Startups are the early stages of companies that have yet to prove themselves in the marketplace. An investment in a startup could result in a significant gain if the startup takes off quickly or is acquired. However, there are risks associated with investing in startups; some may fail while others may take years to generate returns. As such, a beginner needs a clear plan of action to help set expectations, to minimize the number of unnecessary errors made along the way, and to build a repeatable process.
This guide outlines who early stage investing is suitable for, how a beginner can obtain access to early stage deals, what a beginner should review prior to making an investment, and how a beginner can protect their investment once they write a check.
1. Know the Game: Time Horizon, Risk Capacity, Goal Clarity
Investing in the early stages of companies is both high-risk and long-term in nature. Most investments will be illiquid and the returns generated by your portfolio will largely be determined by a few successful investments (i.e., “winners”) within your overall portfolio. Before you begin, you should be able to answer three basic questions:
- Time horizon: Are you willing to hold onto your investments for 7-10+ years?
- Risk capacity: Are you able to afford to lose the amount of money you are planning to invest in a startup?
- Goal clarity: Are you looking to learn, add some diversity to your investment portfolio, or earn a return on your investment over the long term?
Understanding the typical outcomes of investments in startups is also important. These typically include: a shutdown, a small exit, or a rare large exit. It’s also helpful to expect irregular results and delayed feedback.
2. Learn About How Beginners Can Obtain Early Stage Deals
Unlike buying a publicly traded stock, early stage deals are typically obtained via networking and/or platform access. Since beginners are typically focused on learning how to evaluate a potential investment opportunity, they can start small and focus on learning how to evaluate deals.
The following are some common ways beginners can enter the world of early stage investing:
- Angel syndicates: A lead investor identifies the deal and negotiates the terms of the deal on behalf of other investors.
- Equity Crowdfunding: Online portals allow beginners to participate in vetted deals at relatively low minimums.
- Angel Groups: Investors work together to review pitches and share due diligence.
- Micro-funds or Rolling Funds: A fund manager invests on behalf of a group of investors.
While all of these options have advantages and disadvantages (e.g. fee structure, quality of deals available, level of control), beginners should prioritize: transparency, timely and regular reporting, and a history of responsible deal screening.
3. Conduct a Simple, Repeatable Due Diligence Review
Beginners do not need to develop complex models to analyze a potential investment opportunity. Instead, they need to develop a standard checklist that highlights red flags and clearly defines what must happen for the startup to achieve success.
A practical review includes:
- Problem and customer: Who pays for the solution, and why does it matter now?
- Solution and edge: What makes it difficult for someone else to replicate your data, distribution, or technical advantage?
- Market size: Is the market large enough to support a significant return on investment?
- Traction: Does the startup have revenue, pilot customers, good retention/engagement metrics, etc.?
- Team: Can the team execute, learn quickly, and attract new talent?
Some questions to ask:
- What would cause this company to fail in the next 12 months?
- What would qualify the next funding round?
- Who is the greatest threat to your business model, and why?
4. Manage Your Investment Like a Portfolio
One startup is a bet. A portfolio is a strategy. Because of the uneven performance of investments in startups, risk management comes down to diversifying your investments and controlling your pace.
Rules for a beginner’s portfolio that will limit regret:
- Use small check sizes and spread your checks across multiple companies over time.
- Set a maximum for the size of each check you write, and a maximum amount you will spend on startup investing each year.
- Save follow-up capital for the strongest performers, if possible.
- Monitor progress: Track revenue, burn rate, hiring, and product milestones for each of your investments.
Additionally, it is wise to anticipate dilution and slow exits. A disciplined investor evaluates his/her investment decisions based on the quality of the process, rather than on short-term developments.
Conclusion
A beginner’s roadmap to early stage investing in startups begins with a realistic view of the field: high failure rates, lengthy timelines, and limited liquidity. From there, structured access, a simple, repeatable diligence checklist, and risk management of the investment as a portfolio (through diversification and limits) complete the framework. Once a beginner has established these practices, he/she is no longer investing based on hype but rather using informed judgment. In addition, the most credible beginners treat themselves like experienced investors from the beginning – documenting their decision-making processes, identifying patterns, and viewing each deal as one component of a planned, long-term strategy.