Three Reasons to Invest in Startups

0
558

Investing in startups was historically reserved for just the uber-wealthy and those with very strong venture capital or angel investment connections. As a result, less than 0.1% of the U.S. currently invests in startup companies. But with the recently passed JOBS Act and the emergence of equity crowdfunding platforms, investors are now able to get access to a broad assortment of early-stage investment opportunities. Given that this is a very new asset class for most investors, I am going to walk through three reasons to consider allocating capital to angel investments:

1.Overall Portfolio Diversification

I would never advise putting a large percentage of your savings in early-stage investments because it’s simply not prudent. However, allocating 5% of your overall portfolio into angel investments can increase returns while lowering volatility. This is because of early-stage, private companies generally have a low correlation with traditional asset classes, such as stocks and bonds. A recent SharesPost whitepaper concluded that allocating 5% to private growth companies could increase the returns of a traditional portfolio by 12%. Most sophisticated pensions and endowments have also come to the conclusion that allocating a portion of their overall portfolio into the venture and private equity investments can reduce risk while increasing returns. For instance, Yale University’s endowment allocated 31.0% of its portfolio to venture capital and private equity in 2013 and has generated 29.9% annualized returns in private equity and venture capital since 1973. Furthermore, The Yale Endowment’s 2013 Annual Report defends it asset allocation model, noting that “traditional 60 percent equity/40 percent bond portfolios are not diversified, not equity-oriented, and not appropriate for long-term investors.” Along the same lines, a recent Deutsche Asset & Wealth Management report argues that adding alternative assets to a portfolio of stocks and bonds can reduce volatility and increase portfolio efficiency.

2.Returns and Upside Potential

The aggregate returns for the asset class as a whole are better than you might expect. In 2012, Thomson Reuters launched the Thomson Reuters Venture Capital Research Index which seeks to replicate the performance of the venture capital industry. The index shows that venture capital has returned 19.7% per year since 1996 versus just 7.5% and 5.9% respectively for public equities and bonds. Also in 2012, Professor Robert Wiltbank released findings from the largest data set on individual angel investments that have ever been collected and found that U.S. angel investors returned 2.6x their money on average. If we assume that the average time to exit an angel investment is five years, 2.6x equates to 21.1% annualized returns which is slightly higher than overall venture returns. Also, there are few asset classes that offer the homerun potential of venture investments. Peter Thiel’s initial investment in Facebook increased in value by over 2,300x prior to IPO. Although investors should absolutely not expect to find the next Facebook, Twitter or Uber, it is hard to ignore the asset class’ potential to generate outsized returns.

3.Funding the Future

Asset allocation and profit potential aside, angel investors are also often investing in startups for more intangible reasons. Unlike essentially any other type of investment, startup investing provides the opportunity to invest in innovation and to feel real ownership in the companies that you invest in. Every year, angel investments create thousands of revolutionary and life-changing technologies. In addition to providing capital, angel investors have the chance to become involved with the companies themselves. Investors often take on strategic advisory roles, provide advice, or offer industry connections, among other things. For former entrepreneurs and for those who never had the chance to start a company of their own, supporting a startup can prove to be the next best thing. First-time investors need to consider that backing startups can be extremely risky and is very different from investing in public stocks. Risks aside, there are strong reasons for investors to consider allocating a small percentage of their overall portfolio into alternative assets and startup investments in particular.