The startup industry has an ever-growing interest towards smart solutions. It’s only natural that the desire to make good financial decisions has reached investors as well.
The concept of smart investing is a logical continuation of the basic investing principles. It means that investors must make correct decisions that meet their needs. However, it doesn’t sound too different from regular investing practices. So what’s the difference?
The word “smart” is sometimes used as an acronym containing the following components:
S — Specific;M — Measurable;A — Achievable;R — Relevant;T — Time-bound.
Therefore, a SMART investment means achieving a clearly defined and quantifiable financial goal for a set period of time. Basically, a smart investment is a successful investment from the start.
Let’s see how this principle is applied in venture building.
Smart investments in the startup industry
Founders and investors see smart money in different ways because of their varying definitions. We’ll take a look at both perspectives.
Founders’ point of view
When entrepreneurs are looking for smart investments in their business, they usually tell the exact need they plan to cover. For some, a smart investment is the one that takes their startup to the global market. Others are waiting for technical support to implement the product. If a startup does not have a strong IT department, a smart investment should launch a quality development.
In other words, for startup founders, smart investment is money that comes with other beneficial expertise. They contribute to achieving such goals that are unattainable for a startup’s internal resources.
Investors’ point of view
For investors, the “smartness” starts with specialized venture capital funds. When investment opportunities are divided into suitable and unsuitable, it reduces the number of requests and allows VC firms to select a balanced portfolio. Also, when working with startups in a particular area, venture investors gain expertise and experience, hone development strategies, and learn how to bring projects to a market.
From an investor’s perspective, a smart investment is not only about money. It can also be about:
- their experience and knowledge,
- technological means,
- tools and methods for business development,
- assistance with international market expansion,
- networking, including mentoring and connections within the industry.
Thus, in a startup industry, a smart investment is infusing financial and other lacking resources into a project to help it achieve its business goals. However, startup needs do not always coincide with investing decisions. In some cases, a startup’s needs might be way beyond the capabilities of a VC firm, and vice versa. Not every newly-born business is going to get all its issues covered.
The startup needs to be covered by a smart investor
When talking about what a project lacks, it’s easy to cross the line and demand disproportionate investments. Of course, any young business faces difficulties, and yet the portfolio company must remain independent. Investors cannot have more influence over it than actual founders.
Sure, venture capital firms are interested in providing their portfolio companies with skills and experience (as long as such an investment is sufficiently profitable). Nevertheless, founders should never abandon their businesses, thinking that investors will figure it out.
So what do investors include in the concept of SMART investments? Here is a list of business needs to be met by a smart partnership:
- tech support: advice on a project’s development in terms of technology,
- HR: finding personnel, hiring workers, developing a reward system,
- monitoring: meetings to discuss further strategy, milestones, and metrics,
- search for new clients: advertising channels, access to wholesale and industrial customers, access to decision-makers.
Benefits of smart investing
Many startup owners are desperate for money and ready to accept the first offer. In the short term, this isn’t so bad, having capital is always better than not having it. But this approach can have long-term consequences. Money is not a guarantee of development, but only its component. Without an investor’s expert help, such an investment loses a huge part of its value.
Therefore, founders are advised to conduct a thorough analysis of the venture capital industry and choose the most suitable partner. Each advantage of a VC firm can bring its own benefits to a startup. For example:
- The fund has enough experience within a startup’s niche, so it has established go-to-market strategies that can be used for a startup’s growth.
- Years of experience in startup investing shows that an investor can see promising projects and improve their work.
- Valuable connections within the industry provide access to community experts, allow you to hire trusted professionals, and receive high-quality advice from mentors.
- A VC has its own successful business. An investor’s first-hand experience in growing their business provides them with invaluable insights into how to develop, market, and expand a product.
- An impeccable reputation and credibility mean that the market trusts this fund’s projects. Part of this reputation falls to portfolio companies’ shares, which is useful for further fundraising and media coverage.
Investors’ guide: 8 steps to smart investing
Investing in startups can be extremely profitable. According to a study, a well-formed business angel portfolio can bring a 250% ROI in 4 years. In this sense, startup investments easily outperform both the stock market and most other types of assets.
Below, you will find a short eight-step guide to help investors get familiar with smart investing.
