ANGEL INVESTING

SVIC’s Guide On How To Invest In Startups – Part 2

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You can find part 1 of our guide on how to invest in startups here.

This article is written by Yigit Ihlamur (@yihlamur), co-founder and general partner at Vela Partners, an AI-enabled venture capital firm. 

Welcome back. This is part two of Silicon Valley Investors Club’s guide to getting started in startup investing. 

In part one of this guide, we talked about the first two steps of startup investing: to create a startup investing budget and to determine your target market. In part two of this article, we will talk about steps three and four of getting involved in startup investing: to build your startup funnel so that you can develop deal flow and to craft an investment decision process. 

Step #3: Build your startup funnel

As with any “private equity” business, the key is to build a funnel of potential leads [in our case, startups to invest in] and run a disciplined process to determine if these leads fit your criteria. This is no different from hiring, sales or online signup flows that any professional is likely familiar with. 

After you have a clear idea about what it is you want to invest in, how much you are prepared to invest, and how many projects you intend to invest in, the next question you will have to consider is how you are going to find those startups. 

Public markets are about analyzing and evaluating if an asset is undervalued or overvalued. You can be a math wizard and invest in public markets easily with the click of a button from your bed (in your pajamas) and still beat everyone. In the startup investing world, if you don’t know how to source and gain access to invest, then your smarts don’t matter very much. 

There are many ways to source startups. You just have to find your own edge. For example, while Tim Ferris uses his books and podcasts as his sourcing channels, Vela uses an internally-built Google-like search engine to source startups. 

If you want to begin sourcing your own startups, follow these instructions:

  1. Let the world know that you’re an angel investor. 
    • Create your Angellist account.
    • Update your LinkedIn profile to make it clear to founders that you are interested in investing in startups.
  2. Join investment communities such as Silicon Valley Investors Club or alumni groups such as Xoogler.co. Then, build relationships with startup founders, angel investors, and venture capitalists. 
  3. Go to demo days of accelerators and learn how to engage with startups in a casual setting. 

After you complete the steps above, you’ll become more aware of your edge. Here are some examples of what this looks like in practice:

  • If you’re a software engineer, then you can build an algorithm to source developer tools startups. 
  • If you’re a product enthusiast, then you can be active on ProductHunt with reviews and hunts.
  • If you’re an expert in HR, then you can be active in everything relevant to that field: attend meetups, organize events, write blog posts, become a speaker, and build relationships with VCs and angel investors who invest in HR. 

Keep in mind that you must be patient because it will take months or, more probably, years to build your startup funnel.

Moving Startups Through Your Funnel

As you begin talking to founders, you will need to keep track of who you speak with. A simple Google sheet should help you accomplish this when you’re just starting out. The reason you want to track who you speak to is that after some point in time, you will have a large number of startups that you’ll be engaging with and you will need this system of record to help you analyze the funnel and keep existing relationships fresh. 

The Four Phases of Your Startup Funnel

  • Unqualified leads: These are startups that you come across through Linkedin, demo days, recommendations from your network, solicitations from founders, or your own unique sourcing channel, but that you haven’t had a chance to look at critically yet.
  • Qualified leads: An unreviewed lead changes to a qualified lead when you have spoken to the founder or read their pitch deck and decided that their company might be a fit for your investment criteria. Qualified leads are startups that you have looked at and decided that you might be interested in investing in. Less than 10% of unqualified leads become qualified leads. 
  • Opportunities: A qualified lead becomes an opportunity once you have had time to have a deep-dive discussion with the founder and conducted due diligence on the company.
  • Investments: We will talk about how to think about making an investment in step four.

Most VCs invest in 0.1%–1% of the startups they see. Put another way, a typical venture capitalist will invest in somewhere between 1 and 10 out of every 1,000 startups they investigate. What this means for you is that you should be patient when making your first investment decision. At the very least, you should evaluate 100 startups and benchmark them before making any concrete investment decisions. 

Step #4: Create an investment decision-making process

Now that you can find startups, how do you invest?

Each startup has pros and cons. All startups, great or terrible, will be rejected by hundreds of investors. Some investors will reject a startup because of its location, stage, or lack of traction. Sometimes startups are rejected because their idea just doesn’t resonate with the investor. Other times, still, an investor may have some personal reason for rejecting a startup. You have to personally determine how you will weigh each pro and con.

Some investors prioritize teams, while others prioritize growing markets. Depending on the stage at which you invest, it’s also common to evaluate the progress a startup has achieved so far. The more the company progresses, the more expensive the startup will be, and the harder it will be to invest in the company at a reasonable valuation.

