Should You Invest in Startups?

Note: Compound helps tech employees work through decisions exactly like this one. None of this article is financial advice, but if you are looking for modeling tools or human advisors to help you through the decision of if you should invest in startups, we can help. Sign up here. 

If you work at a technology company, chances are that you have (or will have) the opportunity to invest in a startup. 

Startups frequently use the latest technologies to build new products, so if you work in that industry, it’s reasonably common for employees to split off and start a new venture. 

At some point, you could have a friend or colleague who comes to you and says, “Hey, I’m starting a new company and am raising money from a few friends. Are you interested in putting some money in?”

If that happens, what should you do?

First of all, recognize that this is a special moment. You might have the opportunity to invest in the next Facebook or Airbnb! After all, every billion-dollar company was a single-person startup at some point. But you also probably recognize from being in the industry that the statistical odds of a successful startup are very small. You naturally should weigh these factors as a potential startup investor.

For an individual investment into a friend’s startup, it might be worth the risk if you can afford to take the loss within the context of your overall portfolio. For example, if your liquid net worth is over 7-figures, even if the startup fails, a few thousand dollars worth of investment won’t ruin you financially. 

But sometimes a single startup investment is an on-road into a larger decision: should you invest a meaningful amount of money into startups, dedicate time to sourcing and evaluating them, and have it be a line item in your investment strategy? After all, you’ve probably seen the headlines of famous angel investors making tens of millions of dollars through single investments. And there are certainly other benefits to investing in startups – learning, supporting your friend, building a network, and status (among others). 

Could you do the same?

Ultimately, you have to make the decision about what to do with your money. But I’m here to analyze a few of the numbers so that you know what drives returns if you do start investing in startups. 

This essay will cover:

• The failure rates of startups
• Making a case for a portfolio approach to angel investing
• How angel investing can fit into a broader portfolio

Startup Failure Rates

Most startups fail—chances are you’ve heard the “90% of startups fail” cliche. This is directionally true but it leaves out a lot of questions. What constitutes a startup? What does failure mean? How does that impact an angel investor’s strategy?

One commonly cited source is the Bureau of Labor Statistics. This talks about all small businesses as defined as any business with <500 employees. This includes businesses like car washes and corner pubs right alongside the future Facebook—so this data is not fully what post is talking about when we say startups. 

Interestingly though, only about 20% of all small businesses shut down after 1 year and about 50% of them shut down within 5 years (source). When I first began researching this post, I expected the failure rate to be much higher. 

So now let’s look at startups as defined by “startups that have raised money from venture capitalists”. Before we look at the data, let’s define what we mean by “failure”. From an investor perspective, startups can have one of several outcomes:

• Loses all money (startup goes to zero)
• It’s sold for less than the money invested
• It’s sold for more than the money invested, but not enough to make up for the rest of the losing investments (maybe a $250M exit after the company had raised a total of $200M already)
• It’s sold in a successful exit (something like >$1.0B)

Unfortunately, no one has examined provided data for these outcomes exactly, but we can piece together a few sources to get a pretty clear picture of how startup outcomes impact investors. 

To start, let’s look at the loses-all-money failure rates. About a third of startups go completely out of business and return no money to investors. Research from HBS on 2,000+ companies that received venture funding from 2004-2010 found that 30-40% of startups liquidated all of their assets with investors receiving no money back. 

For the other kinds of startup failure, we turn to a 2017 blog post by Sebastian Quinero. With Crunchbase data, he analyzed startup failure rates across a set of 35,568 startups founded between 1990 and 2010. His article took into account the stage of the startup and looked at failure rate in two ways: the failure to raise another round, and the failure to exit. For this article, we’re going to focus on exiting because that’s what investors care most about. 

Companies that have only raised a seed round have a 3% chance of exiting. (Unfortunately, the article didn’t provide any detail around “exit” besides resulting in an acquisition or an IPO). This statistic is part of why people are wary of startup investing. 

For each round of funding, the company gets more and more likely to reach an exit. This lines up with intuition—for each additional round of funding, the company is getting more stable and is more likely to become a sustainable company. 

By Series F, it actually becomes more likely that the company is going to exit than raise another round of funding. Keep in mind though that there’s still a 75.5% chance of either kind of failure (even at Series F!). 

But even when startups are the most mature and least risky—the Series G stage—the chances of failure to exit are still 72.4% [0]. 

Investors have other ways to get money back from their investment, but it won’t be nearly as valuable as if the startup exits for a very large amount. 

Investors typically invest in “preferred shares” which often give them preference over employees in the case of sideways investments. For example, if a company raised $50M and sells for just $60M, oftentimes the investors will get their initial capital back first and the remainder of the value will be distributed according to the ownership structure. (Of course, there are lots of nuances here so if you do invest, read the fine print of your legal docs.) Regardless, these middle-of-the-road outcomes won’t move the needle for an angel investing portfolio. 

[0] The Quinero article was based on Crunchbase data and didn’t specifically say if a small acquisition was considered an acquisition or if it was only above a certain threshold. That said, I think the rates are correct. A quick gut check on Quora also points to “50-90%” of startups failing to exit of any kind with the market conditions dictating the higher or lower part of that range. 

A Portfolio Approach

Venture capitalists and angel investors alike reduce failure risk by investing in many startups to create an index of sorts. If you invest in startups, I recommend you do the same. This gives you leeway for the majority of your investments to have mediocre or negative outcomes while one or two investments make up for the rest. 

Let’s walk through the math. 

For a seed stage investment, a startup might be valued at $12M (this is near the average valuation over the last decade). And a successful outcome might be a $1.0B exit. 