Step 1. Understand how smart investments make money
You might think that with startups, the return on investment is only promised to lucky ones and those who are best at recognizing which company will bring 100x profit in 5 years. However, even among the most successful investors, not anyone is capable of this. In fact, the best tactic is diversification.
The wider the portfolio, the safer the investment. The study showed that to achieve an average annual ROI of about 30%, business angels need to invest in at least 15–20 projects.
Step 2. Determine your investment strategy
Before making the first investment, you need to clarify the following questions.
- Planned number of transactions. As stated above, expanding the portfolio stabilizes it, increasing the chances of making a good profit.
- The planned amount for each transaction. It is necessary to decide whether the investments in your portfolio will be fully balanced, or certain startups will receive more funds. It’s also worth saving some money for further rounds of funding; this will help you prevent dilution of your stake.
- Types of deals that are interesting to you. For example, you might be attracted to big ideas with smaller teams, or mature startups with an already polished sales funnel. This is important because the cost of projects can vary greatly depending on their level of development.
- Universal or specialized investment. The data from the study mentioned above shows that investors who focus on a specific niche have more profitable portfolios.
- Individual investment or joint. According to the report, business angels who invest together with colleagues (for example, as part of an investment group) usually have a higher ROI.
Step 3: Find high-quality trades
Unlike the stock market where investors can invest in any stock, it’s hard for startup investors to find great deals. That’s why the best tool for finding fresh startups is reputation. By gaining credibility in the market, the investor expands their access to top projects.
For aspiring investors, it might be too early to think about a personal brand. They can join crowdfunding platforms or start participating in local startup events.
Step 4. Study the term sheet carefully
Each transaction has unique nuances. They are listed in the business angel’s contractual agreement called the term sheet. It sets out various conditions for the purchase and determines the potential for profit growth, the investor’s participation in future funding rounds, as well as the consequences of possible bankruptcy. Therefore, it is important to understand in advance the advantages and disadvantages of the particular investment.
Step 5: Offer value beyond financial investment
Many companies dream of raising smart money and finding investors who can provide experience and skills in addition to capital. Having SMART capital, a business angel can take part in a project's development, increasing the value of their investment through intellectual, technological, human, and other resources.
Step 6: Be ready to raise the rate
Throughout their lifecycle, startups typically open multiple rounds of funding. If the business is successful, the startup raises the value of its shares. To maintain pre-emptive rights at the time of the new fundraising stage, the investor has to increase the startup investment according to the increase in its appraised value.
Step 7. Prepare (to wait) for an exit
Identifying profitable transactions is only the first step of the business angel’s work. To cash out ROI, the investor must somehow sell, or exit, their share.
The next best ways to make money on startup investments are M&A and IPO. But unlike stocks that are listed on public exchanges, startups do not have a stable market, and therefore are considered long-term investments.
Such investments may remain illiquid for many years until you find a buyer.
Step 8. Repeat steps 1–7
A major part of business angel’s activity revolves around creating and maintaining a flow of quality deals. This should be a repetitive process. This way, you gradually increase the amplitude of your search and receive more investment proposals.
The value of smart investments: An investor’s perspective
For startups receiving smart money, the main value of such investments lies not in the capital but in strategic partnerships that come with it. But what value do investors see in smart investing?
Any business expert will tell you that the purpose of financial investments is to gain profit. However, for smart investors, the value of partnering with startups goes far beyond cashing out. That’s why an activist investor Winston Ibrahim writes, “To me, a smart investment is a purposeful investment.”
In his opinion, the value of smart investment opportunities is determined by three components.
The right moment
When considering an investment, investors usually choose early-stage startups where founders are only preparing to develop and grow their projects. Of special interest are the companies that have already launched their product on the market, proving that they can handle the sales. Having actual customers means that a startup is on the right track, so partnering with a VC firm will only develop and accelerate its potential.
NB! Venture capital firms often avoid becoming the first investor. The less experience a project has, the less data there is. For example, young startups cannot provide metrics needed for analytics and forecasts. Investing in such a project would be just as good as investing with a blindfold over your eyes. The risks are disproportionately high.
On the other hand, many companies specialize in seed and pre-seed investing. However, their selection process is just as rigorous. They are filtering startups very carefully, eliminating all the risks of investing money in a wrong enterprise.
