How To Invest In Startups

It is easy to invest in startups today.

It is really hard to make a living doing it.

I think the real question in 2020 is ‘Should You Invest In Startups’. I will likely tackle this question in a few upcoming posts. Because it has been so rewarding for me, I think everyone should be allowed to invest in startups, but there are a lot of caveats.

Sam Altman has a great post on ‘How To Invest in Startups‘, which everyone should read. Books can be and are written on the subject, but Sam’s short post gets to the heart of how to attack investing successfully.

I especially like this part:

Great founders are the key to great startups. One way to do really well as a startup investor is to get good at predicting who is going to be great before they are—the market rewards finding great but inexperienced people. You can also do well by investing in people who are already proven, but the price of the shares you buy will reflect that.

So how do you identify future greatness?

It’s easiest if you get to meet people in person, several times. If you meet someone three times in three months, and notice detectable improvement each time, pay attention to that. The rate of improvement is often more important than the current absolute ability (in particular, younger founders can sometimes improve extremely quickly).

The main question I ask myself when I meet a founder is if I’d work for that person. The second question I ask myself is if I can imagine them taking over their industry.

I look for founders who are scrappy and formidable at the same time (a rarer combination than it sounds); mission-oriented, obsessed with their companies, relentless, and determined; extremely smart (necessary but certainly not sufficient); decisive, fast-moving, and willful; courageous, high-conviction, and willing to be misunderstood; strong communicators and infectious evangelists; and capable of becoming tough and ambitious.

Some of these characteristics seem to be easier to change than others; for example, I have noticed that people can become much tougher and more ambitious rapidly, but people tend to be either slow movers or fast movers and that seems harder to change. Being a fast mover is a big thing; a somewhat trivial example is that I have almost never made money investing in founders who do not respond quickly to important emails.

Also, it sounds obvious, but the successful founders I’ve funded believe they are eventually certain to be successful.

In addition to learning to predict who will become great founders, you have to be at least okay at predicting what markets will be good.

Startups are likely to happen in many more industries—startups can win wherever costs can be low and cycle time can be fast. Startups do particularly well in industries with rapid technological change, because their fundamental advantages over large competitors are speed and focus. A higher rate of change gives startups more opportunities to be right and the large competitor more opportunities to stumble.

Like the founder, and like a company, what you should care about is the growth rate and eventual size of a market (I don’t know why most investors are so obsessed with the current size of a market instead of how big they think it will be in ten years, but it’s an opportunity for you).

The best companies tend to have the courage to lead the market by a couple of years, but they know the secret for telling the difference between a real trend and a fake trend. For a real trend, even if there aren’t many users, they use the new platform a lot and love it. For example, although the iPhone was derided for not having many users in its first year or two, most people who had an iPhone raved about it in a way that they never did about previous smartphones.

The very best companies tend to ride the wave of a new, important, and rapidly growing platform.

The spectral signatures of the best companies I’ve invested in are remarkably similar. They usually have most of the following characteristics: compelling founders, a mission that attracts talented people into the startup’s orbit, a product so good that people spontaneously tell their friends about it, a rapidly growing market, a network effect and low marginal costs, the ability to grow fast, and a product that is either fundamentally new or 10x better than existing options.

You should try to limit yourself to opportunities that could be $10 billion companies if they work (which means they have, at least, a fast-growing market and some sort of pricing power). The power law is that powerful. This is easy to say and hard to do, and I’ve been guilty of violating the principle many times. But the data are clear—the failures don’t matter much, the small successes don’t matter much, and the giant returns are where everything happens.

Because everyone in Generation Z has a smartphone and their own social networks, we should be exposing them to the idea and lessons of investing, not just in public markets but in their own networks and products they use and the people they think can be great.