Creating a startup investment portfolio can be tricky. It’s impossible to predict when a startup will fail miserably or ascend to the heights of a Silicon Valley Unicorn. But, it is possible to develop a startup investing strategy that can help you make informed investment choices.
Startups can be high-risk with no guarantee of earning any returns. This makes diversification a vital aspect of managing a healthy startup portfolio.
Laying the Groundwork for a Startup Investment Portfolio
If you’re a first-time startup investor or still learning the ropes, here are five things that can help you make better investing decisions:
- Learn the lingo – Understanding common venture capital terms can prepare you for comprehending the risk and mechanisms of startup investing.
- Know where to look – There are many crowdfunding portals you can invest through but choosing the right one requires a bit of research. The Financial Industry Regulatory Authority (FINRA) has a complete list of registered portals you can view.
- Dig into due diligence – Performing due diligence is a fundamental step in choosing the right startup investment. At the bare minimum you should review cash flows, valuations, founders, exit strategy plans, product traction, and overall funding needs.
- Two-Way Communication – Not all portals are created equal. For example, all funding portals—including First Democracy VC—are required to provide dedicated investor discussion boards that allow investors to ask questions, and review information, such as financials, business models, and other important data. But not all portals do it well.
- Know how to diversify – Balancing your portfolio can help minimize the chance of incurring losses. Consider diversifying your portfolio with multiple startups that can balance your overall risk.
Managing portfolio risk plays a key role in the success or failure of your investments. Becoming familiar with these five items can potentially help you identify startup offerings that match the level of risk you’re comfortable with.
One of the first steps to creating a startup investment portfolio is to understand where you’re eligible to invest. There are three main brackets of investors:
1. Accredited Investors
According to the SEC, an accredited investor must meet one of the following criteria to qualify:
- Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
- Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence)
- Any trust, with total assets in excess of $5 million, not formed to specifically purchase the subject securities, whose purchase is directed by a sophisticated person, or
- Any entity in which all of the equity owners are accredited investors
2. Sophisticated Investors
A non-accredited investor who has sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment may be considered a sophisticated investor.
3. Non-Accredited Investors
Subject to certain inflation-adjusted investment limits, anyone can invest in Regulation Crowdfunding offerings:
- If annual income or net worth are less than $107,000, then during any 12-month period, that limit is the greater of either $2,200 or five percent of the lesser of annual income or net worth.
- If both annual income and net worth are equal to or more than $107,000, then during any 12-month period, that limit is the lesser of 10 percent of your annual income or net worth, not to exceed $107,000.
It is important that investors read and understand key disclosure and education information related to Regulation Crowdfunding in general and as well as any investment under consideration.
Conditions for accredited, non-accredited, and sophisticated investors can vary based on the rule each startup uses to raise capital. For example, Rule 506(b) allows up to 35 sophisticated investors to take part in a funding round, while Rule 506(c) does not allow any funds to be accepted from sophisticated investors.
5 Steps to Prepare for Your Startup Portfolio
There are five initial steps investors can follow that aim to make the planning process run smoothly:
1. Have startup capital ready
It’s good practice to have your capital easily accessible when you identify an investment opportunity. There won’t be much downtime in waiting to liquidate funds, and it’s convenient for you as well as considerate of the startup you’re investing in.
2. Understand startup investment risks
Startup investments are highly speculative and risky. There is no guarantee that you will earn any sort of return and you could even lose all of your investment. You should never invest funds that you can’t afford to lose.
3. Be willing to wait
Investing in startups is a long-term commitment. Many startup investments can take up to ten years—or more—to pay back your investment or generate profits for investors. Make sure you’re willing and financially able to wait a minimum of five to ten years before seeing potential returns on your initial investment.
4. Understand the exit strategy
Many early-stage companies have a goal to achieve a liquidation event sometime in the future. Startups with a well-defined exit strategy can be a good indication that the focus is on earning a return for investors. Acquisitions, initial public offerings, and mergers are some of the most common types of exit strategies.
5. Be a mentor or provide connections
Some startups can use expert advice just as much as they can use funds, which is why some angel investors serve as board members and company mentors in addition to investing their money. If you have expertise to offer a startup in addition to capital, consider how you could contribute to its success.
Once you’ve taken the time to absorb these five preliminary steps, you can begin formulating a strategy for startup investing.
Create an Investing Strategy
For the best possible chance at achieving profitable startup investments, you should consider creating and implementing a strategy.