At Vela, we have three key initial screening criteria: thesis-fit, team-fit, and 100X+. 

  1. Thesis-fit: Can we intelligently evaluate this startup? Do we have an informed opinion?
  2. Team-fit: Is this the right team to execute this venture?
  3. 100X+: Do we see a 100 times or greater return potential in the market that the startup is operating? In other words, for seed-stage startups, can the beachhead product of the startup generate $100M annual revenue?

Like any recruitment process, the next steps of startup investing are to run an interview process, deepen the analysis, and evaluate the startup in various other sub-dimensions. At Vela, we prepare a scorecard for each qualified startup and write an investment memo to articulate our thoughts and weigh the pros and cons. Running the same process for many startups helps you weed out the bad investments and, more importantly, enables you to separate the great from the good. 

Unlike almost any other recruitment processes, though, startup investing is a two-way interviewing process. How you build your relationship with the startup founder matters. Being transparent, friendly, fast, well-prepared, and capable of demonstrating your edge are all important attributes that will grant you access to invest. If you’re a business development, sales, recruitment, or partnership professional, then you have an added competitive advantage in this part of the process because this will all be natural to you. This is essentially a partnership business more than an investment business. 

How can I do all of this if I am a full-time professional?

If you’re serious, then I recommend that you make startup investing your only hobby outside of your primary job. Like all great things, startup investing requires an ongoing time commitment. (It may very well consume your other hobbies, anyway.) At the very least, I recommend that you carve out a minimum of 5 hours from your weekly schedule to engage in investing.

You also need to determine what your investing goals are. What do you intend to gain from startup investing? For reference, some people invest with the goal of learning how to become an entrepreneur, others invest to expand their networks, and still others invest solely as a financial instrument. 

If investing is mainly a financial instrument for you, then focus on networks with the highest return on investment for your capital and time. Here are some definitive ideas about how you can get started, from the highest effort to the lowest effort, in descending order:

  1. (High Effort)Build your proprietary deal flow to source and invest.
  2. (Medium-High Effort) Attend YCombinator/500/Techstars demo days and invest in a few startups in each winter and summer batch.<
  3. (Medium-Low Effort) Evaluate and invest in syndicated deals one by one on Angellist.
  4. (Low Effort) Invest in a venture capital fund.
    These actionable steps will help you get started with startup investing. Remember, startup investing is about sourcing as many startups as possible and then having a logical decision-making process to filter out the weak ones effectively. If you don’t spend the proper time preparing yourself to invest in a startup before you actually begin investing, then you will most likely get randomized and be likely to drop out quickly. If you read this far, then I expect that our paths will cross someday. For now, though, I wish you the best of luck in your startup investing journey.This content is for informational purposes only. All views contained herein are my own and do not represent the views of Vela Partners LLC (“Vela Partners”) or any Vela Partners affiliate.

Read SVIC’s guide on how full-time employees can get started in real estate investing.

Silicon Valley Investors Club (SVIC) is a community of tech employees who are interested in making smarter financial and career decisions. Our private group page provides SVIC members with a moderated space to engage in rich discussions about investment topics such as real estate, stocks, angel investing, private equity, financial planning, career success, and more, as well as to participate in exclusive Q&A sessions with special guest experts.

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SVIC’s Guide On How To Invest In Startups – Part 2

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SVIC’s Guide On How To Invest In Startups – Part 1

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This article is written by Yigit Ihlamur (@yihlamur), co-founder and general partner at Vela Partners, an AI-enabled venture capital firm. 

 

As a venture capital firm, Vela Partners is frequently approached for advice about startups. How does someone build a successful startup? How does someone invest in a promising startup? Many articles try to answer the first question, but few take a stab at the second, and, consequently, the process of investing in quality startups remains frustratingly mysterious to many. 

In this two-part guide, I will explain how to get started in startup investing. By the end of this guide, you will have learned the following skills:

  1. How to build a startup investing budget 
  2. How to determine your target market 
  3. How to build your startup funnel
  4. How to create an investment decision-making process

But before we get started, it’s critical to understand that investing in startups is speculative and should not be done at the expense of more conservative investments found in your company’s 401k plan. Make sure you are maxing out your 401k and have adequate savings before engaging in startup investing. 

