Chapter 1

The Risks and Rewards of Startup Investing

Source: https://fundersclub.com/learn/guides/vc-101/the-risks-and-rewards-of-startup-investing/

What is a startup?

The world is so much more convenient today than it was at the turn of the century. No need to leave the house to shop for groceries, or step off the curb to hail a cab. There’s an app for that.

Running out of paper towels? Place an Instacart order.

Need a ride to the airport at 4am? Call an Uber.

In the last few decades, startups have turned age-old industries on their heads, solved big problems with the click of a button, and have managed to cash in big on their products and services – if they’re successful. As do the lucky investors who took a risky bet on fledgling company that happened to land on an idea that worked.

A startup is traditionally defined as a newly established private company (< 5 - 10 yrs old), that is designed to scale very quickly. Most startups kick off as very small operations while they develop their initial idea, and then seek additional funding from venture capitalists and angel investors as they build out their businesses.

What is startup investing?

Startup investors are essentially buying a piece of the company with their investment. They are putting down capital, in exchange for equity: a portion of ownership in the startup and rights to its potential future profits.

By doing so, investors are forming a partnership with the startups they choose to invest in – if the company turns a profit, investors make returns proportionate to their amount of equity in the startup; if the startup fails, the investors lose the money they’ve invested.

Liquidity refers to how easy it is to convert a security (something that you own with economic value) into cash money. Equity in a well traded public company (Facebook, for example) can be nearly instantaneously traded on the stock exchange, and is therefore highly liquid. Equity in a startup, or private company, is relatively illiquid, as it is more difficult to sell.

Startup investors make a profit from their investments when they sell part or all of their portion of ownership in the company during a liquidity event, such as an IPO or acquisition.

A liquidity event is an opportunity to turn money that is tied up in equity into cold, hard cash. A common example is an IPO (Initial Public Offering) – the first sale of stock by private companies to the public – often referred to as “going public”.

During successful IPO’s, the price per share of stock rises dramatically from pre-sale values, increasing the value of investors’ holdings, and giving shareholders the opportunity to trade their stock on the public market if they want to liquidate (cash in) any of their assets.

An asset is a piece of property with economic value, owned by an individual, a corporation, or the government, and expected to provide future benefit to the owner. Assets commonly generate future cash flow, reduce expenses, or improve sales.

Assets are divided into asset classes – groups of securities (ownership rights) that exhibit shared characteristics, behave similarly in the marketplace, and are governed by the same laws and regulations.

Startup equity, for example, is regarded as a high-risk, high-reward, highly illiquid asset class.

This means that investing in startup equity is very risky, because many startups fail to return investors’ money, and startup equity is relatively more difficult to sell before the company IPO's. However, this increased risk and illiquidity is coupled with the potential for a very large return if the startup succeeds.

Some startups will allow investors to sell their shares of stock in the company before the IPO; referred to as a secondary sale of stock.

However, many startups will issue a right of first refusal, which requires investors who want to unload stock before a company goes public to first offer to sell it back to the startup or its early investors (called a tender offer). Most startups also put restrictions on the secondary sale of common stock, or stock held by founders and employees.

EXAMPLE

In 2014, an early Uber employee found a buyer for his currently vested stock at $200/share. However, Uber refused to approve the transfer.

The employee had two options: sell his stock back to Uber at $135/share (the same amount investors paid in Uber’s Series C round the previous July), or hold it. He chose to hold it.

Uber had implemented a right of first refusal, and amended their bylaws to restrict any unapproved secondary sales of stock. The buy-back program helps Uber to collect stock issued to early investors and employees at a reduced price, and then sell it at a huge profit to later-stage investors, effectively doubling as an anti-dilution program.

Investing in Startups vs. Investing in the Public Market:

• Timelines: Investors in the public market could theoretically see a return within a few days or weeks; it generally takes 7-10 years for a major liquidity event to occur for startups (though smaller liquidity events may occur earlier).
• Selling Stock: Investors in the public market can sell off their stock at any time. It is more difficult to sell startup shares before the IPO, as stocks are often issued with provisions such as the right of first refusal and other restrictions on secondary sales.
• Returns: IPOs have become less common over the last few years, and tech companies are deferring IPO till much of their value has been accrued, making it more lucrative for habitual public market investors to invest in private early-stage startups while they are still private.

High-Risk, High-Reward: The Appeal of Startup Investing

Startup investing comes with some good news and some bad news.

Bad news first: 90% of startups fail.

Many others will return only the money you initially put into them, leaving you exactly where you started – no loss, no gain.

Now for the good news: Investing in one big winner could make up for all of your failed investments, and still leave you with an enormous profit. (Bonus: the US government provides a tax benefit to qualifying startup investors to help them recoup investment losses).

And there’s more (good news) where that came from… In the 80’s and 90’s, most value creation happened for investors in the public market who bought stock in tech giants like Amazon and Microsoft after they IPO’d. Now, however, most of the value creation has shifted to early-stage private company investors.

In fact, if you were to wait until a startup goes public to invest, you could be missing out on 95% of the gains, which are often accrued by investors before the IPO.

This is because more and more startups are choosing to delay IPOs or stay private indefinitely.

Staying private longer holds certain advantages for startups:

• Startups can avoid activist public market investors, who may try to manipulate public market executives, or even force executives out of the company.
• Companies can avoid paying $2-5 million in accounting expenses and fees involved with disclosing necessary information to the public market.
• Startups can avoid the pressure to deliver quarter-to-quarter gains, and focus on setting their company up for long-term success.

