With emerging equity crowdfunding platforms that make it easy for curious investors to review available startup deals, there is an interesting learning curve that needs to be addressed among new startup investors, which is my main motivation for writing this piece. Daily, new investors joining RockThePost most commonly ask one question: What ROI can I expect from my investments? This is a rational question, but not one that can be answered simply for a number of reasons. Rather, it’s best to be well-versed on the implications of angel investing in order to formulate an educated set of expectations. With that in mind, here are 3 key points I emphasize when investors ask about the expected ROI of startup investments.
1. Get in early
The primary goal of angel investors is to invest in startups, early on, before they take off. Paul Graham, co-founder of Y-Combinator, said, “As an angel, you have to pick startups before they’ve got a hit—either because they’ve made something great but users don’t realize it yet, like Google GOOG +1.61% early on, or because they’re still an iteration or two away from the big hit, like Paypal when they were making software for transferring money between PDAs.”
At a seed stage, the two debatably most important factors to gauge your potential returns are the market opportunity, and the team itself. 9 out of 10 startups fail, and you have to be able to truly empathize with the founders to get a good read on whether they have the chops to stay the course and relentlessly push until they succeed.
2. Identify early key indicators of success
The challenge about early-stage startup investing is the lack of data available to analyze the viability of a business. How do you know if people will use the product or service before the startup has any revenue or even a minimum viable product? Well, there are early key indicators that can help you gain insight into the likelihood of the startup’s success. Well-respected startup thought leader and Stanford professor Steve Blank underscores in his blog that startups are not smaller versions of large corporations, so therefore looking at a startup’s five-year financial forecast early on is ludacris, especially because it is based on a series of unknown variables. It’s necessary to evaluate startups in a different light from established companies.
By definition, a startup, according to Blank, is a temporary organization that is designed to search for a scalable and repeatable business model. Therefore, as an investor, finding out what hypotheses the startup has formed and what data they have collected that either validate or invalidate those hypotheses will be helpful in determining what type of progress has been made to date. Not to mention, it will shed light on the methodology being implemented to find product/market fit, which is what, ultimately, every startup strives to achieve.
3. Diversification, High Returns, and Low Correlation to Traditional Asset Classes
A recent report of SharesPost by Tony D Yeh and Ning Guan, about historical return analysis and asset allocation strategies detailing investments in private growth companies, showcased the benefit of alternative assets in any investment portfolio. It was concluded that an investor who allocates 5% to Private Growth Companies, and the remainder to benchmarked portfolios (such as the 60/40 stock/bonds or 50/25/25 stocks/bonds/REIT portfolio) could have experienced 12% higher returns.
These higher returns can be realized due to the fact that there is a low correlation between alternative asset classes, such as private companies, and traditional asset classes, such as the stock market and fixed income.
Granted, this report was written specifically about Private Growth Companies, but the same benefits of low correlation and diversification, and potential for large returns can also be applicable for early-stage startup investments. Take for example the recent $19B Whatsapp acquisition, Twitter’s $24B IPO valuation, etc., which no doubt produced unprecedented returns for early investors of those companies, who all once started out as young and uncertain, too.
Until recently, startup investing has been out of reach to the average investor. Now, this landscape is opening up, and alternative assets, such as startup investments, can provide exposure to industries and ventures that have historically been inaccessible through traditional investment vehicles. Startup investing is a field where risk is real and expected ROIs can’t be calculated with high degrees of accuracy, but when understood, this landscape can be navigated and the benefits of added diversification and potential high returns can’t be ignored.