So many people miss out on the staggering gains they can get from startup investing because of one thing: fear.
It's the biggest mistake a potential investor can make - being so terrified of making any mistakes that they don't take a step forward at all.
The opportunity cost of not investing is high, and can lock them out of returns from one of the highest-performing asset classes of all time.
Opportunity cost is not a financial cost. It doesn't appear on your bank account. But it can still be substantial - and in this case, it can mean missing out on hundreds of thousands or even millions of dollars.
Venture capitalists like to say that their losses are bounded to 1x their money - or, you can only lose the money you invest - while their potential gains are unbounded. Previous startup returns have been as high as 10,000x in certain cases (where an investment of $10,000 results in a $100 million return) and sometimes even higher.
It's inevitable that you'll make several mistakes while starting on your journey as an investor. This is absolutely OK, even expected.
What's great about angel investing is that you can start by investing a very small amount ($100) and can make money while making mistakes.
Plus, you have an advantage if you're just getting started with angel investing. You have me, who's already learned from these mistakes and can show you how to sidestep them.
Here are the four most common mistakes that angel investors make in their first year of investing. Avoid these, and you get to the rewarding part of angel investing faster.
Mistake No. 1: Investing in Companies That Need Your Help
If you are like most people (including myself), you'll naturally gravitate toward startups that need your help the most.
This is a good inclination at its core; it means that you care about others. Unfortunately, except in very rare circumstances, this is an ineffective way to invest your capital.
There are a couple of reasons for this. The first is because the best entrepreneurs are highly resourceful and do not need much outside help. By focusing on entrepreneurs that need your help the most, you're selecting the least resourceful entrepreneurs, which is directly correlated with how successful they're likely to be.
Don't get me wrong - even top entrepreneurs need your help. The difference is that the help they need is typically a very specific function, such as making key introductions to investors or customers.
Entrepreneurs that need too much day-to-day help, especially from angel investors (vs. venture capitalists, who take on a more active role), are entrepreneurs you should avoid as an investor.
Due to the dynamics of power law returns, in order to succeed as an angel investor, you must stick to backing only world-class entrepreneurs. Investing is a business and should not be treated as a charity.
Mistake No. 2: Investing in Startups Outside Your Circle of Competence
Entrepreneurs pitching to investors is a form of game theory, in which both entrepreneurs and investors adapt to each other's behavior.
Good entrepreneurs are masters at storytelling, and many have learned how to sell to generalist investors (who do not have deep expertise in a specific vertical).
The same circle of competence strategy applies to angel investing. If you want to be a great angel investor, you must focus on investing in a space where you (or your co-investors) have expertise.Warren Buffett is famous for doggedly sticking to what he calls his circle of competence and only investing in areas that he understands well. This has not come without significant criticism. Warren Buffett has stood his ground, and this has helped him become the greatest investor of this generation, having amassed a fortune of more than $70 billion (with an original investment of $5,000).
Note: This is one of the benefits of angel groups, where people with different competencies can work together to perform due diligence on a startup investment.
Mistake No. 3: Investing Without a Syndicate
The most dangerous thing you can do as an investor is to invest into a startup by yourself. All things being equal, the more money that goes into a startup (especially at an earlier stage), the less risky the investment becomes.
More money means that the company has a greater ability to execute on its strategy... and the resources required to do so (follow-on capital serves as a Plan B in case the initial strategy is not successful).
You never want to be the sole investor in a given raise. It's much better to invest as part of a syndicate or as one member of a large group. This also helps ensure that there are more investors that can help the startup and provide the necessary introductions and connections in order to make that startup successful.
Mistake No. 4: Not Understanding Startup Valuations
First-year angel investors tend to over-obsess about valuation. This is due to a lack of understanding of power-law dynamics, as well as the fact that valuation is one of the only quantifiable and standardized metrics available to angel investors.
Novice angel investors tend to make two mistakes around valuation:
1) Not understanding the market valuation for a given company in a given sector. For example, there may be a first-time founder that is asking for a $20 million valuation, whereas the market value may be $5 million for his/her startup. In this case, investing at a $20 million valuation is foolish, and can cut your return by 4x.
2) On the other hand, some investors are overly sensitive toward valuation. As discussed in a previous blog post, if a company goes public for $10 billion, it doesn't (really) matter if you invested at a $10 million valuation (a 1,000x return) or at a $15 million valuation (a 666x return). Passing on a seed deal due to valuation alone is a rookie mistake, and many people rue the day that they passed on great startups due to a valuation they thought was too high.
Whatever You Do, Don't Sit This Out
Angel investing has been a source of much excitement and financial returns in my personal life, and I look forward to the day where we can co-invest together in a top startup.
And in the meantime, you've been invited to join three angel investing experts in the Private Dealroom...
In the Dealroom, they'll be reviewing three revolutionary startups and giving the small list of attendees every single detail. These companies are the cream of the crop. In fact, the last time one of these companies opened their doors to investors, they had to close in under 24 hours.
Now, they're planning for a second wave and compiling a list of potential investors before opening their doors again. You can get all the details here - just don't forget your meeting access password: JULY2020...