Profiting From Promising Startups: Improving the Odds (Part 1)

You’re wealthy and wired. You just read Become an Angel Investor in 2010: An HBS Framework and 2010: The Ultimate Buyers’ Market for Investor. You’re getting antsy. You’re ready to invest in a startup. You’re ready to tap into your Rolodex and pave the road to success for any startups that cross your desk.

Whoa. Slow down! Angel investing is risky — the exact reason why it garners such high potential rewards.

On average, 55% of startups fail within 5 years. Even accredited angels who invest with organized angel groups see a negative return in 40% of their investments, according to Scott Shane, author of “Fool’s Gold?: The Truth Behind Angel Investing in America.”

If angel investing is so risky, why on earth would anyone in their right mind do it?

Well, some angel investors aren’t strictly financially focused. Some might want to give back to the society; others might want to get involved with startups. After all, launching or help launching a startup can be one heck of a ride. These investors might loosen up the rules a little if they really dig the startup. But they aren’t philanthropists; they do expect to make some money.

Successful, financially focused investors often focus on the success rate rather than the failure rate. They see 45% of startups succeeding or still operating in 5 years, not the 55% of startups that fail. They know for fact that it’s the few homeruns among the 45% that would make up for the losses and generate a very handsome return.

What makes successful investors different from the average ones?

Successful investors understand risks, and they use risks to their advantage.

So let’s talk about risks. Let’s talk about how you may improve the odds of turning someone else’s idea into a huge profit.

Risks: Improving the Odds

What are the risks? There are plenty. But we’ll focus on 4 primary types:

• Financial
• Market
• People / Execution
• Product / Technology

Financial Risk

A company will die without sufficient funding. If it dies, you’ll lose most, if not all, of the money you invested. Wise angels would invest together as a group to pool capital and share financial risk. There’s safety in numbers.

More quality investors, more smart money, higher odds of company survival. Co-invest with seasoned investors or collaborate with other angel groups to mitigate financial risk.

“Last year, everyone was going around in a panic about financial risk and about the wherewithal of follow-on capital,” says James Geshwiler, managing director of Lexington’s CommonAngels and past chairman of the Angel Capital Association.

Reserve money to participate in future funding rounds. The money you and your fellow angels reserved could be the key to turning the company around and bringing it from red to black. This, of course, assumes that the company in question still has potential and worth your follow-on investment.

Capital-efficient companies and industries are more suitable for angels since the amount required by these companies is within angel investors’ funding threshold.

“[Capital efficient] means go-to-market (funding) is right around [US]$2 million, and maybe up to $4 million to get to cash-flow break-even and that’s got to be it,” states Geshwiler.

Steer clear of capital intensive industries like cleantech and pharmaceuticals, especially if you’re a beginning or solo angel.

When evaluating an opportunity, some questions include:

• What’s the exit strategy? Does it look plausible?
• Is there a cushion in the budget?
• How long will this round of funding last?
• Will the startup able to hit milestones for the amount raised?
• Have follow-on rounds of financing planned?

Market Risk

Will people pay for this product? How will the market respond? Is the market big enough? Seasoned and successful angels look for big markets. If the market isn’t there then sayonara!

But the funding required to launch a successful tech startup is decreasing. Some investors point out that the market can be smaller if it can generate a desirable return on investment, which can vary from 5x to 30x.

Look at the market the startup competes in, not the general market. For example, the market for an online social gaming startup is people who like to play social games online, not the entire Internet population. The market size you look at must be relevant.

The startup should provide you with data that help you gauge market acceptance. Focus group research and potential customer surveys are good but real paying customers are even better.

To reduce market risk, you’ll also want to see the startup working closely with potential customers.

The startup should release fast and iterate often, as Paul Graham of Y Combinator would say. It should launch with a minimum viable product, which is “the minimum required to measure the response of early adopters,” according to Eric Ries, a frequent public speaker about the lean startup methodology. The startup should “use the insights gained by studying [the] customers to make improvements” and release a better version of the product. Repeat.

Maybe, the product has potential but the market doesn’t exist. It could be because it’s a tad too early for the market. In this case, the company might need to spend a large chunk of the funding on market education before it can gauge market acceptance.

This increases market risks and you’ll need to decide whether the potential return would outweigh the risk.

Some evaluation questions include:

• Does the market exist?
• Is the market crowded?
• Is there growth potential?
• Is the relevant market size big enough?
• Does the market need or want the product?

We’ll discuss People / Execution and Product / Technology risks in our next post.