From an investor’s point of view, the best founders are those who have a clear vision and a strong will but are flexible enough to delegate authority. If a founder is looking for an expert’s opinion, they should be open to collaborating with people who know more. So the other big value is synergy. However, investors and professionals are only attracted by it when the founders show their readiness to cooperate.
Sounds obvious, right? In practice, entrepreneurs may see external participants as a threat to their product. This is why a founder needs to be humble about delegating hiring processes to investors: a founder’s knowledge is imperfect, so their startup needs specialists who know better.
There is another common thing. Once having achieved success, some founders start to believe that they have some sort of a Midas touch that turns everything into money. Such entrepreneurs find it hard to take advice. Their ego is inflated to such an extent that investors have no credibility in their eyes. As a rule, such founders waste smart investments on something completely unnecessary and eventually lose their business.
The bottom line is, startup founders need to know when to stick to their vision and when to be flexible. Otherwise, no matter how good the product is or how much money it has already made, such a startup won’t attract capital. A business with illiterate and stubborn management is too risky and does not fit into the concept of smart investing.
The product is close to an investor’s personal interests
Smart investing is not just a financial race where venture capital firms compete to see who will earn the most money. A smart investment opportunity should be worth the resources spent on it, bringing something else apart from the actual profit.
For a startup to get smart capital, it needs to at least inspire an investor and make them eager to participate. People are enthusiastic about what they have vast expertise in. That’s why venture funds form their circles of interest, i.e. areas of their specialization, to constantly develop and test various strategies.
As soon as a passionate founder meets an equally passionate investor, a strong bond is formed that can create a truly exceptional product. Thus, the ideal smart investment combines interest, skills, experience, and expertise.
Successful and unsuccessful examples of smart investing
We continue to consider the experience of Winston Ibrahim.
In his article, he shared a story about the best and worst smart investments from his personal experience.
One of our most successful investments was with a Halal frozen food brand. We met the founder at an interfaith philanthropy event at the Obama White House in 2011 and immediately hit it off. We invested in his company during the seed round, and today they’re an industry leader. He also wound up as an advisor at Hydros and connected us with a number of other key experts.
According to Winston Ibrahim, this partnership looked promising from the get-go. But why? Communication between the investor and the founder flew naturally from the start, and the relationship showed the potential for mutual benefit.
Here is another example where Winston Ibrahim recollects his worst investment.
Our most disastrous investment was doomed, on the other hand, by a strained relationship with an uncooperative founder. Despite access to many top advisors in the space—our team included—he simply would not listen to the experts around him. He wouldn’t hire professional operators. He was spending capital in all the wrong places. His financial projections were all off, and he wouldn’t fix them even after we pointed out the errors. Ultimately, he was kicked out of his own company, lost all his equity, and our investments were turned into “all-stock,” meaning we only cash out if the acquiring company gets bought. The worst part? The product was truly exceptional. It had “billion-dollar exit” written all over it.
Winston Ibrahim emphasizes that smart investing must go hand in hand with the right team and product. If the company is not coherent, then there will be no investment. But it’s not just about making money. He writes, “Our goal is to make not only wise, but meaningful investments of capital and expertise in companies, people, and products we truly believe in.”
Smart investing is a continuation of basic investing principles that consists of five components:
- time limit.
A smart investment must achieve clearly defined and quantifiable financial goals over a set time period. For this purpose, an investor makes such investment choices that meet both their current needs and future financial goals.
In the startup industry, smart investment means providing not only financial but other types of resources to meet the project’s needs. As a rule, when investing smart money, business angels and venture funds share their experience, technology, teams, connections, and other advantages necessary for a startup’s development.
An investor cannot take full responsibility for a startup’s journey. Instead, the portfolio company remains independent and autonomous while receiving the appropriate support from the investing company.
As a rule, investors don’t see smart investing as a way to earn money. It’s more of mutually beneficial cooperation that both companies can gain from. For example, smart investment can provide access to new markets, help with new business connections and acquaintances. Therefore, three things are important:
- A smart investment is only made when a startup has proven its potential.
- The startup management must be ready to delegate their authority.
- A project must be interesting enough for an investor to be personally involved in its development.