If you’re a new First Stage Investor member, welcome to the community. If you’ve been a member with us for a while, we thank you for joining us on this remarkable investing journey. On Twitter, @DDay_68 alerted us to the fact that many of you have some questions about the process of investing in startups. So over the next few weeks, we’re going to review some of the basics to help make the investing process easier.
This week, we’re looking at time frame, liquidity and portfolio construction.
Time Frame and Liquidity
Investing in startups is fundamentally different than investing in the stock market. In the stock market, you can buy and sell shares whenever you want. For example, if you noticed Apple stock was down for some reason, you could buy some shares and invest in it right away. And let’s say Apple stock went up a few hours later and you wanted to sell to lock in your profits. You could do that quite easily too.
That’s because stocks are fundamentally liquid assets. They can be bought and sold easily. Shares in startups are fundamentally illiquid. You can’t sell them easily. And you have limited opportunities to buy them. So you have to approach investing in them differently.
One of the biggest changes in your investment approach is understanding how long you’re going to have to hold on to your investment. In the earlier example of Apple stock, you could hold on to it for a few hours. Or you could hold on to it for a few years. The choice is yours. Because Apple stock is liquid, you’re just looking for the “right” time to sell. If you think the stock will continue to go up in price over the next few years, maybe it makes sense to hold on to it. If you think the stock could drop in value over the next few years (or months or days, depending on your personal investment timeline), then maybe it makes sense to sell.
When you invest in startups, you’re automatically holding on to that stock for a minimum of three to five years. That’s because investments in startups are illiquid. You profit from a startup investment only when there’s a liquidity event. That’s when the startup either goes public (IPOs) or gets acquired.
It can sometimes take longer than three to five years for companies to achieve a liquidity event. But that’s okay. Most people sold their Amazon stock when the dot-com bubble burst in 2000. Amazon’s stock lost 90% of its value and was trading for less than $10 per share at the time.
But if you had the discipline (and vision) to hold on, you would have booked a return of 17,975.8%.
Asking human beings to show this kind of discipline is unrealistic. We get that. But that’s why we like startup investing. Investing in startups automatically enforces that type of discipline. You don’t have a choice! Some startups struggle to find their footing. And it can be tempting to bail. But if you stick with them and if they succeed (granted, two big “ifs”), you will be rewarded.
Portfolio Construction
When you invest in the public stock market, you’re celebrating big-time when you get a 300% winner. In startup investing, a 10X gain is your minimum target. But that’s not what you’re really looking for. Startup investors are looking for the truly big gains – 30X to 100X… or more.
That’s because when you invest in startups, you’re investing in young and growing companies. These are companies that are still proving themselves. You’re taking on more risk, so you should get more rewards.
Some startups will fail. That’s okay. You’re investing in companies with a limited track record and more potential than profits. It’s all part of the process.
Consider this… In many businesses, 80% of the revenue comes from 20% of the customers or clients. This maxim is known as the Pareto principle. And it holds true in startup investing. Your big winners are going to generate your income.
Hollywood movie studios work the same way. The big blockbusters generate most of the revenue. But the studios don’t know which movies are going to be the big blockbusters. So they keep churning out movies hoping to get enough hits to make a lot of money.
As a startup investor, you’re going to want to do the same thing. Your goal should be to build a portfolio of 20 to 25 companies. You don’t have to (or even want to) invest in 25 companies at once. Take your time. Get a feel for the startup space and the different types of companies there are to invest in. Learn about things like convertible notes. And if all of this sounds daunting, don’t worry! We’re here to help.
You don’t have to invest a lot of money to be successful in startup investing. You can invest in many startups for as little as $100. So grow your portfolio slowly. Don’t invest any money you aren’t willing to lose. And most importantly, have fun!
Investing in startups could be one of the most exciting and rewarding things you’ll ever do. So enjoy the process.
Good investing,
Vin Narayanan
Senior Managing Editor, First Stage Investor
P.S. If you want to keep up with me on Twitter, follow me @vinistic. You can also follow Early Investing on Twitter @Early1nvesting.