“Diversification is protection against ignorance.”
That little gem comes courtesy of one of the world’s most successful stock market investors: Warren Buffett.
And we must admit, Mr. Buffett has done pretty well for himself without the benefits of diversification.
That said, we’re not so sure how Mr. Buffett would do enlisting the same strategy for private company investing. When it comes to start-up investing, it’s clear that diversification is one of the key rules for success.
As in turns out, that isn’t the only ”golden rule” of public-market investing that translates poorly into a successful early-stage investing strategy…
The Kauffman Report
Several months ago, when my partner Matt and I were first discussing launching Crowdability, we discovered a little-known report on the angel investing market.
The report was published by the Kauffman Foundation, a 50-year-old non-profit organization dedicated to fostering entrepreneurship and entrepreneurial education throughout America.
We were thrilled. The study offered one of the most in-depth reports on angel investing returns we’d ever come across.
Researchers collected and analyzed 18 years of data on over 1,000 investments. The investments were made by 500 individual angel investors and over 80 angel groups.
The goal of the study? To identify the most successful early-stage investing strategies.
The strategies they uncovered are fascinating – and they’re wildly different than successful strategies for the public equities markets.
The Three Keys
1. The Magic Number
20 hours. That’s the magic number.
According to the Kauffman study, investors who performed at least 20 hours of research on their potential investments earned 590% over a three-year period.
Not convinced? At the opposite end of the spectrum, those who performed under 20 hours of research were lucky if they broke even.
In the public equities markets there is no magic number: some people take months to do their research, others take a few minutes. Reason being, there’s an infinite number of ways to make money: you can trade a stock for a short term profit using “technical analysis”; you can hold it for a long-term gain; you can even sell the stock short in the hopes that it goes down.
But with private companies, it’s black or white. Either the company works, or it fails. So your primary goal when performing research is to determine which companies have low odds of success – for example, companies that have an inexperienced team, or are targeting a small market, or don’t have any traction.
2. Experience Counts
The report also found that, for angels who limited their investments to companies in which they had significant industry experience, their profits were twice as high as angels who spread their money across a variety of industries.
This is quite different from investing in public-market securities. In the stock market, investors are used to spreading their bets around many different sectors. There’s so much info around publicly traded companies – everything from analyst reports to customer reviews to historical performance – an investor doesn’t need to be an expert in a particular field to get a feel for a particular stock.
With early-stage, private companies, you’re generally dealing with very limited information on the company and the industry. Therefore, it’s easy to see why industry experts tend to outperform non-experts in early-stage investing.
And this is precisely why we always recommend that you “be a follower” when it comes to equity crowdfunding. When evaluating an opportunity, check to see if any industry experts have already committed to invest in the company!
3. All Hands On Deck
When it comes to public companies, you’re generally dealing with mature organizations that have thousands of employees and millions (if not billions) in sales. They aren’t start-ups anymore, and there’s very little an individual investor can do to help move the needle and make the company more successful.
But when it comes to start-ups, an individual can have a tremendous impact on the company’s trajectory. This explains why the Kauffman report found that investors who proactively assist their portfolio companies enjoy returns 3x higher than investors who invest only passively.
How does this apply to you?
Well, you won’t always be able to make a meaningful contribution right away, but you can start with small steps and see where it leads…
For example, recommend the company’s products to your friends. Share links to their content on Facebook or Twitter. Introduce other potential investors when the company is raising capital.
At the earliest stages of a business, every little bit helps!
You Don’t Have to Be Perfect to Make Money
Using any of these 3 rules seems to dramatically increase your odds of creating a profitable early-stage portfolio. But don’t take our word for it!
Here’s a link to the full Kauffman report so you can see the data for yourself. If you’re serious about making money in early-stage investing, this is a “must read.”