Three Ways To Invest in Startups
You must have read about the surge of unicorns in the USA and China a few years ago and now are hearing about a similar proliferation of unicorns in India and Southeast Asia. This might leave you wondering how you can get your hands on startups to invest in and companies that will scale-up.
While the startup ecosystem is consistently growing, it is important that you only invest in high quality startups. Here we explore different ways that you can invest in promising startups.
Solo Angel Investing
The first and the most common way is to become an angel investor and invest a small amount in multiple startups. By investing a small proportion of your net worth in more than one venture, you will be able to diversify your holdings akin to the common proverb “don’t keep all your eggs in one basket.”
Updating your social media like LinkedIn to mention that you are an angel investor and joining platforms like AngelList will allow you to source more deals and possibly higher quality startups.
The biggest issue with becoming an angel investor that invests directly in startups is that your ticket size of investment in a particular company is going to be limited and as a result the absolute gains might be limited.
Also, it will be difficult for an individual angel to conduct proper due diligence on a startup because it requires a lot of time and resources which that angel might not have. We’ve heard a lot of stories from angels who made bad investments when they were first starting out. Being an individual angel investor can be rewarding but is fraught with unknowns and obstacles.
Angel Syndicates
A way to overcome the obstacles of being an individual angel is to form an angel syndicate.
An angel syndicate will allow individual investors to pool their capital and then make investments that have a significant impact on the cap table of a startup. The angel syndicate pools the resources and contacts of different angel investors which in turn helps the syndicate in better deal sourcing and due diligence of startups.
While forming a syndicate on many grounds seems to be a better proposition than investing alone, the effectiveness of the syndicate is directly proportional to how resourceful the members are. If the members do not have sufficient time, resources or connections, the syndicate might not be able to achieve strong results.
Till now we have seen that most angels have relatively smaller ticket sizes coupled with lack of time and resources to attend conferences, undertake research and attend different events to source deals and conduct adequate due diligence. Angels might also suffer from a bias for or against the idea which in turn might lead to missing a good investment opportunity and an investment in a poor startup.
Venture Capital
One way to overcome all these issues is to become a Limited Partner in a Venture Capital fund. A VC is able to build a fund that is able to identify and invest in high quality startups which in turn might generate huge returns on investment for LPs.
VCs do not suffer from the lack of resources or time to source for startup deals and conduct due diligence on them. Actually it’s a core part of what they do and why they can be effective. This is simply because a VCs daily life is to source high quality companies. The earnings of VCs is often dependent on the performance of the startups they invest in.
As a result, the goals of the VCs and LPs are more often than not aligned which in turn creates a win-win situation for both parties. Given the VC network is highly connected, one VC can draw upon another VC or relevant people for mentorship for particular startups which in turn will help the startups make more money.
“Higher risk, higher return” is synonymous with investing. No investment is free of risk. Some investments have very low risks while investing in startups have relatively higher risk.
An individual who is good at investing his/her money realises that while returns are important, risk management is even more important. And for an individual looking to invest in startups, the best combination of risk and returns (also known as sharpe ratio in public markets) are potentially offered by VCs.
You might be wondering how to identify a VC to invest in; that could be a topic for future conversation but it is important to realise that VCs have good risk management practices for individual investors and can take some of the heavy lifting out of investing in startups.
Ultimately deciding how you choose to invest if it’s as an individual angel, through a syndicate or network or a VC fund comes down to how much time, industry knowledge, your risk appetite and how much capital you have to invest.