The first step is to determine how you want to invest in startups. The most common ways include:
- Via venture investing platforms for direct investments
- Through your IRA or self-directed 401K
- Through personal connections with founders and entrepreneurs
- By attending pitch events
One of the easiest ways to invest is through an online platform or portal, like the one MicroVentures provides.
The next step is to establish a method for vetting investment opportunities that may become part of your portfolio. Research important metrics like revenue growth, customer acquisition costs, churn rates, burn rates, and gross margins for each startup opportunity.
This data can indicate the company’s financial health and historical performance. Use any valuable information that you find to inform your investment decision.
What to Look for in a Good Startup Investment
There are different ways to identify startup opportunities with the potential to succeed, but there is no guaranteed method for identifying an investment that will become profitable. One of the most important things to do is always question the data and conduct thorough research before investing.
Here are a few ways to identify signs of a potentially good startup investment:
- The founder(s) and leadership have a strong background in the chosen industry with a track record of previous success that is easily accessed online
- The startup’s target market size is generous, and it has favorable growth projections
- The startup has a detailed business plan that includes pricing, costs, margins, and other key data
- The startup has a competitive advantage or intellectual property rights that set it apart in the industry
- The startup has documented financial projections
- There is an efficient, detailed marketing and sales strategy in place
- An exit strategy or planned liquidity event is in place
- The startup has documented the investments it is looking for such as the amount of equity, size of investment, and timeline for raising funds
Once you’ve identified a startup that ticks all of your respective boxes, it’s time to create investment goals.
The goal for some early-stage investors is to achieve a distribution to paid-in capital (DPI) ratio greater than 2X. Essentially, that means an investor would earn double the funds they initially invested in a startup. For example, if you invested $1,000 in a company and achieved a DPI of 3X your initial investment would be worth $3,000.
DPI is one of two important metrics that you can include as part of your startup investing strategy:
- The total amount to invest – What are the minimum and maximum investment amounts allowed? Establish the amount you can afford to invest and risk losing, then choose a startup investment that falls within your parameters.
- Distributed to paid-In (DPI) capital ratio – Many startup investors aim for a DPI of 2X or higher.
Investors should also consider the startup’s valuation, as this will impact the current and future worth of their investment. There is no exact science to the valuation of a startup because it is mainly determined by market forces which influence the startup’s industry.
Assess & Manage Your Risk
Startup equity investments typically are considered to be high-risk and highly illiquid. Investors often have trouble liquidating their equity in startups the same way they can liquidate other investments because it’s relatively difficult to sell startup equity prior to an IPO event.
One way to try and offset the risk of your startup portfolio is to diversify by backing multiple startups. While there’s no guarantee, this can help spread your risk and balance the overall portfolio.
A variety of startup investments can also mean your portfolio’s performance doesn’t depend on a small handful of investments to turn a profit. Adding companies with potentially lower risk can also help diversify your startup portfolio.
Here are 6 ways to manage your risk and potentially minimize the chances of making a failed investment:
- Invest in pre-vetted startups
- Invest in a range of startups to diversify your portfolio
- Set aside a portion of capital to invest in follow-on rounds
- Invest in startups that are in industries you understand well
- Invest in companies with high growth projections and the potential for a liquidation event
- Invest in companies with a profitable and scalable business model
It is impossible to remove risk from the investing equation, so your best course of action is to assess and manage it. Understanding each of the risks that a startup is exposed to can help you make better informed decisions.
4 Ways Startups Realize Investing Gains
Realizing profitable gains is the whole purpose of investing in startups. There are several events that can provide ways for investors to cash in on their portfolio companies:
- Acquisition of the startup
- The startup undergoes an IPO
- The company starts paying dividends
- The investor sells their shares to other investors
A survey conducted by the Silicon Valley Bank found that 57% of all startups have a long-term goal of becoming an acquisition and 18% plan to IPO. Liquidation events—like acquisitions and IPOs—are some of the most common ways investors can realize startup gains.
Wrapping Things Up
Creating a startup portfolio that follows a detailed strategy can help you curate startup investments which contribute to a well-diversified portfolio.
It’s important to know that diversification should involve meticulously choosing vetted investments, rather than diversifying just for the sake of diversifying.
Investing in startups is risky, but if you’re methodical and risk-aware you could be in a position to minimize your risk and possibly realize gains. Just remember, it’s helpful to conduct thorough research, create and follow an investing strategy, assess and manage the risk of your startup portfolio, and never invest funds that you can’t afford to lose.