Investing in early stage businesses can be risky; after all, 90 percent of all startups do fail. Moreover, a startup can take anywhere between 4 and 16 years to provide its investors with an exit; thus, it is safe to assume that the investor money will be locked up for a while.
But this inherent risk is also what makes new ventures hugely rewarding, allowing investors to cover any losses by “making back 10 to 100 times their investment on all a small fraction of their investments”, says entrepreneur James Baker.
While risks are part and parcel of the game and cannot be completely avoided, there are ways that an investor can mitigate some of the more common challenges in early stage investing and come out on top.
Focus on your circle of competence
Warren Buffet talks quite often about the “circle of competence”. A lifelong champion of value investing, he advises to concentrate on what you already know. If you move way out of your comfort zone, it may not be so easy to see a pitch for what it is or to distinguish between a temporary problem and a red flag.
So, how do you deal with the problem of the unknown when a fantastic investment opportunity in an unfamiliar industry knocks on your door? If you really want to get in on a deal that’s too hard to resist, lean on your network. Seek out experts in that space and consult with experienced advisors, to get professional advice on how to move forward.
Invest in ideas that cater to a large market
To earn outsized returns, pick a startup, product, or idea that targets a large enough total addressable market, to allow for the occasional failed investments and other losses. In this case, “large” means a minimum of $1 billion per year in revenues. The larger the TAM, the more ways for you to make a reasonable exit.
It’s not so much about the size of the business problem. Being in a big market is the more important consideration, even if the problem within that market is not so substantial. As Scott Orn of CFO firm Kruze Consulting explains, “Often you solve a small problem in a big market and then find more opportunity than you could have ever imagined from the outside”. Indeed, new avenues for growth tend to open up as the business evolves.
One example of a small problem in a big market is AirBnB. Starting off as a couch rental business, the company ended up transforming the entire vacation rental market. Aiming for something that can be big makes it worthwhile to put in the effort and take the risk of investing in an early stage venture.
Evaluate the people behind the business
According to a Stanford study, the ability of the founder and the management team is one of the most important driving factors in the investment decisions of venture capitalists. After all, even the greatest business idea in the world will not reach its full potential, if the people behind it are not dedicated enough, not invested enough in the idea, or maybe simply don’t have what it takes.
Getting to know the founders is a lot like dating. There’s the pre-investment period, where you learn all about each other: What motivates them? Is it just about the money or are they in it for the long haul? What’s important is to ask as many of the important questions early enough in the courtship, before you go all in and realize too late that it’s not a good fit.
There is no fixed formula here; you just have to rely on information, your experience, and yes, your gut and intuition.
Normalize overly optimistic projections
Startup founders can be too eager when pitching to investors, and present financial projections that are a bit on the ambitious side. Well, why not? They are out to transform the world and become the next Facebook or Google.
But while confidence in one’s business idea is great, even a good sign to an extent, unrealistic targets can be a challenge to early stage investors. Besides overestimating growth rates and revenue projections, founders might also tend to underplay expenses. If left unchecked, this can lead to overvaluation and ultimately, significant financial loss.
As an early stage investor, use your filter and adjust the revenues and expenses to saner levels. Perhaps, the outflows are much higher and inflows are more conservative than what the pitch deck shows. As they say, revenue is vanity, profit is sanity, and cash is reality. Bottom line: Focus on cash flow.
Build a large portfolio
Even in this age of unicorns, the Pareto rule still applies: 80% of returns are generated by only 20% of startups. When the business model is new and untested, failure rate is high. But if the startup makes it, your investment will pay off in spades.
Nevertheless, early stage investing is a risky business, and many of your investments might not succeed. Your best countermeasure is to build a sufficiently large portfolio. Experienced VC Paul Cohn estimates, “VCs invest out of funds (pools of capital). Each fund will have anywhere from twelve (small fund) to thirty or more (big fund) investments”.
Build up your portfolio of investments such that the 20% success candidates are sufficiently large in number to balance out the remaining 80% that might result in losses.
Investing in early stage ventures is as much art as it is science. It is about the financials and product-market fit; but it’s also about being able to read people and manage relationships. If you can manage the key risks described here and strike that precarious balance, the chances of success will significantly increase, both for you and for the startup.