Investing in startups is, by all means, risky business.
In September of 2018, CBInsights published a report stating that 67% of VC funded companies stall or fail after raising seed funding. Put simply, in the world of startup investing, failure is common. Thus, a critical key to success when investing in startups is to build a diversified portfolio that will return enough winners to not only balance out the losers but drive an outsized return.
The key to success in startup investing is DIVERSIFICATION!
However, before we even begin to consider diversification, we need to calculate how much investing capital (aka money) we have to work with on a yearly basis. When you think about your overall investment portfolio (including stocks, bonds, real estate, mutual funds), we at KingsCrowd believe that 5-10% of your entire investment portfolio should be invested in long-term, risky investments – a.k.a., startups!
Thus, if you plan to invest $20,000 per year across all assets including stocks and bonds, you should plan to invest no more than $2,000 in the startup asset class. Luckily, investment minimums in the equity crowdfunding space tend to be in the $100 range, so a goal of investing in several startups on a yearly basis is attainable.
What Does a Diversified Startup Portfolio Look Like?
In order to achieve a suitably diversified startup portfolio, most experts suggest investing in at least 20 startups. Alex LaPrade, a startup professional who has spent time in strategy roles at Angie’s List and Dispatch, two well-funded startups, enjoys covering the venture market. In his phenomenal post, Alex breaks down why you should have at least 20 startups in your portfolio.
Alex used data collected by the Kauffman Foundation and their Angel Investor Performance Project, a compilation of data from 539 angel investors who had experienced 1,137 exits from angel investments throughout North America, to run 1,000 portfolio return simulations. The results of these simulations led him to the conclusion that startup investing is highly risky. Angel investors that invest in only five companies can expect at best to receive their money back 83% of the time. Investing in five or fewer startups results in a one-in-six chance of a total loss of investment capital.
However, when you invest in at least 20 startups, simulation results indicate that the chance of at least recouping your money improves to over 98%. In addition, 67% of Angels who invested in at least 20 deals saw a three-fold return in this analysis, which is very positive.
To be very clear, there are no guarantees in startup investing, and the numbers in the following table represent just one study and one data group.
Regardless, there is a clear lesson here: investing in more companies helps to reduce the risk of losing your entire investment while increasing the chances of achieving positive returns over the long term.
Source: Alex LaPrade Blog
Along the same lines, consider the following chart. It illustrates one of the more recent studies by Correlation Venture and shows that nearly 70% of deals invested in will return 1X at best. Less than 3% of venture returns will hit the coveted 10X+ mark most venture capital firms look for. While losses should be expected, with a diversified portfolio, you can reduce downside risk and hopefully enhance your upside.
Source: Correlation Ventures with data from Dow Jones VentureSource and other sources
How To Build Your Startup Portfolio
When it comes to building a diversified portfolio of startups there are a couple of keys to ensuring your startup portfolio is well-balanced.
Develop Your Investment Strategy
First, we think it is always a good idea to create a startup investment strategy to focus your startup investment approach. Before beginning, consider some of the following criteria about companies you want to invest in:
- Geography (e.g., southeast, west coast)
- Stage of the company (e.g., pre-seed, seed, series A)
- Market sector (e.g., food & beverage, tech, healthcare)
For instance, when I began investing in startups about three years ago, I decided that since I was running a financial technology blog, I would invest in U.S.-based, seed stage, financial technology companies. I chose this direction because I knew I had deep expertise across all three dimensions and felt confident I could make better-informed investment decisions about these types of startups compared to others.
However, investing in one sector does come with its own risks should an entire industry be negatively impacted by an event. For instance, in 2016, I was invested in marketplace lending companies (think Airbnb for loans) and a major scandal erupted amongst one of the industry leaders, LendingClub. The news sunk the entire industry for a while and hurt many early-stage startups who could no longer raise capital.
Consider Your Investment Thesis
With this in mind, taking a diversified approach to investing in multiple sectors can help reduce the systemic risk associated with investing in any one market.
One investment thesis we have at KingsCrowd is that companies built by more diverse founders (e.g., female and minority founders) will drive outsized returns over the next ten years since their ideas are unique and focus on new or unmet market needs.
Your investment thesis defines the purpose of each investment you make so you can fundamentally understand how each investment fits into your portfolio. Essentially, this helps create focus and boundaries on your startup portfolio and prevents you from being swayed by erroneous factors and market noise.
It All Comes Down to Fundamentals
Despite creating a thesis and investing in areas where you have more expertise, it is still incredibly important that you conduct due diligence on any startup and ensure you understand the fundamentals of the business.
As we have talked about in the past, there are five key criteria we always utilize when conducting due diligence:
- Market size
- Founder experience
- Terms
- Product/service differentiation
- Business model
Put simply, there are many ways you can diversify, from a broad investment thesis to a focus on certain geographies or types of businesses. However, you should always ensure that you conduct your due diligence before investing in any startup.
Other Resources To Consider
The most important step to building a well-diversified and fundamentally sound startup portfolio is to conduct your own due diligence. Spending 10-20 or more hours researching a company is important for improving the likelihood that the startups you invest in will be a success.
Conducting due diligence is not everyone’s forte; that’s why platforms like ours, KingsCrowd, exist. We track all 46 equity crowdfunding platforms and conduct our own independent due diligence.
Happy Investing!
Chris Lustrino is the Founder & CEO of KingsCrowd, the first ratings and analytics platform for the equity crowdfunding market. He’s a former management consultant gone rogue writing a fintech blog focused on the alternative lending and investing markets with a passion for bringing improved access and transparency to financial markets.
If you are interested in investing in startups, KingsCrowd can help. Sign up for a membership with coupon code WEALTHKING to get 2 months for $1.
Great article, thank you. However, I quite disagree with a point of automation, i think at the beginning individualized approach is crucial. And it is also important not to focus on sales solely, it is also important to hire dedicated developers for all stages of a startup.