Investors all over the world are beginning to recognize early-stage companies as an asset category that has its place in a diversified portfolio. Early-stage companies offer a potential for high return (though with significant risk) and tend to be non-correlated with other asset categories. However, investing in early-stage companies is not like investing in public companies—or even late-stage companies like Pinterest or Lending Club: They don’t have five years of historical financials to review, liquidity is rare (or non-existent) and management is likely to evolve significantly in the near future.
Here are the most common mistakes investors make when beginning to invest in startups:
New investors are often prone to investing on a whim. The sales pitch may be tempting — if it wasn’t, the company would have never gotten off the ground. But investors should dig deeper, resist early infatuation, ask hard questions, and look at the company materials with a critical eye. Research on early-stage investing returns shows that positive returns depend heavily on doing substantial diligence before investing.
On the other hand, new investors often expect too much from the data they get about companies, forgetting (for instance) that for young companies, financials are almost always just an educated guess. It’s common for investors to ask for more material than is even available, or to ask for “one more meeting” when there’s nothing left to learn. Sometimes new investors ask so many people for input that they lose track of their own analysis.
Not Testing the Product
Too many people invest without investigating the company’s product. That’s a huge mistake. Investors should understand how users interact with a company’s product. Try it out if you can—remember Peter Lynch’s exhortation to invest in what you know—and take a close look at the product from the perspective of different target users.
Not Understanding the Competition
It’s not enough to test the product—investors should also understand the market environment, how a company’s product compares to others in the space, and what the company’s unique value proposition is. Placing the company in the market and understanding its comparative strengths and weaknesses can provide insight into how quickly the company can develop its target market and how large that market can become. Few investors understand a target company’s product; fewer still familiarize themselves with the full product landscape.
Failing to Ensure that Your Time Horizon Aligns with the Company’s
Before investing in this asset class, investors should understand that startup investments take years to mature. This is no get-rich-quick opportunity. Even companies looking for a quick exit can take years to get there. Investors should ask whether the startup aims to build a long-term business or is seeking to generate medium-term cash through sale to an acquirer. Investors hoping for a major long-term capital gain opportunity may be disappointed in an investment that returns 2x in 2 years, while investors expecting a return of capital in a couple of years will be disappointed by a company focused on getting to IPO—perhaps in 10 years. Ask whether the company you’re considering is expected to be a medium-term investment or a long-term investment and whether you’re comfortable locking up your money for that period—years, and probably several of them.