The first steps as an early-stage investor define your learning curve and how hard the journey will be. Initial investments are marked with overenthusiasm, but we often learn the hard way. The truth is investing always carries a degree of risk, and the difference between a pro and an amateur investor lies in the ability to pick winners and make objective decisions.
In this blog, we cover Troy Niehaus’s tips on creating a winning investment strategy that helps us discover winners in the early stages and safeguard our portfolio from risks. You will learn to evaluate whom to invest in and the best practices experienced investors follow.
Establishing Your Core Capital
Before diving into any investment strategy, especially in early-stage markets, it's crucial to establish your core capital. This fundamental concept serves as the bedrock of sound financial planning and ensures you're not putting your retirement lifestyle at risk. It's not just a simple calculation but a stress-tested figure that accounts for three critical factors:
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Prolonged periods of poor market returns
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Sustained high inflation
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Living longer than expected
The goal is to achieve a 90% level of certainty that your core capital will weather these potential challenges. After securing this foundation, you should consider allocating funds to more volatile investments like early-stage markets. For those still building their core capital, it's essential to approach investment allocation strategically. A balanced portfolio typically consists of three main categories:
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Return-seeking assets: Higher-risk investments with the potential for greater returns
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Risk-mitigating assets: Stable, protective, and liquid investments
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Diversifying assets: Unique investments that behave differently from traditional stocks and bonds
For example, an experienced investor might adopt a 65/35 risk-return allocation profile. This could translate to 35% in risk-mitigating assets (e.g., municipal bonds), 10-15% in diversifying assets, and 50-55% in return-seeking assets. The majority of the return-seeking portion should be allocated to diversified global stocks. This leaves about 5% for higher-risk investments like crypto, venture capital, or angel investing. The key is determining how much you can afford to invest in riskier assets without jeopardizing your core capital. By following this approach, you can pursue exciting investment opportunities while maintaining a solid financial foundation for your future.
Navigating Early-Stage Investments: Key Criteria for Success
When venturing into early-stage investments, it's crucial to have a structured approach to evaluate potential opportunities. Here are three essential criteria to determine which companies are worth investing in:
1. Quality Deal Flow and Due Diligence
Being part of a strong network with a solid reputation and a clear due diligence process is paramount. A comprehensive due diligence should cover the following:
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Management team evaluation
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Sales and marketing strategies
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Competitive landscape analysis
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Financial health assessment
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Technical aspects (for tech companies)
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Intellectual property review
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Advisory group assessment
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Reference checks
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Legal review of corporate and deal documents
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On-site visits
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Previous and current investor analysis
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Term sheet examination
A robust due diligence process helps mitigate risks and provides a solid foundation for investment decisions.
2. Personal Interest and Excitement
It's essential to invest in areas that genuinely excite you. If you're not enthusiastic about a company's mission or industry, it's often best to pass. This personal connection can drive you to stay engaged and potentially offer valuable insights or connections. Identifying your areas of interest and expertise can help you focus on investments where you can add the most value.
3. Strong and Experienced Team
From early-stage startups to significant VC investments, the team behind the company is critical. When evaluating a team, consider the industry experience of each member, previous entrepreneurial experience, leadership capabilities, and a track record of success.
A seasoned team with relevant experience significantly increases the odds of success. After all, you're not just investing in an idea or product but in the people who will execute the vision.
Evaluating Founder Commitment
One crucial aspect for investors to evaluate is the level of commitment from the founder and their team. This commitment goes beyond just having a great idea or working hard. Here are several key factors to consider:
Financial Skin in the Game: It's important to assess whether the founders have invested their money into the venture beyond sweat equity. Founders who have put their personal financial capital at risk demonstrate a higher commitment and belief in their project.
Full-Time Dedication: Part-time founders can be a red flag. Look for entrepreneurs who are fully dedicated to their startups. A full-time commitment indicates that the founder is all-in and willing to give their venture the attention it needs to succeed.