The Differences Between Investing in the Stock Market and Investing in Startups

Investing in the Stock Market

When people say they are going to invest in the stock market, they are referring to buying an ownership stake (shares) in a publicly-traded company listed on the New York Stock Exchange, Nasdaq, or other stock exchanges. These publicly traded companies are regulated by the Securities and Exchange Commission (SEC) and are required to publicly report their earnings on a regular basis.

For the most part, these companies tend to be mature, earn revenue (hopefully making them profitable), and follow proven business models. 

It’s easy to purchase through online brokers such as Charles Schwab, Robinhood, Etrade, etc. All it takes is cash in your brokerage account and the company’s ticker symbol to easily purchase shares in the company. Each publicly traded stock has a designated abbreviation that represents the company. For instance, Facebook’s ticker symbol is FB, and Amazon’s ticker symbol is AMZN. An added benefit of purchasing publicly traded stock is that most of the listed companies you’ll find are liquid, meaning you can easily buy and sell them when you want to. However, your return on investment won’t surpass investing in “successful” startups. I say “successful” because the failure rate for startups is quite high, upwards of 90% of startups fail.

And finally, with publicly traded stocks you can easily sell your investment when you want, whereas with startups your investment isn’t liquid so if you want to sell the startup you have invested in, you will have to wait probably 7-8 years, assuming the company is even viable. 

Investing in Startups

Unlike established publicly traded companies,  most early-stage startups are still discovering their business models. A business model is a method for how a company will go about creating products and selling them to customers. Being that a startup’s business model is a work in progress, usually these companies haven’t yet earned any revenue. By investing in startups, you are taking on much more risk because their business models are unproven and no one really knows if their potential customers will be willing to pay for their product at a price that will make the startup successful.

The benefit of investing in a startup is the potential to earn a higher return than you would for investing in a publicly-traded company. When you invest in a startup, you have the ability to invest at a discounted price that doesn’t take into account the potential value of the company when it becomes profitable. Whereas if you invested in a mature company with strong revenue and healthy profitability, you are purchasing shares of the company at full price or potentially at a premium because the business is proven to be profitable.

Another benefit of investing in startups is that with large publicly traded companies you have very little impact on how the business functions, but with startups, you have the opportunity to meet the founder and provide them with valuable advice and introductions to people in your network that can help the company achieve its goals. Not only is it financially rewarding to invest in a successful startup, but it is also satisfying to know that your help contributed to the overall success of the company. 

How do you pick the right startups to invest in?

There is no one right answer, and no one knows the leading indicators of startup success. If someone did, then there would be one firm dominating the market. But there are ways you can minimize the risk involved in investing startups if you build your own process to evaluate as many startups as possible, build a disciplined qualification process to separate the great from the good, build a large enough portfolio to account for outlier potentials, and remain patient. Most investments will fail, a few will break even (or do slightly better), and one or two will succeed spectacularly.

So with that being said, let’s get started with the first step in building your startup investment process.

Step #1: Build a startup investing budget

Although this asset class is probably the riskiest and most illiquid one out there, its return profile is the most promising. As a starting point, allocate a budget as you do for your 401K. This should be an amount that you won’t touch for a long time. Choose an amount that is low enough to not materially change your life should you end up losing it. In other words, only use funds for startup investing that you don’t mind losing.

How much capital you should allocate varies based on your risk profile. Young professionals may have a higher risk appetite, fewer commitments in their lives, and a longer time horizon for returns. Their allocation of capital for the startup asset class may be much higher than a professional with a few kids at school. Your net asset allocation to startups should be between 5% and 10%. You can increase this allocation as you build more confidence over time. 

The next step is to determine what your diversification strategy will be. Based on our studies at Vela, we estimate that ~5% of a typical venture firm’s portfolio brings an outlier return (100 times return on investment, or more). This means that 1 out of 20 startups may bring more than 100x return on your capital; even if 19 of your portfolio companies go bankrupt, the return on your capital will be large enough. Let’s think of this scenario. If you invested $1 for 20 companies, your return in this scenario would be $80 ($1 * 100 – $20). With this in mind, the suggestion is to invest in at least 20 companies. 

The other aspect of diversification is the rhythm of investing. Should you invest in 20 companies in a period of one month? Probably not. You should invest in at least 20 companies over a period of some time to avoid the time bias or in other words seasonality. For example, at Vela, we invest in 20+ companies over a period of 3 years. 

Step #2: Determine your target market

Now that you know your budget and how many startups you will aim to invest in, you can calculate how much you can invest in each startup. It is time to determine your target market.

