Investing in seed stage startups - risk management

When I talk to family offices and high net worth individuals about seed stage investing in startups, they frequently say, “but that’s very risky, isn’t it?” Yet the same investors are sometimes prepared to pay high premiums for interests in late stage loss-making private tech companies, or invest in derivatives, gold or even bitcoins. So, to some extent, risk is in the eye of the beholder. 

However, yes, seed investments in startups involve a high level of risk, and the willingness to hold illiquid investments for what may be a long time. However, these investments can also produce an outsize return. So the key question is, how do you manage that risk?

Rule 1. Diversification

A key element of managing risk in a seed portfolio is diversification. There is a high risk that if you make only one seed investment, the startup will fail. Even a portfolio of ten is too small.  Ideally, one should be looking to hold investments in a minimum of twenty or even thirty companies. Out of these 30, 15 will probably fail, 10 will provide, at best, a small return, and the investor is dependent on the remaining 5 to deliver an outsize return. 

Because the aggregate initial investment that a seed company requires frequently can be relatively small (say $150,000 to $250,000 per company, and less in many markets -- this amount typically is syndicated among a group of angel investors or taken by a fund), it doesn’t require a large investment to secure this level of diversification. Of course, many companies may require multiple seed rounds of increasing size before a larger Series A round, so aggregate investments in later seed rounds will be larger. Additionally, funds should be reserved to follow on with companies that make progress. Finally, the process of selecting companies for such small investments is time-consuming, so many investors are not likely to achieve this level of diversification without investing in an external fund or through an angel syndicate.

Rule 2. Co-founders and team comes first 

It is easy to make the mistake of investing in a startup because it has a brilliant idea, great technology, or is addressing a really important market that is not adequately served. All of those are important, but the starting point at this stage must be team and its ability to execute. If this business is to succeed, the team needs to be well-balanced, with co-founders who can establish a healthy corporate culture and work well together over the long-term. 

Having at least one experienced co-founder is a big plus – startup founders make lots of mistakes, and it is better if they have made them on someone else’s investment! However, most startups have first-time founders, and this is simply one of a number of risk factors. In any case, investors need to judge whether the co-founders have the ability to assess, and integrate, the wisdom and experience of others, including employees, mentors, and professional advisors.

Be somewhat wary of startups where the founders, while very experienced, have only had experience in large corporates. Make sure that they understand the difference between operating a startup on a shoestring and functioning in a larger organization, with large budgets and support. Not all corporate executives are able to manage this transition, and I unfortunately have seen a number of instances where they could not.

Running a startup is really hard, and involves a lot of sacrifices. It is important that the co-founders be passionate about what they are doing, and you need to be comfortable that they are in this for the long haul.

Co-founder diversity is important. Multiple studies have shown, for example, that startups with mixed gender co-founders perform better than where the co-founders are all male. There is a significantly greater risk that co-founders will have “blind spots” if they come from similar backgrounds and experience.

You also need to be comfortable with how the co-founders interact with you as an investor. Do they understand good governance? Will they want to keep you informed? Similarly, founders need to have a clear understanding of your role as an investor -- the extent to which (if at all) you are willing to help beyond your cash contribution. Finally, you need to respect the limitations of your role as an investor - even if you agree to serve as a non-executive director, you will not be a manager of the business.

While beyond the scope of this blog, many of these same points are relevant to the selection of a seed fund.

Rule 3. Understand the industry and market

It goes without saying that investing in industries that you, or someone you can consult, knows is a lot less risky than investing without that knowledge. No matter how impressive its ideas, a startup will fail if it does not understand the key challenges of the market that it is attacking, whether those are issues of customer acquisition or retention, integration with legacy or other systems, large corporate wariness of doing business with startups, better-capitalized competitors, healthcare reimbursement issues, regulatory challenges, or whatever.  You need to do your own due diligence to assess whether the startup is on the right track. This research and analysis is time-consuming, and most family offices or high net worth individuals are not going to find it cost-effective to do themselves, so, again, investment through a fund or angel syndicate makes sense.

Particularly at seed stage, it is also a significant plus if you or others whom you know are able to deliver value to your portfolio companies through knowledge, experience and contacts.

Rule 4. Understand the journey

A key element of startup investing is to have a strong sense of the journey to exit.  How long is it likely to take, and what is the likely exit? How many further rounds of dilutive financing will be required? Assuming all goes well, what return on investment can be anticipate? It is a rule of thumb that early stage venture capital firms will only invest if they can expect at least a 10x return on a successful exit, since these returns are needed to balance the loss of investment on the companies that fail.

 Rule 5.  Due Diligence on Founders and Investors

The relationship between startup founders and early stage investors is critical and long-term, and needs to work for both sides. Consequently, it is important for both investors and founders to do appropriate due diligence. Investors should get as much information as they can from those who have worked with founders in the past. Good investors should want the founders to do the same in respect of the investors, including by speaking with founders of their portfolio companies and former portfolio companies. This is not simply because there are both good and bad founders and investors, although that is certainly critical. It is also a question of the meshing of styles. Again, similar considerations are relevant to investment in a seed fund.

 Rule 6. Invest in what you like

Investing in startups is challenging. The journey has huge peaks and troughs, and active investors can play a key role in helping the startup through challenges.  

Conversely, however, interacting with startups can be immensely rewarding and fun, particularly for those who are more used to a conservative corporate environment than to startup agility.

Consequently, it makes sense to invest in startups addressing challenges that interest you, whether you do so directly or through a fund.

Conclusion

Seed investing can be profitable. It is socially important, since early stage investment is critical to innovation and job creation. Seed investment also provides a way for investors with experience and useful relationships to pass on their benefits to founders. However, it is easy for investors to approach seed investment emotionally rather than rationally. As with any investment, that is a clear recipe for disaster.

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This discussion is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions or comments, feel free to contact [email protected].

You will find a listing of Bob’s startup and scale-up blogs on US and international expansion and other startup and scale-up matters here: http://bit.ly/StartupGuidesIndex