Startups that decide to remain private will often raise $40 million + late-stage rounds that serve as “quasi-IPOs”, creating enormous wealth for early-stage investors.

EXAMPLE

Apple: Rainfall for Public Market Investors

In 1976, Steve Jobs and Steve Wozniak sold their most valuable possessions – Job’s VW bus and Woz’s programmable calculator – for a combined $1,750, to buy the parts that became the Apple I.

That $1,750, a $250,000 seed investment from Apple’s employee number 3, Mike Markkula, and later investment by Sequoia Capital kept the company running for the next four years, until it IPO’d at a $1.8 billion valuation in 1980.

Jobs, Wozniak, and Markkula, made a combined $436 million in the IPO.

Apple then grew from its $1.8 billion valuation to its current $594.71 billion valuation, creating over $592 billion in value for public market investors – far more than the $436 million made by Apple's early founding team.

This is a product of startups at that time tending to IPO quickly, at relatively low valuations, and to raise fewer venture capital dollars before going public.

Twitter: All Profits Flow to Private Investors

In 2007, Twitter founders Evan Williams and Jack Dorsey were looking for investors in their unconventional social media site. Ev invited his personal friend, Dick Costolo, to invest “$25,000 or $100,000”.

Costolo replied that he was “on the $25k bus,” and, shortly afterwards, Twitter closed a $5 million Series A round.

Costolo became the Twitter CEO in 2010, and led the little blue bird to IPO at a $26 billion valuation, creating millions of dollars in value for early investors. Costolo’s stake at the time of the IPO was reportedly worth over $300 million.

Soon after the IPO, however, Twitter’s stock prices started to slump, and the company valuation eventually fell to $12.5 billion over the next few years. For investors who bought stock in Twitter when it IPO'd, their investment value has been cut nearly in half.

This has been a common trend for big-name tech startups in recent years (think: Yelp and LinkedIn), that grow enormously in value while they are private, and stagnate or lose value after the IPO.

Facebook: Value Added for Private & Public Investors

In line with the current trend, Facebook waited until their valuation climbed over $100 billion before filing for their IPO.

Early (private) investors, like Peter Thiel, who invested $500,000 in Facebook’s Seed Round on 2004, made the vast majority of the gains.

By the time Facebook IPO’d, eight years later, Thiel cashed out for over $1 billion.

However, public market investors haven’t fared so poorly either. If you had invested in Facebook on its first day trading on the public market, your shares would now be worth over 3.5x their initial value.

For startup investors to make money, their investments have to return 100% of the initial capital invested, and then some.

To understand the likelihood of making a profit via startup investing, it’s important to understand the distribution of venture returns:

Successful startup investors are subject to the Babe Ruth Effect– they strike out a lot, but their home runs make up for it.

At the heart of every startup investment strategy are a lot of strikeouts (total losses), a handful of home runs (10x - 50x), and a few grand slams (50x - 250x +). This is hard for most investors, because people hate losing money.

In fact, behavioral economists have found that people feel worse about losing a sum of money than they feel good when making that same sum of money.

But, to quote top VC, Bill Gurley, “Venture capital is not even a home run business. It’s a grand slam business.”

And when successful investors are pulling in outlier returns on billion dollar startup outcomes, the losses pale in comparison to the wins.

EXAMPLE

Founders Fund’s 2005 fund exhibited power law distribution:

The best investment within the fund produced returns that were worth nearly as much as every other investment within the fund combined. The second best investment was as valuable as the third best investment through the last place investment within the fund, and so on.

Experienced individual investors and VC’s practice diversification to increase their chances of investing in a company that produce an exponential return on investment.

Diversification basically amounts to the age-old adage “Don’t put all your eggs in one basket”.

It is an investment strategy that involves making multiple smaller investments in various asset classes, rather than sinking all of your capital into a single investment opportunity.

A well-diversified investment portfolio will typically include investments in a high-risk, high-reward asset class (like startup investing), some relatively lower-risk, lower-return investments (e.g. public equity), and more stable investments (e.g. government bonds).

Within each asset class, investors will invest in a variety of opportunities (i.e. an investor has a higher chance of investing in a top startup if she invests $10,000 in ten startups, rather than investing $100,000 in a single startup).

EXAMPLE

Angel investor and founder of SoftTech VC, Jeff Clavier, practices diversification in both his personal investment portfolio and within his VC firm.

Jeff has personally invested in over 20 startups, and is known to deploy as much as $6 million in a company he believes in. He has also invested in about 160 startups via SoftTech VC. Some big names within the SoftTech VC portfolio include Postmates, Shippo, and SendGrid.

Investing in multiple startups increases Jeff’s chances of investing in a big winner within his personal and institutional portfolios.

Most investors have multiple motivations for investing in a startup, aside from just pursuing a profit.

The Rewards of Startup Investing:

• Diversification: Diversify their portfolio to include a high-risk, high-reward asset class
• Entrepreneurial Community: Support new entrepreneurs and help companies that they believe in to succeed
• Networking: Meet and connect with founders, other investors, and active members of the tech community
• Relevance: Stay up-to-date with new tech trends and emerging top startups.
• Returns: Potential to make outsized returns, which far exceed returns on other types of investments, if an early investor funds a very successful startup