As a preview of my opinion: don’t do it!
We are frequently asked by clients whether or not they should invest in a particular start-up business and in fact we are reviewing a couple right now. My general response is always the same so I thought I would put it down on paper to share with all in case you are ever in this scenario or in case you just might find it interesting (everyone watches Shark Tank right).
As many of you know, I was one of three founders of Venture51 which is an early stage technology startup investment management firm—i.e., venture capital firm—you can check them out at www.venture51.com. In 2010 we started a fund and raised money from individual investors to make investments in businesses related primarily to mobile internet opportunities. Typically, we would get involved at the stage where the founder had a working product, had run out of friends-and-family money and was raising ‘professional’ money for the first time. We listened to hundreds of pitches from founders and invested in about 40 deals.
Ultimately the fund wasn’t large enough to support all three founders so in 2012 I removed myself from day-to-day operations. This experience was a serious crash course in early-stage investing.
What I already knew
- Venture Capital (“VC”) is the riskiest and least liquid part of an investor’s portfolio and rarely should represent more than 5% of your total net worth. So when we were asking someone to invest $250,000 in our fund I wanted to make sure they had net worth of at least $5 million.
- VC funds have produced very attractive aggregate returns, but getting manager selection and vintage correct is crucial. The “average” return is somewhat meaningless because there are huge dispersions of returns among the many VC managers and across time—i.e., you have to get a bit lucky and be in the right place at the right time.
- Those historical returns were generated like this—a fund would invest in around 20 deals, 15 would die worthless, three or four would be marginally successful and the returns of the entire fund would hopefully be driven by one or two home runs.
- Because of this return pattern, venture investing done right requires taking a lot of swings, so doing it through a diversified fund is the best solution for most.
That was pretty much it.
What I learned
Here is a list of things we would look for to get us interested in a start-up:
- A working business with real users—not just a concept
- The type of business is one that someone on our team knew well (or someone we know well knows well)
- The founder has a history of successfully starting and exiting businesses
- The founder’s passion and skill blow you away and he/she is “all in” with this company
- The founder has a tight grip on their business development and financial metrics—otherwise there’s no way to believe the money they’re raising will be effectively spent
- · Have they raised money from any impressive VC investors? Always preferable to invest alongside others with a history of identifying the best deals and/or who can add value to the startup through advice and mentoring
Assuming you get all of those things right these challenges remain:
- Whether the company fails or succeeds this probably isn’t the last time they’re asking for money. Hard to determine if you’re saving your investment or throwing good money after bad.
- If the company does grow they’ll almost always need a lot more money to capitalize on their opportunity and the future rounds of fundraising will likely be more than you can afford—maybe for your “seed” round they raised $1 million but a couple years later they’re raising a $30 million B round. Those future rounds almost always dilute your investment beyond what you rightfully feel you deserve for being an early backer.
My experience leaves me with a general cynicism with regard to investing in start-ups by non professional investors. Clearly we have all heard of the rare successes and those stories are what feed entrepreneurial spirits and loosen the wallets of the hopeful. But like I said above, to do this right you need to participate in a lot of deals. In each case you have to be okay with assuming that’s the last time you’ll ever see that money. You have to keep your total commitment to under 5% of your portfolio. Most deals aren’t very good, so to find even 10 investment-worthy deals you need to look at 50+. Most normal people simply can’t check all those boxes.
There’s no doubt that if this note reaches enough readers and it is at all persuasive I will in aggregate save lots of people from wasting money, but there will be somebody who is convinced that I am an idiot because they took a pass on the next Uber (which for the record, we passed on the real Uber—this stuff ain’t easy!).