There is something exciting about investing in an early-stage company.
You meet a founder who is convinced they are about to change an industry. The product makes sense. The market is huge. The pitch deck is beautiful. And somewhere around slide 14, the founder tells you that if they capture just 1% of a massive market, the company could be worth billions.
It's hard not to get excited.
I've sat through enough startup pitches to know that the excitement is real. I've also seen enough companies to know that excitement isn't an investment strategy.
The truth is, even very good investors are going to be wrong about some startups. Some promising companies will run out of money. Some will get beaten by competitors. Some will discover that customers don't love the product nearly as much as the founders thought they would. And occasionally, a company that looks like a sure thing simply falls apart.
That's why I believe one of the smartest ways to approach early-stage investing is to stop thinking about finding the next great company and start thinking about building a portfolio of great possibilities.
You don't need to predict which horse wins every race.
You need to own enough horses that you have a good chance of owning the winner.
Think about it this way. If you had $300,000 to invest in early-stage companies, you could put $100,000 into three companies and hope you've found three winners. Or you could put $10,000 into 30 companies and give yourself 30 opportunities to be right.
Neither strategy guarantees success. But the second strategy changes the mathematics of being wrong.
Maybe 15 of those companies fail. That's painful, but not necessarily fatal to the portfolio. Maybe eight return roughly what you invested. A few produce respectable returns. And then one or two companies really take off.
That's where startup investing gets interesting.
The returns don't necessarily come from being right all the time. They can come from having enough exposure to the occasional company that becomes an extraordinary winner.
It's one of the reasons venture capital is so different from investing in established public companies. In the public markets, investors often think about consistency. In venture investing, the distribution of outcomes can be much more extreme.
One company can go to zero.
Another can double.
Another can produce a modest return.
And another can become a 10X, 20X or even larger investment.
That doesn't mean every diversified startup portfolio will make money. It certainly doesn't mean every fund manager is good. It means the portfolio has to be constructed with the understanding that some investments are going to disappoint.
That's where I think investors sometimes get the whole thing backward.
They spend an enormous amount of time trying to find the one perfect startup when they might be better served figuring out how to build a portfolio that can survive being wrong.
And there is a second part to that equation that may be even more important: who is doing the picking?
You can diversify into 30 terrible companies just as easily as you can diversify into 30 promising ones.
The quality of the screening process matters.
If someone tells me they have access to 500 startups and they want to invest in all 500, I'm not impressed. If they tell me they looked at 500 companies and found 25 that survived an unusually rigorous screening process, now I want to hear more.
There is a big difference between diversification and indiscriminate investing.
The ideal is diversification after disciplined selection.
And this is where professionally managed investment vehicles become interesting.
Not everyone wants to become an angel investor. Not everyone wants to read pitch decks at night, negotiate term sheets, conduct due diligence and spend years wondering whether the founder is going to hit the next milestone.
For those investors, there are several ways to get exposure to private companies without personally picking every investment.
Traditional venture capital funds are one option. Angel syndicates are another. And there is another structure that I think deserves more attention from investors: the Business Development Company, or BDC.
A BDC isn't simply a fancy name for a venture fund. It is a specific investment-company structure designed to provide capital to smaller and developing businesses.
One example is Capital Q Ventures and its Capital Q Business Development Company.
What makes the Capital Q model interesting is that it combines venture capital, BDC investing and private equity strategies. For an investor, that creates a potential way to participate in a portfolio of private and growing businesses without personally having to source and manage every individual investment.
That doesn't make the investment safe.
In fact, investors should be very careful about making that assumption. A BDC can still own companies that struggle or fail. Private investments can be difficult to value and difficult to sell. Leverage, fees, expenses and the quality of the underlying portfolio all matter.
The word "BDC" shouldn't make anyone reach for their checkbook.
But the structure is worth understanding.
If you're an investor who wants exposure to private businesses but doesn't want to personally make 30 startup investments, a professionally managed vehicle can solve a very practical problem.
