Anyone can invest in startups, and here are 5 reasons you should consider adding them to your portfolio.
The world has been absolutely packed with uncertainty in recent times. A pandemic, a war in eastern Europe, inflation, supply chain issues, chip shortage, oil prices skyrocketing, and now we might be heading for a prolonged economic downturn. This has left tons of people wondering whether to hold through the storm or sell and put it in something safe to hope it passes and they come through on top at the other side. While I, unfortunately, can’t give you all the answers, I think most people are heavily sleeping on startups. For those that aren’t aware, anyone can invest in startups now. Venture capital and angel investing are no longer for the rich and connected, and if you want to know how to get started, check out this video:
While startups still have their risks, it’s definitely worth allocating a part of your portfolio to this area to stay diversified and curb some of these issues. With that, here are 5 reasons to have startups in your portfolio.
1. Better sleep at night
Ok, this isn’t the real perk, but it does make a point. Startups aren’t subject to the daily highs and lows you have to deal with on the public market. This means you won’t really watch your startup investment more than a couple of times a year to see how they’re doing. You can be more involved if you want by spreading the word or buying their product, but other than that, not really. Realistically, the only thing that matters as an investor is their revenue growth, ability to attract funding/future valuations, and that they are still in business. If those are going well, then you basically just chill and wait out the storm. Often there will only be 1 update on valuation and share price a year, which means there’s little volatility in the space, and not much to keep up with. You don’t have to watch or manage it because if the revenue is increasing then so is the valuation typically. If they are raising funds or profitable, you’re good. Other than that, you just rest easy at night and wait for the payday.
Recessions are rather loosely defined periods in which GDP, jobs, and growth fall, while unemployment rises. During this time, larger companies slow down on spending which means wages go stagnant, and there are often layoffs. These massive operations can often operate in a loss during favorable markets because they can just finance everything with debt, stock sales, and so on because their stock will go up and debt is easy to get. So, in order to survive a recession, they have to transition to a more sustainable model, but that usually means spending less money and fewer employees.
How is ANY of this good for startups? Well, it’s really good for a few reasons:
Startups can poach top talent much easier
Startups don’t have a public stock price, so the stock price doesn’t really matter
Startups can take market share with aggressive techniques while larger companies are downsizing.
These are all pretty common and standard things that happen during a recession. If a number of top tech companies decide to stop hiring temporarily, that isn’t going to stop top engineers from needing jobs. While startups may or may not be able to pay these engineers those salaries worth $400,000 or whatever, they may entice them with stock in a top startup worth more than that vests over several years. Working at Facebook with a $400,000 salary is great, but working for Facebook and owning 5% of their stock could be much better. Since these companies might have a hard time finding those well-paying jobs, they could take a smaller salary in a promising startup with a big stock bonus over time.
As kind of mentioned in the first section, stock prices don’t really matter to startups because at that point the stock price is for no other purpose but to allow previous investors to track hypothetical returns. So, while most larger companies will be directly impacted by a decline in their stock price because it will hurt their ability to borrow, that will have no impact on a startup directly.
Lastly, startups are risky as is. The assumption for startups is that it is going to fail, so typically they need to adapt, grow, and pivot in order to actually go anywhere. This is to say: What they are doing is already extremely risky so they usually are using risky strategies to grow as is. Where most larger businesses might be cutting marketing, they’re ramping it up to capture those customers on the cheap.
3. Consistently Great Performing Asset
Unlike companies like Facebook and Netflix, venture capital and investing in startups isn’t necessarily focused on picking several great performing companies and hoping all of them outperform. If you invest in the stock market, and one of your investments goes bankrupt, it’s likely going to not only hurt the whole fund but you have done something terribly wrong. Warren Buffet, for example, currently has nearly 50% of his portfolio in Apple stock, and several others worth 1–10% of the portfolio. Bill Ackman went “all in” on streaming and invested $1.1 billion in Netflix, only for it to plummet nearly 80% and he took losses of $400 million. It’s generally pretty normal for companies to invest in a handful of companies they believe will outperform while also diversifying. The idea is growth in the overall market but hoping that specific stocks outperform.
Venture Capital and investing in startups are much different. While a company going bankrupt is a huge hit for a typical stock market fund, it’s actually the norm for most venture capital. In fact, the saying is that roughly 80–90% of the companies you invest in will go out of business, and the 10–20% should make a good enough return to pay for the rest with a nice premium.
Due to this, however, when you get one right the returns are usually massive, and if you outperform the market, the rewards can be astronomical. Obviously, this is extremely high-risk, high-reward, so while many VC firms might underperform the market, the industry as a whole tends to perform extremely well. For example, most VC funds target a return of 25–35% a YEAR over the life of the fund. How does that happen?
Well, it’s pretty simple: You choose 1 winner.
Here’s how that would look:
You invested in 10 companies
All at a $10m valuation
Most funds are a 5-year fund
At that point, if one of them becomes a billion-dollar corporation, but all 9 go out of business, that one company will return roughly $50,000, and the rest go out of business. So, you started with $5,000 and turned that into $50,000 over the course of 5 years, that’s an annual return of 60%.
Now, imagine if you outperform the market, and 2 of your 10 investments do similarly well? You have 2 exits that are roughly a billion dollars? Or maybe not a billion-dollar exit, but rather a 10x exit, or even a 2x exit. Oftentimes, it might not be that you get that 100x payday, but rather have a 10x payday, and 2–3 smaller 1.5–3x paydays.
However it breaks up, the idea here is that it’s typically much larger returns culminating into a big payday, and when it averages out, you actually get a really solid, consistent return when done correctly.
4. Make an actual change
I have never met someone from any of the companies I have invested on the open stock market. I’ve put money into Apple, Ford, Facebook, and many other stocks. However, not only has this money not really impacted the world in any way, I have never met any of these founders.
Since I started investing in startups, not only have I met DOZENS of amazing founders, I have invested in companies I think NEED to be everywhere. I’ve invested in some amazing green energy, and industries I think that are doing well in the world. Apart from this has been meeting with, and talking with several founders over the years, and several I still hold stock in and regularly interact with. Investing is more of a community than just some faceless competition for money.
If nothing else, it’s a great way to diversify your portfolio. VC, due to the long-term time horizon, is often one of the best-performing assets during recessions and market downturns. As long as the startup can weather the storm and come out the other side, it can IPO at an ideal time and catch those moments when money starts flowing into the stock market. This means not only do you still get a good IPO price, but it’s more likely to be a successful business if you continue to hold.