New to angel investing? 5 mistakes rookies make

Startups are exciting again. Reeling from the 2007–2008 financial crisis, investors seemed to sour on illiquid investments. Too many financially-engineered investments in derivatives and wacky mortgage products made investors feel that the game was fixed.

But that’s all changed as America’s economic engine — small technology-driven companies — is revving up. Companies with big visions and ambitious growth goals are getting snapped up, merged and acquired, and IPO’d, making their early investors celebrities… and extremely wealthy. Events like Facebook’s multi-billion dollar IPO in 2012 and its subsequent purchase of Whatsapp for $12 billion in 2014 have attracted new investors seeking their fortunes in angel investing.

New investors, new mistakes

Many of the same rules of the game apply to angel investing, as they do to investing in the stock market. But given the fact that most startups are private, small, and closely-held companies, investors new to the asset class are finding that there is a learning curve to scale before they’re able to reap the historical returns which average close to 30% per year, according to a Kauffman study.

While we have very experienced angel investors investing with us at OurCrowd, we also have plenty of successful businessmen and women making their first forays into private equity. To help you scale that learning curve, you can use the experience of investors who’ve succeeded in this asset class.

For new (and battle-proven) investors in startups, we’ve compiled a list of many of the mistakes new angel investors make and with a little insight, can be avoided.

1. Swinging at the first pitch

Warren Buffett famously doesn’t invest in things he doesn’t understand. He has a clear investment strategy that requires a prospective investment candidate to align with. If it doesn’t, Buffett passes and is on to his next investment candidate. In essence, his great success, that makes him one of the most profitable investors of all time, derives from the fact that he’s very systematic in his research process. Unfortunately, many new angel investors drop money into the first pitch they hear. OurCrowd sees over 150 pitches per month and I can honestly say, it’s important to have a pipeline and experience hearing these investor pitches because then you can benchmark them against one another. You’ll get a feel for how one pitch stacks up relative to others seeking capital. Rookies angel investors swing at the first pitch — experienced investors wait until they get the “right pitch”.

2. Investing in sprinters, not marathoners

While some startups (and their investors) are lucky enough to exit soon after they’re launched, the truth is that things typically take a lot longer to play out (on average, 6.5 years). That means the teams you’re placing your bets on must be in it for the long haul and can handle all the ups-and-downs associated with building out a new company. Weston Bergmann put it really well in VentureBeat, “Founder pain, relocation of the company, mission-driven attitudes — these are all examples of things that will ensure the entrepreneur won’t quit when times inevitably get hard. If you’re not seeing these signs in the founder, move on.

3. Under-diversifying

If you’re used to being a stock market investor, you’re surely familiar with the concept of diversification. The concept has become almost gospel in investing circles: given the fact that different assets appreciate under different scenarios, it’s important to own a diverse basket of them. Diversification minimizes risk and maximizes returns — truly one of the only free rides in this world. But because startups are more risky than publicly traded companies, they require a higher level of diversification. It’s not uncommon for experienced angels to have portfolios of 15–25 different companies. Unlike stock market returns which are more evenly distributed, angel returns are powered by blockbuster, breakout companies (Unicorns) that compensate the investor for all his mediocre and failed investments. That means to get to the Promised Land of Startup Profits, you’re going to need to have some big exits in the portfolio and that requires diversification.

4. Not understanding the finance terms

Convertible notes are used frequently in the startup space. Essentially, these types of investments are structured as loans to the company with the intention that they convert into equity under certain terms. Making an investment this way means neither investor nor entrepreneur needs to set a valuation on the current financing round, opting instead to address that issue at the next round (when a convertible typically converts at a discount). Savvy investors know to look for convertible notes with valuation caps — a maximum amount the company can be valued at when the conversion trigger happens. Otherwise, your money can merely be a stepping stone for an entrepreneur to quickly raise another round at a much higher valuation, diluting your share all the way to the Startup Deadpool. As a rookie angel investor, take your time and read the fine print (also, check out our easy-to-understand advice on understanding financial terms and term sheets).

5. Failing to keep some powder dry

David Rose, CEO of venture software, Gust, and author ofAngel Investing: The Gust Guide to Making Money and Having Fund Investing in Startups, has his own candidate for #1 rookie mistake. Rose casts his vote for top error: “failure to keep dry powder for the inevitable, yet somehow always unexpected, ‘re-opened’ first rounds.” What David is referring to is the fact that it takes startups some time to find their footing, to gain traction. They’ll typically end up taking on more investment money early on than they expected as they find their market. Many of these rounds will be done at valuations near the original angel round. If an angel investor doesn’t take this opportunity to maintain his stake in the company, he runs the risk of getting diluted very badly. So, especially, if you’re going to “bet on the jockey and not the horse”, you’re going to want to keep some money earmarked for future investment rounds to prevent massive dilution. As 500Startups’ Dave McClure simply states: Invest BEFORE product/market fit, double down after. Amen, Dave.

Turning mistakes into success when investing in startups

Investing is a process, not a destination and the more experience you gain as an angel investor, the less likely you’re going to fall prey to these rookie mistakes. There are lots of resources for new angel investors (including 40 of our epic tips for new angel investors) to help ensure you scale the learning curve quickly, preserving your capital along the path to big profits investing in startups.