Securing early-stage venture capital is easy for quality start-ups. What’s often neglected, however, is the other side of the equation – the difficulty for angel investors to find and determine between a company worth investing in from one that’s unlikely to succeed.
It’s a feeling that any punter who has lost big on the Melbourne Cup understands. You’ve researched the jockey and team, looked at the field and track conditions and felt confident you had a winner, only to be last across the post.
In fact, the parallels between early stage investing and the horse racing industry might surprise you. Deciding to invest in an early-stage start-up is not so different from trying to pick the winning horse.
The earlier you invest in a thoroughbred racehorse, the risks and potential returns increase. The valuations are difficult to pin down and you need to rely on qualitative indicators of future performance. Furthermore, the quality of the support team around the horse is important, as is the strength of your network and understanding of the ecosystem.
Thoroughbred owners and early stage investors both have a strong passion for the people, ecosystems and process of developing and picking winners. Both groups also know that no matter how many good picks they’ve made, they will not always get it right. It is a game of risk and there are many elements that are beyond any single person’s control.
So how do you reduce your risk and increase your chances of picking winners in the early stages of investing in startups?
- Build your network – Learn about your start-up ecosystem, locally and globally, and find out who has the best record and integrity. Then, attempt to access and meet these people and their networks. Study available information on them and read or listen to what they have to say. By becoming entrenched, you can then find and network with other like-minded, aligned and experienced early stage investors.
- Start small and slow – Your success is likely to improve over time. Considering the risk associated with this asset class, your investment pool shouldn’t be more than a small portion of your overall asset pool in the early stages. You will not have much spread, so you need to be able to lose the lot if something goes pear-shaped.
- Look for ways to access quality deal flow – You are best to develop a portfolio of twenty to thirty investments at least over time, so do not get seduced by the first potential unicorn you see and invest too heavily.
- Keep your powder dry – Consider the possibility of later capital raising rounds. If the founding team hit all of their milestones and are executing strongly and communicating well with investors, you may want to invest more heavily in the next round. Sure, it might be at a higher valuation but if it is a good company with a good management team there should be plenty of growth left in it.
- Seek sound advice – Get a good lawyer who has experience in startups to review your documents before investing. It is vitally important to have an expert review the many terms of your investment as they could impact the future value of your investment. As an example, it is important to secure pre-emptive follow on rights in the term sheet or subscription agreement in your initial investment. This will give you the right, but not an obligation to at least maintain your percentage in the company and not be diluted by any subsequent capital raising.
Whether we’re picking the Melbourne Cup winner or the next start-up unicorn, the best we can do is understand the many pitfalls and mistakes that founders and investors can make. If you put a few key principles in place, you can manage the risk, and hopefully be first past the post.
About the author
Hugh Bickerstaff is the Director of Investment with Sydney-based start-up generator Investible.
See also: Investible co-founder Trevor Folsom on the value created by astute start-up investors