While there are shared commonalities between investing in startups and investing in stocks, there are certain nuances that can make the difference between generating market-beating returns or suffering disappointing losses.
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Most investors ‘come of age' learning the mechanics and strategy of investing through their involvement in stock markets. That makes sense: stock markets are typically comprised of the largest and most stable companies within a given geographic region. Stock markets also have enough of a consumer pool making it relatively easy for investors to buy and sell shares. Individual shares and mutual funds make up the retirement portfolios of many long term investors. And it's the stock market, we've always been told, that deserves investors' dollars and attention.
But as new technology enables investing in newer and diversified types of assets, stock market investors are beginning to look beyond the stock market and more towards investing in alternative assets: like real estate, commodities, and more often, startups.
For the sake of this article, we're going to focus on investing in small, growth-oriented private companies (startups). Small companies are the lifeblood of the US economy, driving growth and providing new jobs to the workforce. It's the allure of large, outsized returns by investing in the next Google, facebook (FB) and Apple that is captivating investors right now.
So, how does a stock market investor to invest in startups? How do stock market investors transition successfully to becoming angel investors?
While there are shared commonalities between investing in startups and investing in stocks, there are certain nuances that can make the difference between generating market-beating returns or suffering disappointing losses.
Here's how investors with experience in stock markets should best think about investing in startups:
Diversification
Diversification is a key concept in investing and whether you're a stock market investor or angel investor, diversification is going to impact your investing results. At a high level, diversification is the surest way to avoid disaster and stack the odds for success. By not putting all our eggs in one basket, we not only lower the risk to our portfolio – we actually improve our performance. This is backed up by some (pretty intense) math as part of the Modern Portfolio Theory.
For investors putting money into the stock markets, the prevailing rule of thumb is that a properly-diversified portfolio contains 15–20 securities spread across different industries (which perform differently in various economic environments). The idea is that by putting your money into different investments, some will perform well, while others struggle, lowering an investor's exposure to general market risk and increasing returns in the process. Of course, too much of a good thing can go the opposite way; there is a point where an investor can be over-diversified.
Angel investors also have to deal with risk. But for angel investors, the issue is more acute. If 3 out of 4 startups fail, managing risk becomes paramount for someone investing in startups. As opposed to investing in publicly-traded securities which rarely flop, startups have a much higher attrition rate. Experienced angel investors understand the portfolio dynamics unique to this asset class: typically, a handful of their investments fail, a few have small returns, and just 1 or 2 have large, out-sized returns that pay for all the losses (and then some). The data show that to get those returns that headlines boast of (2.5X over 4 years), you're going to need to invest in at least 10–15 startups. Returns continue to improve with angel portfolios of up to 50 investments. We call this the portfolio approach to investing in startups.