Team Composition: Evaluate the entire team, not just the founder. Key considerations include:
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Technical expertise (e.g., a capable CTO)
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Separation of roles (e.g., CEO and CTO shouldn't always be the same person, especially as the company grows)
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Ability to articulate the company's vision and attract investors
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Executive partners or support team of mentors and advisors
Professional Support Network: A strong support network can significantly boost a startup's chances of success. Look for founders who have surrounded themselves with:
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Industry experts as mentors or advisors
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Experienced legal counsel
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Competent tax and accounting professionals
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HR support
By evaluating these factors, investors can better understand the founder's commitment level and the startup's potential for success. A truly committed founder with a strong team and support network is often better positioned to navigate the challenges of building a successful company.
Assessing Market Potential
Troy’s next tip is to look beyond the product or service and evaluate the market potential. Identifying a specific customer base with an acute problem is essential. The more pressing the issue, the better the company's chance of adding value and growing its customer base. A well-defined target audience indicates that the startup understands who it's serving and why.
While having a clear customer is essential, investors also need to know if there's a market large enough to support the business and justify the investment. Understanding the Total Addressable Market (TAM) helps assess the startup's growth potential and scalability.
Evaluating the competition is also crucial. Investors need to determine if there's room for another player in the market and how the startup plans to differentiate itself. This analysis helps gauge the startup's potential for success in a crowded or emerging market.
Another critical point is having a solid plan for acquiring customers. Even the best product or service can fail without an effective strategy to reach and convert potential customers. Investors should look for a well-thought-out go-to-market plan demonstrating how the startup will win business.
Understanding the business model and its economics is critical. Investors should consider:
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The potential for profit maximization
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Current burn rate
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Cost-effectiveness of production
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Runway provided by the investment
Investors also need to consider the timing of the product launch and the "why now" factor. In other words, they must understand what makes the current market conditions favorable for the startup's success. This could be due to a novel idea, changes in market dynamics, and new enabling technologies.
Finally, investors should look for what makes the startup special. Intellectual property or other unique factors that create a protective "moat" around the business can provide a significant advantage, at least for a few years. By carefully considering these factors, investors can make more informed decisions about a startup's potential for success and growth in its target market.
The Investor's Checklist To Identify Promising Investment Opportunities
According to Troy, one of the first questions to ask is about the investment amount and its intended use. Understanding how much runway the startup will have before needing additional funding is vital. It's also important to identify milestones indicating the company is on the right track, as these will be crucial for future funding rounds.
Revenue projections are another key aspect to consider. While many startups aim for the coveted "hockey stick" growth curve, it's essential to understand if the team expects a more extended period before investors see returns. This information helps set realistic expectations and align investor goals with the company's trajectory.
As an individual investor, evaluating how much you're being asked to contribute is crucial. Minimum investments often range from $50,000 to $100,000, though smaller amounts are occasionally possible. Considering how this investment fits into your overall portfolio strategy is essential, especially if you've allocated a specific percentage for angel investing.
The deal terms are a critical component of any investment decision. The term sheet outlines the investment conditions, focusing on company share control and financial division upon exit. Pay close attention to the structure of the investment, whether it's a SAFE (Simple Agreement for Future Equity), convertible notes, or equity. Click here to learn more about the types of equity you should consider per your investment goals.
Valuation is another crucial factor. Understanding whether you're dealing with pre-money or post-money valuation is essential, as it affects the percentage of equity you'll receive for your investment. Clarifying this point can prevent confusion and potential conflicts down the line.
Regarding stock options, preferred stock often offers advantages for investors, such as unique terms and conditions that don't apply to common stockholders. However, common stock can still be viable, depending on the specific deal structure.
Finally, consider the exit strategy. Understanding when and how you might be able to recoup your investment, potentially with upside, is crucial. While finding a "unicorn" is rare, proper due diligence can help identify promising opportunities.
Throughout this process, leveraging the experience of seasoned investors and reputable investment groups can provide valuable insights and help navigate the complexities of startup investing. Remember, thorough evaluation and careful consideration are crucial to making informed investment decisions in the high-risk, high-reward world of startup investing.
About the Speaker
Troy Niehaus is a private wealth advisor to ultra-high-net-worth individuals, non-profits, and foundations at Bernstein Private Wealth Management. He has ten years of military experience in the United States Air Force and uses the lessons he learned as a special agent to give valuable investment advice.
