We’ve all heard the success stories of Facebook, Google and Amazon who started out as startups and have grown into some of the world’s largest companies, making their founders and early investors billionaires in the process.
But what exactly is a startup and what differentiates it from other small businesses? In this article we will break down the basics of what a startup is and give you the practical steps you need to take to make startup investing a part of your investment portfolio.
What is a startup?
Literally, a startup is any new business starting out, but when we talk about startup culture there are normally two main principles which differentiates them from other small businesses:
Startups are designed to scale very quickly.
The whole objective of a startup is grow really fast – usually with minimal amounts of capital. The objective of a startup is to become an industry leader and quickly grow to monopolise their sector.
This has two implications:
1- Startups care very little about short term profitability and a lot more about long term growth. That is why the majority of startups will be loss making in their first few years and spend majority of their cash flow on increasing user growth.
In fact, you still have companies like Uber who are loss making up till today based on this principle. While this is an extreme case and startups do look to reach profitability within at least 5 years, it shows how startups are willing to put off short term profits for much larger profits in the future.
It is also why some loss making startups have much higher share valuations than their profit-making peers because investors are looking forward to the large potential future growth.
2 – The majority of startups are internet based, and almost always tech based. There are very few products and industries that allow startups to scale very rapidly with minimal amounts of capital.
The internet is one such place. A startup can scale to millions of users across the world at very little cost. There is no need to build more factories or set up foreign offices. Everything can be done from the company’s main headquarters at a very small marginal cost.
It is important to keep these two factors in mind when looking for startups to invest in. Many companies today tout themselves as startups because they are tech-enabled, but if they don’t fit these two criteria, their investment risk may not be worth the reward.
Startups solve new problems or old problems in novel ways.
Normally, startups are working on hard problems where the solution is not obviously known. The best kind of startups are working on a problem where there is an underlying industry or cultural shift. Think Google in the 1990’s when the internet was just taking off and we needed a good way to sort through all this new information being generated.
Or Facebook in 2006 when interacting online was a novel but growing trend.
A recent example is Beyond Meat where there is an underlying cultural shift towards more ethical forms of protein, but we still desire the taste and texture of meat. Beyond Meat solves this problem and has grown to a market cap of $3.5 billion dollars in just a few years.
All these companies run great businesses on their own, but what has caused them to explode in scale is the underlying industry shift.
There are also cases where the startup itself can create an industry shift. Good examples include Uber and AirBnB where these startups completely disrupted old industries and created completely new industries in and out of themselves.
When looking at a good startup to invest in, you need to find the startup’s ‘defensibility’. This is what differentiates this startup from the tens of others trying to solve similar problems, and why it is this startup that will grow to become the industry leader.
In a lot of cases it is not so much to do with the idea but why it is this startup that will solve the problem better than anyone else. Defensibility could be intellectual property (stuff that can be patented), network effects, economies of scale or the passion and background of the founder or a company’s unique business model.
So now that we know what a startup is, how can we get started investing in them?
The first thing you need to ask, is startup investing right for you?
To see if startup investing is right for you we first have to look at the characteristics of this type of investment.
- High risk high reward. Startup investing is very risky. There is a high likelihood that could lose all your money invested, but also that you could make very large returns if you invest in the next big thing.
- Highly illiquid. Startups are not publicly traded which makes them illiquid. Unless you can personally find somebody to buy the shares off you, your capital is most likely stuck in the startup until it ‘exits’ – when it is either bought by a larger company or lists on the public markets (IPOs).
- Long-term investment. The average length of a startup investment is 5-10 years before seeing your returns. Of course, if you invest on a regular basis you will start to see the returns more frequently as your portfolio builds up.
- Diversified portfolio: Ideally you want to invest into 10 to 20 startups over a 3 – 5 year period. This helps balance out the risks as many of the startups you invest in will fail, but you just need that one to scale exponentially to more than cover the losses of the others.
- Capital requirements: Because you need to have a portfolio, and because early stage startups have minimal investment requirements (ticket sixes are normally not less than $5,000), ideally you want to have around $50,000 over 3-5 years set aside for startup investing (around $10,000 a year).
Now that you know what a startup is, and whether startup investing suits you, let’s see how you can get started!
The easiest way to get started in startup investing is through crowdfunding platforms where you can you can invest in startups from as little as $10. This is a good way to get a feel for startup investing and will help you learn how to differentiate a good startup from a bad startup.
The downside of crowdfunding platforms is that almost anybody can list on the platform, and because there is some marketing effort on the side of the startup it is normally a last resort from the side of a startup when looking for funding.
For this reason the quality of startups on crowdfunding platforms are not always of the highest quality, there is minimal information on the startup you are able to access, and no further due diligence is done by more experienced eyes.
Additionally, mainstream crowdfunding platforms do not sharia-screen the startups they list so there is no way of guaranteeing that that company won’t take on lots of haram debt in the future etc.
Join an Angel Syndicate
An angel syndicate is a group of angel investors who band together to invest in startups. An angel syndicate could be focused around a certain sector or industry or be sector agnostic. There are many benefits of being part of an angel syndicate. Because you are investing as a group you are able to:
- Source larger number and higher quality startups.
- Invest larger amounts of capital in each startup and therefore have more say.
- Get access to more information about that startup for example detailed financial accounts.
- Benefit from the due diligence of a larger number of experienced investors.
Personally find and invest in a startup yourself
If you are looking to personally find and invest in startup yourself, the best way to do this is to plug yourself into your local startup ecosysytem.
Startup culture is all about collaboration and sharing talent and resources and are therefore normally clustered around the same events and organisations. A good place to start are ‘demo days’. This is where startups who have gone through an accelerator programme pitch to an audience of investors.
This is a good place to meet with startups directly as well as to start making a name for yourself in startup circles which naturally improves your deal flow.
Investing in startups yourself gives you the most control over your investment.
The downsides, however, include a lower number of startups you are exposed to, high minimum investments (normally $20,000 – $50,000) and no second opinion on which startups to invest in.
Overall, depending on your time and risk appetite, you should be looking to do a combination of all 3 option when you want to get into startup investing.
We’ve taken you through some of the basics of startup investing and you are now ready to go out there and try it for yourself! As a final tip to increase your startup knowledge, we recommend listening startup podcasts. One of our favourites is Reid Hoffman’s Masters of Scale.
Of course, IFG also has its own podcast – Millionaire Muslim – where you can listen to our interviews with startup founders, investors and all-round interesting individuals.
And lastly, we’ll shortly be bringing out our ultimate startup course where we go in detail through all the how to’s of startup investing.
You get to listen to billionaire startup founders, investors with 3 unicorns (£1bn companies) in their portfolios, as well as startup lawyers and other professionals to take your through the details of startup investing.
This article is part of our angel investing series. Check it out here.