It puts the portfolio construction in someone else's hands.
And that brings us to another question: How early should you invest?
There's a tendency in startup investing to believe that earlier is always better.
It isn't.
Getting in before everyone else can produce enormous returns. That's true. But you're also buying the greatest amount of uncertainty.
A founder with a great idea is interesting.
A founder with a great idea, paying customers, growing revenue, improving margins and evidence that customers actually want the product is much more interesting.
Yes, you may have to pay a higher valuation.
But you're buying information.
And information is valuable.
I've always thought there is a strange obsession with getting into a company as early as possible. Investors talk about being "first money in" as though being first automatically makes you smarter.
Sometimes it does.
Sometimes it just means you were the first person to discover the problem.
There is nothing wrong with allowing a company to prove a few things before you invest.
In fact, for many investors, that may be the smarter way to move down the risk curve.
You aren't eliminating the risk. You're exchanging some potential upside for additional information.
And that's a trade many investors should be willing to consider.
There's another part of the equation that experienced investors understand: the first investment isn't necessarily the most important investment.
Imagine you invest $25,000 in 20 companies.
Most struggle. A couple survive. Two begin to take off.
Suddenly, you have a much more interesting problem.
You have to decide whether to invest more in the companies that are proving themselves.
That's why I like the concept of keeping capital in reserve.
If you have $300,000 available, you don't necessarily have to put all $300,000 to work immediately. You might invest $200,000 or $225,000 initially and keep the rest available for follow-on opportunities.
Now your portfolio has a little flexibility.
If a company starts producing exactly the results you hoped for, you have capital available to participate in its next round.
If another company continues missing milestones, you don't have to keep throwing good money after bad simply because you already invested in it.
That's one of the advantages of thinking like a portfolio manager instead of thinking like a gambler.
You're constantly asking, "Where should the next dollar go?"
Not, "How do I save the last dollar I invested?"
There is also something else that can make a tremendous difference in early-stage investing: experience.
This is one reason I like organized angel investing.
Imagine sitting around a table with ten investors.
One has built software companies. Another understands manufacturing. Another has spent decades in financial services. Someone else knows consumer products. Another investor has taken a company public.
The founder gives the same pitch to all of them.
But they're not hearing the same thing.
One investor may see a terrific opportunity.
Another may recognize a problem with the distribution model.
Another may realize the company's margins don't work.
Another may know that the competitor the founder dismissed is actually very dangerous.
That's the value of an experienced investment network.
You're not just pooling capital.
You're pooling judgment.
And when that judgment is combined with a diversified portfolio, you can create something much more powerful than simply writing checks to startups you happen to like.
You can create a process.
That, ultimately, is what I think the smartest early-stage investors are doing.
They're building a process that doesn't depend on being right every time.
They're looking at management.
They're looking at the market.
They're looking at customer validation.
They're looking at valuation.
They're looking at how much capital the company needs and what it's going to accomplish with it.
They're looking at the competition.
They're looking at the next financing round.
And they're asking a question that sometimes gets lost in the excitement of a great pitch:
"What could make us wrong?"
That's one of the best questions an investor can ask.
Because the objective isn't to eliminate risk.
That's impossible.
The objective is to understand the risk well enough to size your investment appropriately.
And then diversify the rest.
So what kind of returns can investors actually expect?
This is where things get uncomfortable, because everyone loves the upside story.
Nobody puts a startup pitch on the front of the room and says, "Here's our exciting plan to return 1.3X your money over eight years."
The attraction is the possibility of a huge outcome.
A 10X investment can make a portfolio.
A 20X investment can transform it.
And a truly extraordinary winner can potentially make the performance of several failed investments almost irrelevant.
But that doesn't mean investors should expect those outcomes.
Early-stage investing can produce very high returns, but it can also produce very high losses.
A 20% annualized return over ten years would turn $100,000 into approximately $619,000.
That's an incredible result.
