It’s a feeling that any punter who has lost big on the Melbourne Cup understands. You’ve researched the jockey and team, looked at the field and track conditions and felt confident you had a winner, only to be last across the post. In fact, the parallels between early stage investing and the horse racing industry might surprise you. Deciding to invest in early-stage startups can be not so different from trying to pick winning horses.
The earlier you invest in a thoroughbred racehorse, the risks and potential returns increase. The valuations are difficult to pin down and you often need to rely on qualitative indicators of future performance. Furthermore, the quality of the support team around the horse is important, as is the strength of your network and understanding of the ecosystem. Thoroughbred owners and early stage investors both have a strong passion for the people, ecosystems and process of developing and picking winners. Both groups also know that no matter how many good picks they’ve made, they will not always get it right. It is a game of risk and there are many elements that are beyond any single person’s control.
Learn about your startup ecosystem, locally and globally, and find out who has the best record and integrity. Then, attempt to access and meet these people and their networks. Study available information on them and read or listen to what they have to say. By becoming entrenched, you can then find and network with other like-minded, aligned and experienced early stage investors.
Your success is likely to improve over time. Considering the potential deal by deal risk associated with this asset class, your investment pool shouldn’t be more than a small portion of your overall asset pool in the early stages. You will not have much spread initially , so you need to be able to lose the lot if something goes pear-shaped.
On a horse by horse basis or deal by deal basis the risks are high. On a portfolio basis there is research that indicates if you look at all the transactions across all stages of investment the Angel/Seed to early series A area offers superior multiples of return than the later stages. If possible a portfolio of at least thirty early stage investments but preferably more will help increase the chances of finding one or two “flyers” and reduce the impact of any failures.
You are best to develop a portfolio of twenty to thirty investments at least over time, so do not get seduced by the first potential unicorn you see and invest too heavily. You will potentially need to see hundreds of startups before you are invested in thirty. So you will need access to quality sources of diverse Founders.
Consider the possibility of later capital raising rounds. If the founding team hit all of their milestones and are executing strongly and communicating well with investors, you may want to invest more heavily in the next round. Sure, it might be at a higher valuation but if it is a good company with a good management team there should be plenty of growth left in it.
Get a good lawyer who has experience in startups to review your documents before investing. It is vitally important to have an expert review the many terms of your investment as they could impact the future value of your investment. As an example, it is important to secure pre-emptive follow on rights in the term sheet or subscription agreement in your initial investment. This will give you the right, but not an obligation to at least maintain your percentage in the company and not be diluted by any subsequent capital raising. But there are many other important terms to consider.
Whether we’re picking the Melbourne Cup winner or the next startup unicorn, the best we can do is understand the many pitfalls and mistakes that founders and investors can make. If you put a few key principles in place, you can manage and reduce the risk, and hopefully be first past the post.