: even if a startup becomes wildly successful overnight, you’re not going to make money off it immediately. Unlike investing in the stock market, where you can freely buy and sell company shares to turn a profit, once you’ve stuck your hand into giving your money to a startup, you can’t back out. The small company doesn’t really have a way to pay off loans, and it could take years before it creates an initial public offering (IPO), which would be the first real chance for investors to earn some money back from their equity shares.
In fact, Statista suggests that it takes slightly over five years on average between a startup’s first venture capital (by which point it could be too late to become an angel investor) and the IPO. For the early birds, the wait can be even longer, between seven and 10 years.
This can put an investor at a significant risk of spreading their resources too thin. Without a reliable way to get the money back quickly, an investor needs to guide the company through years of innovation, market research, and improvement. And if another, better opportunity comes along, you might be forced to miss it because you literally can’t afford to take yet another risk before the previous ones have paid off.
For best results, think of angel investing as more than just sending seed money to companies. It’s about creating commitment and new experiences for the company and its customers. An early investor can help visions come true and make the world a slightly better place (all the while fattening their wallet).
Think Bigger, Wider
As with traditional investing, diversifying your portfolio can be the key to success. Remember, it’s impossible to get a perfect investment record. And that’s OK. Not every idea will be worth a million (or a billion) dollars, and you might not get one on the first try. Or the fifth. What’s important is to get to the point where your successful ventures can help pay and offset those inevitable losses.
Let’s use a relatively simple example, with 10 different startups that received investments. Two of those startups manage to turn some profit over the initial investment, but seven of them fail. The remaining one becomes a billion-dollar venture. That single success story will be the crutch for the entire portfolio, which allows an investor to get their money back and start again with a fresh batch of startups to invest in.
But diversification goes well beyond sheer numbers. Going across different industries and even regions can make a significant difference. Take the recent trends in AI technology as an example, which has permeated many different industries to the point where Forbes has listed mainly AI companies as “startups to look out for in 2024.” This can lead to some industries, like biotech, energy, and consumer goods, being ripe for the taking, and a startup can break through relatively easily when you’re not looking.
At the same time, developing countries have a much higher growth potential. With roughly 80% of the world’s population living in a country considered “developing,” that is a huge number of people needing access to modern infrastructure and jobs, which are only created through making new companies to do the work. Investing in companies that focus on these locales could be a fulfilling and lucrative investment, but it can take much longer to pay off.
Doing the Work
Angel investing is much more than investing your money into a company and hoping it takes off. You also have to invest your time and energy into the project, even before you actually start writing the first check.
With so many startups popping up each year, it’s practically impossible to pander to all of them. You have to be smart with the companies you choose to invest in, as an early-stage startup will see you more as a partner than an investor. Apart from being responsible for the company continuing to exist, you also have to understand the business, how the company plans to enter the market, and what are the risks inherent in it.
Think about the following:
- How far does your early investment actually go (i.e. how long can the startup operate without needing more investments)?
- Who takes the shots in the company, and are there enough experienced and knowledgeable people to cover all the bases of running it?
- Does the industry have a history of legal disputes, litigations, compliance issues, or any other bad reputation?
- How do you, as an angel investor, fit into the picture? Can you help the company in more ways than just sending it money?
Some of the answers you get can reveal a company that’s far more risky than it’s worth.
Investors as a Community Resource
Due to the inherent risks that come with angel investing, it can be helpful to soak in the knowledge of other investors who have gone through the same ordeal and succeeded. Investment communities can be found in various places, like social networks, syndicates, forums, or investment companies. They can all help an investor new to the process navigate through the most common pitfalls of investing into what turns out to be a dud.
But there are two other major benefits to becoming a part of a wider angel investor community.
First, it reduces the barrier to entry for angel investments. There’s a notable lack of resources that specifically cater to investing in startups. This can be explained by the sheer speed at which industries and global practices evolve, so what was previously actionable advice can easily become faulty within a few years.
Secondly, communities can pool their funding and knowledge to create more meaningful opportunities for startups to profit from. While this might sound counterintuitive, both sides get the best of the deal. Since you’re a smaller part of a larger investment, your monetary contribution (and personal risk) is that much lower. At the same time, the community will have the knowledge, connections, and resources to help the startup get to the growth stages faster, which accelerates the process of returning on the investment.
But – and there’s always a but – being a part of a community also means that you don’t have nearly enough of an impact. While communities can help inject fresh ideas, they can also lead to staleness. It can be deceptively easy for a community of investors to carve out a niche for supporting specific industries. This can lead to discounting potential unicorns just because they’re out of the existing niche, or overestimating the potential of a dud because it fits inside an existing portfolio. A community can self-correct, but it also means it can be more difficult to change course.
So, regardless of whether you have a community to support you in your investment endeavors, make sure to do your due diligence before writing the check.
