The Truth about Diversifcation
When investing in startups, more is better
So far the most fun I’ve had getting divorced is re-hauling my investments and analyzing how to breathe life into a stale portfolio and diversify it.
When I was married, I had a traditional investment portfolio of real estate and stocks, but being part of the tech world for 20 plus years, I wanted to invest in technology startups. When I was married, I thought investing in startups was for the uber-wealthy, venture capital and angel investing insiders. It felt exclusive and risky — an alternative asset class where losing is part of the strategy.
Venture capitalist leaders highlight how often you lose before you win. Industry thought leader Fred Wilson of Union Square Ventures says,
“Investing in startups is risky. If you make just one investment, you are likely going to lose everything. If you make two, you are still likely to lose money. If you make five, you might get all your money back across all five investments. If you make ten, you might start making money on the aggregate set of investments.”
How Much to Invest
That being said, no one will advise you to put a large percentage of your savings into early stage companies. However, if you allocate 5% of your overall portfolio into startup investments, you can increase returns and reduce risk.
According to a SharesPost whitepaper if you allocate 5% of your investments to private growth companies you can increase the returns of a traditional portfolio by 12%. Successful venture capital firms generate approximately 80 percent of their returns from less than 20 percent of their investments. So I know my odds are 90 percent of my cash returns will come from 10 percent of the winners.
How Many to Invest
The next question is how many companies should you invest in to create a diversified startup portfolio? According to the “Siding with the Angels” report by Nesta, they recommend investing in a minimum 10 companies. This is because, based on statistical analysis, only 1 or 2 businesses soar, 2 or 3 will do okay, and the rest will fail. However, ten is simply the minimum number for proper diversification. An increased number of companies invested in will increase diversification. With increased diversification comes the increased likelihood that you have multiple big winners in your portfolio.
Entrepreneur and investing think tank, Kauffman Foundation, released a Monte Carlo simulation done by Simeon Simenov. This simulation demonstrated the likelihood of different cash returns that come with different portfolio sizes. He found a portfolio size of around 50 companies to be the sweet spot, significantly increasing the likelihood of receiving the desired 4x return. Most major venture capital funds have 50+ investments in their portfolio and individual investors are starting to look for this same level of diversification.
Investor demand has led many online investing platforms to create “index” funds that allow one to invest into 25–100 companies with a single investment. In 2015, CircleUp, a online startup investing platform focusing on consumer products, launched the CircleUp Marketplace Index Fund allowing investors to invest in 25 of their deals. Similarly, startup investing platform AngelList offers a variety of index-like funds that tend to include around 100 startups and track different sectors of the market.
OurCrowd, the company I work with, has a fundamentally different business model than these other platforms. OurCrowd co-invests in every deal and has skin in the game.
To respond to investor demand to make diversification simple, OurCrowd launched the OurCrowd Portfolio Index Fund, or OC50. OC50 allows one to invest in the next 50 OurCrowd-sourced companies (in which OurCrowd will also invest, with a minimum of $1.5 million overall). With one check, investors diversify across the next 50 companies with a minimum of $1000 in each. Another key value — exclusive to OurCrowd — is pre-emptive rights, or the opportunity to prevent dilution of existing shares while continuing to invest in the well-performing portfolio companies.
What Criteria to Invest
If funds are only part of your investing strategy and you like learning about each startup like me, you’ll want to also be able to pick and choose your deals. Then you can be your own mini-venture capitalist and build your own portfolio of diversified deals.
Beyond the criteria on how to evaluate each deal, here are three rules on creating your own personal portfolio: Each of the companies should range in 1) the stage of the life of the company (based on time and progress), 2) the industry or sector (advertising, financial, health and wellness, cyber security, e-commerce, mobile, etc.), and 3) geography (US, Israel, India, etc.)
Another basic tenement to follow is invest in ideas you understand and select every investment as though it’s your only one. If you lower the bar, you will only build a bad portfolio.
Read my past blogs on other criteria for startup investing:
Part 1: People and ideas
Part 2: Markets and co investors
Part 3: Traction and valuation
To start creating your own startup investment portfolio, I encourage you to visit the online equity crowdfunding platforms that allow you to invest in vetted startups alongside other angel investors, venture capitalists and strategic corporate partners.
First time investors need to remember that backing private startups is risky and is very different than investing in public stocks. Risks aside, there are strong financial reasons for smart investors to diversify their portfolio and allocate a small percentage to startups. In this world, more is better.
The Angel in the Crowd blog is for smart individuals who want to learn about investing in startups via equity crowdfunding websites.
Note: These are my personal views, not the opinion of my company, nor am I a financial advisor. Please discuss with your professional advisors before investing.