Here are our assumptions:

• You invest $200k into 10 startups ($20k each)
• Each investment is at the seed round
• The average valuation is $12M (this is near the average valuation over the last decade)
• 19 of the 20 startups fail to exit (this is generous as 97% of seed stage startups fail to exit)
• The 1 startup that succeeds exits at a $1.0B valuation
• For this 1 winning startup, it took 5 total rounds of funding (Seed through Series D) before the exit and you experienced 15% dilution at each round
• It took a total of 7 years from when you invested in the Seed until the company exited

Given these assumptions, 19 of your investments will go to zero. You won’t ever see the $190,000 that you invested in them ever again. 

However, your one winning startup will have turned $20,000 into $739,509. This is the headline number that you get to brag about to your friends.

The reason that you invest in a portfolio of startups isn’t for the $190,000 that you lost, or the $20,000 that turned into hundreds of thousands of dollars. Rather, the portfolio as a whole returned 20.5% over 7 years and you were able to get there by taking 20 shots on goal. 

The chances that you would earn a 20.5% return investing in a single startup is incredibly rare; because so many startups earn nothing, you have to invest in a lot of them with hopes that the winners make up for the losers as a portfolio. This is exactly what venture capitalists do as well – take a portfolio approach and try to make the winners as big as possible. The individual investments within startup portfolios just have a much higher range or outcomes than other assets in more traditional portfolios like public equities or other types of alternative investments.

So should you invest in startups?

The natural conclusion to this article is that to invest in startups, you should treat it similar to any other kind of capital allocation decision, and consider the decision to invest in startups as a portfolio itself and within your overall asset allocation and tax situation. And since you will often personally know the founders asking you for an investment, you must also weigh your investment against numerous other personal factors. 

If you decide to invest in startups but want more clarity on how to evaluate them, consider Sacra. Sacra is a private markets research firm that makes you a better investor. They provide research on pre-IPO, growth stage and early-stage companies. Get access to their research here. 

Risk tolerance. Do you want to treat your startup investment as part of a larger portfolio whose overall odds of success are higher, or as an individual investment with a very high degree of risk? Or would you prefer investing in assets with a much narrower range of potential outcomes? At the end of the day, you need to decide what type of investor you want to be. Keep in mind as well that your risk tolerance is likely dependent on what stage of life you are currently in and when you will need liquidity.

Liquidity sensitivity. If you invest in seed-stage startups, expect that your capital will be locked up for at least 7-10 years (the average time until a liquidity event). There’s a possibility that you would be able to sell in a secondary market, but this is usually only available for startups that have a lot of investor demand. 

Personal asset allocation. Even if you have $100k in cash, that doesn’t mean that you should invest all of it into startups. While you don’t need to go full “risk-off” and invest 50% of your portfolio in bonds, a balance between public and private markets might have real benefits like stronger risk-adjusted returns and the ability to borrow against the asset. Keeping 3-6 months of expenses in an emergency fund is also a good idea. Not to mention that if the rest of your portfolio is in technology companies, getting more exposure to that market will make the downturns even harder. 

Some people allocate between 0%-10% of their liquid net worth to startup investing. This is a personal decision that this article can’t make for you—that said, if you’re interested in working with a financial advisor, Compound can help you create an investment strategy. Request access here and we’ll be in touch. 

Financial goals. Instead of investing in startups you might be able to buy a home or pay for a big purchase (like a wedding). There’s also the opportunity cost of capital – what other assets could you invest in if you didn’t invest in startups, and what return could you earn? For example, public markets typically return 7-10% over the long run and are lower risk. 

Skillset as an investor. Be honest with yourself – are you a better startup investor than 50% of venture capitalists? This is what it will take to generate above-average returns in angel investing. This isn’t meant to scare you away completely. For example, you might have an information advantage (you know more about a new industry) or an access advantage (you might know friends who are founders resulting in better deal flow). But make sure you know what you’re getting into. 

QSBS tax advantage. There is a special tax benefit for those who are some of the earliest investors in startups, called Qualified Small Business Stock “QSBS”. QSBS refers to the tax exemption that enables you to receive tax-free gains from the sale of your investment in startup stock, so it can have a very large impact on your after-tax investment returns and startup investment decisions.  The full details of QSBS are outside the scope of this article–and you should consult a CPA for personal tax advice–but you can read more about it here. 

Personal enjoyment. For a select number of people, startup investing has benefits beyond a financial gain. They might want to learn more and build a network. They might believe in the mission and impact of the startups they’re investing in. They might want to look cool to their friends who also value these things. Whatever the specifics are, investing in startups can have other benefits. 

Finally, “investing in startups” can mean several different things, a few of which we’ve already discussed in this article. It can mean:

• Investing $1,000 into a friend’s first financing round
• Investing $50,000 into a few different startups
• Investing $500,000 into 20 startups using your own money
• Investing $500,000 into 20 startups using someone else’s money (scout program)
• Investing as a limited partner (LP) in venture capital funds that invest in startups
• [And many more variations]

Some of these enable you to invest in startups without risking your capital. For example, a scout program is when you work with a venture capital firm or other wealthy investor to invest their money for them in exchange for part of the upside. This way you get the experience (and a reward if things go well) and the fund might get access to new investment opportunities. 

You can also earn higher returns by investing more money or using special purpose vehicles (SPVs) in follow-on rounds to avoid dilution. 

Whatever you decide to do, go into the situation knowing the risks and rewards. Startup investing doesn’t always go the way you want, but can be lucrative and fun if you do it right.