If you do not know who your target market is, that’s okay. Put yourself into exploration mode for the next 3 months and do some market research: 

  1. Update your calendar for a regularly scheduled time to learn about startups. It should be at least a few hours per week.
  2. Read about startups and the investment theses of other venture capital firms.
  3. Attend startup events and “demo” days.
  4. Ask other startup investors if they can share the pitch decks they are looking at. You can connect with startup investors at SVIC’s Facebook group. 
  5. Review at least 100 startups. The more startups you review, the better. Only by reviewing dozens of startups will you learn the patterns that signal which startups are critically flawed.
  6. After each startup investigation, score it on the promise or quality of its various dimensions, including its team, market, and idea. 

After reviewing more than 100 startups, you will realize that you have no interest in investing in certain markets. This is good; in time, you will dismiss companies and categories immediately without having to think too much about it, allowing you to focus on the ones you like. 

Determine what dimensions you care about most. Some example dimensions are team, market, location, innovation, and traction. Scoring startups this way will help you articulate what kind of startups you prefer to invest in. 

Here are the most common dimension-driven strategies:

  1. Team-driven: Startups that were founded by friends, ex-colleagues, under-represented communities, ex-Googlers, etc.;
  2. Market-driven: Startups that pertain to a specific market (e.g. SaaS, finance, developer, retail, etc.);
  3. Location-driven: Startups you can visit face to face;
  4. Innovation-driven: Startups with a focus on an innovative market or technology (e.g. quantum computing startups, machine learning startups, etc.);
  5. Traction-driven: Startups with more than $10K monthly recurring revenues and less than $5M in valuation.

To Do:

  1. Open a Google Doc to create an investment journal to track your startup investing journey and to answer the following questions and save links from your research.
  2. Determine what your startup investment budget will be.
  3. How many hours per week will you dedicate to startup investing? Make sure to schedule recurring time on your calendar to review startups.
  4. Update your social media profiles to make it clear you are interested in investing in startups.
  5. Determine which kinds of startup dimensions (team-, market-, location-, innovation-, or traction-driven) you enjoy and explain why.
  6. Who do you know that invests in startups? If you know someone who does, reach out to them to learn about their experiences. 
    • Try starting a conversation within the SVIC community to connect with other investors.
  7. Scour the internet for information on startups and review venture capitalist websites and blogs to learn how they analyze startups.
  8. Review startup pitch decks to get a better flavor for what is included in a standard pitch deck.

Well, that’s a wrap for part 1 of this guide. In part 2 of the guide, you will learn how to find deals and how to decide which startups to invest in. If you enjoyed this article, please share it! Also, please let us know your thoughts by leaving a comment in the comment section below or within the SVIC community. 

Thanks to Jordan Thibodeau and Joe Ternasky for reading, reviewing, and editing this article.

The content here is for informational purposes only. All views contained herein are my own and do not represent the views of Vela Partners LLC (“Vela Partners”) or any Vela Partners affiliate.

Silicon Valley Investors Club (SVIC) is a community of tech employees who are interested in making smarter financial and career decisions. Our private group page provides SVIC members with a moderated space to engage in rich discussions about investment topics such as real estate, stocks, angel investing, private equity, financial planning, career success, and more, as well as to participate in exclusive Q&A sessions with special guest experts.

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Investors Therapy Session #1: How to Become an Angel Investor with Yigit Ihlamur

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“It’s important to maintain an investment journal. Not only is it a way to help you make an investment decision, but two to three years from now, you will see how you made that decision, and it will help you to improve yourself in the next set of investments that you make.” – Yigit Ihlamur

We here at Investors Therapy are excited to announce the launch of our new web show! Creatively named, Investors Therapy is a brand new video series based on our monthly newsletter that can be found here on the SVIC website or over on our YouTube channel. Our goal with this series is to showcase the diverse and unique mindsets, tendencies, and journeys of a variety of well-respected and successful investors in order to help you continue to hone your own investment skills. Shot in an interview format, each episode highlights one investor as they share their personal investment story in their own words. The series emphasizes the psychological aspects of being an investor.

In the premiere episode of Investors Therapy, Jordan interviews Yigit Ihlamur, a former Googler and founding partner of the venture capital firm Vela Partners. The two discuss the ins and outs of Angel Investment, and Yigit shares a number of tips and tricks that helped him become a successful Angel Investor.

We hope you enjoy the episode. If you can, please like, subscribe, and share the video.

 

The interview in Episode #1 of Investors Therapy covers the following topics:

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