But it would be a mistake to look at that number and assume every startup fund is going to produce 20% a year.
The reality is much messier.
You might have investments that return nothing. Others might return your original investment. Some might double. A few might produce multiples of your original investment. And, if you're fortunate, one or two may become extraordinary winners.
That's why experienced investors often look at MOIC—Multiple on Invested Capital—as well as IRR.
A 3X return sounds fantastic.
But 3X over three years is a very different investment from 3X over ten years.
The clock matters.
So does liquidity.
So does risk.
And so do the fees.
That last part is easy to forget when everyone is talking about the next big startup.
The structure of the investment matters almost as much as the investment itself.
If you're considering a fund, understand the management fees and carried interest.
If you're considering a BDC, understand its fees, expenses, leverage and portfolio.
If you're investing directly, understand the valuation, dilution, liquidation preferences and the terms of the financing.
Don't fall in love with the company and forget to read the deal.
I've seen enough entrepreneurs to know that founders are naturally optimistic.
That's one of the reasons they're founders.
Investors need to bring a little skepticism to the table.
Not pessimism.
Skepticism.
There's a difference.
The optimist says, "This could be a billion-dollar company."
The skeptic says, "Absolutely. Now show me how."
That's the mindset I think investors should bring to early-stage investing.
Don't bet everything on one founder.
Don't assume the prettiest pitch deck is the best investment.
Don't assume the lowest valuation is the best deal.
Don't assume getting in earlier automatically means getting a better return.
And don't assume diversification alone will save you.
Instead, build a thoughtful portfolio. Invest in companies that have earned your confidence. Keep some capital available for the winners. Surround yourself with people who understand areas you don't. And, if you don't want to build the portfolio yourself, consider whether a professionally managed fund, syndicate or BDC is a better fit.
Capital Q Ventures is one example of the BDC approach worth researching, but it is just that—an example. The same due diligence you would apply to a startup should be applied to the vehicle investing in the startups.
At the end of the day, the smartest early-stage investor isn't necessarily the person who can predict which company will become the next great American business.
It's the person who understands that they won't be right every time—and constructs their portfolio accordingly.
You don't have to find every winner.
You just have to make sure that when you find one, you own enough of it to matter.
Investor Q&A
Can early-stage investing really produce 20% or more annually?
It can, but there are no guarantees. Startup returns are highly uneven, and a small number of exceptional companies can generate a disproportionate amount of a portfolio's overall returns.
For perspective, a 20% annualized return for ten years turns $100,000 into about $619,000. That's the attraction. The risk is that individual investments can also go to zero.
What does a 3X return mean?
It means your investment ultimately produces three times the amount of capital invested. A $100,000 investment that returns $300,000 is a 3X MOIC.
But don't forget the time involved. A 3X return in three years is dramatically different from a 3X return in ten years.
Can a diversified startup portfolio still lose money?
Absolutely. Diversification reduces concentration risk; it doesn't eliminate investment risk.
You can still lose money across an entire portfolio, particularly if the investments are poorly selected or purchased at excessive valuations.
Is a BDC safer than investing directly in a startup?
Not necessarily.
A BDC can provide diversification and professional management, but it still carries investment risk. Investors should examine the underlying portfolio, management team, leverage, fees, valuation practices and offering documents.
Why might someone choose a BDC such as Capital Q Ventures instead of picking startups themselves?
Convenience and professional portfolio management are two major reasons.
Rather than personally sourcing, evaluating and monitoring dozens of private companies, an investor can potentially gain exposure through a professionally managed vehicle.
The tradeoff is that you give up some direct control and take on the risks and costs associated with the investment vehicle.
What's the biggest mistake an angel investor can make?
Putting too much money into too few companies.
The beauty of a diversified portfolio is not that every investment works.
It's that one exceptional investment can potentially make up for a lot of investments that don't.
That's the game.
And if you're going to play it, you might as well play it with enough horses in the race.
