I’ve been investing professionally for the past six years, first as an early partner at Google Ventures and now at Felicis Ventures. I’ve seen the highs of watching a startup IPO and the lows of having to lose money when a company folds.
I’ve watched many of my friends and colleagues play their hand at investing as well. Some have made money, but most have learned hard lessons, as the odds are usually not in their favor. Here are some of the easiest mistakes I’ve learned to avoid when advising someone who wants to personally invest in tech startups.
1. Expecting to make money at startup investing early on
I’ve watched close friends lose money in startup investing, and the anguish is even worse when they had the money earmarked for something else—a vacation house, a home remodel, or something they were hoping to use the money for. The funds I deploy personally into investing in tech startups comes from my “Vegas budget,” which is money that I would be comfortable losing at a craps table in a casino.
I hate to say it, but startup investing has much worse odds than craps or Roulette. In one top Silicon Valley startup incubator, only three or four companies out of more than 100 they curate do really well—that’s a 3 percent chance of finding a winner, so you’re much more likely to lose your money than not. It takes years to develop great deal flow and pattern recognition and to build a large enough portfolio to find a winner. You’ll be likely disappointed if you expect to hit the jackpot early on in tech investing, if at all.
2. Putting all your eggs into one basket
Top-returning venture funds don’t just invest in one company, most have tens, if not hundreds in their portfolio to spread out their risk. A few large winners generate most of the returns among the thousands of new startups every year. Most will lose money. As one of my mentors who is a top Sillion Valley VC once told me: “To find your prince you have to kiss a lot of frogs.”
I once had a friend who put most of the money he set aside for personal investments in one company. He would say, “I’m sure this startup is going to be the next Facebook—the traction is incredible—why not put every dime I have into it?” The company did well for a couple of years, but then they faced a more well-funded competitor that unfortunately executed better. Three years later the company went through a fire sale and early investors got less than 10 cents for every dollar they put in. Spread out your risk among lots of companies rather than concentrating it into only one or two startups, no matter how attractive they may look at the beginning. It’s amazing how quickly a company’s fortune can turn on a dime—for better or for worse.
3. Falling for deals that seem too good to be true
I get notes from many of the CEOs I work with asking for my advice on whether they should invest in a particular startup. Usually the e-mails go something like this: “The founder seems AMAZING and the market size appears to be HUGE, and the valuation is so LOW. This could be the next UBER, what do you think?” When you dig deeper, you realize that their product has no traction and they have no paying customers; the market they are targeting may not be ready to adopt their particular technology; or they are missing several key team members. It’s easy to believe that a deal is amazing, but it’s hard to dig in and realize that if the price on a deal is too low, there’s usually something wrong with it. It’s easy in this business to believe what you hear but hard to verify and diligence, because not all the information is obvious. Additionally, founders are often overly optimistic in their assessments and underestimate the challenges involved in building their company. What you don’t know can hurt you when you invest in startups.
So what should you be doing?
Investing in tech is inherently risky, and if you lack the patience, deal flow, network and pattern recognition, the risks compound exponentially. Unless you can focus on it full-time and really understand the art and science of portfolio construction, you’re doing yourself a disservice by not outsourcing your investing.
The best way to go about investing in startups is to do so as a limited partner in a top fund where you have an amazing team to do it for you professionally. A bank spreads its assets across a portfolio of loans instead of putting all its money into one loan because it lessens the risk of a particular default losing all of the bank’s money. Similarly, investing in a portfolio spreads risk across multiple investments that have been vetted by professional venture capitalists who have already learned the hard lessons above early on. But if you do get the itch to personally invest in startups, do so with your Vegas budget—you’ll be less likely to be disappointed that way.
