In our last post, we discussed the details of the two main risks that Angel investors will face when investing in startups - small businesses risk and liquidity risk. This post presents a few strategies that will help investors mitigate these risks and increase your chances of making successful Angel investments. At the bottom of the post, we have pasted in a quick-cheat graphic that you can refer to rather than having to read through this whole post again. I am sure you all will set it as your desktop backgrounds. Thank me later.
To reduce small business risk, there are several strategies that you can implement to increase your chances of success. The first is diversification, which can include such strategies as spreading your money out across several investments rather than investing a large amount in one or two businesses, as well as spreading money out across businesses in different geographies and industries.
For example, if you have $100,000 to invest in startups, you will have better chances of succeeding if you invest $10,000 in 10 different companies, than if you invested $50,000 in two. In addition, if you decide to invest in several different companies, you may want to invest in several different industries and geographies; that way, if one industry or geography has a downturn, you will be able to make it up in other industries or geographies that are doing well. (See Strategy #6 for caveat).
Strategy #1: Don’t put all your eggs in one basket – diversify by investing in several companies rather than one or two, and invest in several different industries and geographies.
In addition to diversifying, you can help reduce the small business risks by doing some simple research on the companies that you are considering. Here are some things you should be sure to keep an eye out for:
The first is the “Use of Funds” section. Be sure to pay close attention to how the business plans to spend the money you invest, and be thinking about how long it would take, based on their plan, for them to run out, as startups tend to underestimate how much money it will take to get started. As we pointed out in our last post, you also want to watch out for what they are spending money on and to see if they plan to spend money on smart projects. I would not think you would want to end up investing in a business that raises $200,000, of which $175,000 is going to the CEO’s salary.
Strategy #2: If you are not comfortable with how a company plans to use their funds, you may want to pass.
You will also want to pay close attention to the management team. Do they have experience running or starting a business? Do they have experience in the field they are trying to get into? How do they make decisions and resolve disputes? A bad management team is a major deal killer for most investors, so it should be for you, too.
Strategy #3: If you are not comfortable with the management team, you may want to pass.
This next one may seem obvious, but we will say it anyway. The idea may be a great idea that you love, but can it/does it make money? There are plenty of good ideas out there, but there may not be a good plan to monetize the idea. The financial section is a great place to find the information you will need to help with this, as you can identify in their financial section if the projections and assumptions are realistic. You should not only question their financials, but you should consider such factors as competition (how are they different?) and barriers to entry (is it too hard for them to enter the market/is it too easy for competitors to get into the market?).
Strategy #4: Is the great idea able to make money?
The next three strategies come from extensive research done on the returns of Angel investors over time. The study can be found here (Returns to Angel Investor in Groups).
It identifies three strategies you can use to increase the chances of making successful Angel investments:
1) The research showed that exceeding 20 hours of diligence has a large effect on the outcomes of investments and that Angels that spent at least 40 hours of diligence before making an investment experienced on average a 7.1x return.
2) Angels with experience in the industry in which the investment company operates showed multiples that were twice as high as those investors who invested in unfamiliar industries.
3) Angels who played an active role in advising, mentoring or helping with connections experienced success rates three times higher than those who did not get involved with their investments.
Strategy #5: Do your due diligence.
Strategy #6: Invest in what you know.
Strategy #7: Get involved.
We will stop with these seven strategies you can employ to mitigate small business risk for now. In our next post, we will address the other risk mentioned in our Risks of Angel Investing post, liquidity risk. However, we will go ahead and post the cheat sheet, and you can get a head start on our next post.