This is the second installment in our multi-part series on startup investing. If you haven’t read Part I on why you should consider adding the venture capital asset class to your overall portfolio, you can do so here. Part III can be found by clicking here: Part III – Diversification and the Potential for Outsized Returns.

During Part I we learned that venture capital returns have not been highly correlated with the returns generated by public stocks historically and because of that venture capital can actually help you diversify and de-risk your overall portfolio. The question now becomes: how should you go about investing?

Invest Like a VC

It’s fairly common knowledge that fundraising is hard. It also makes sense to learn that the majority of early-stage companies never receive VC funding. What may be surprising to learn is just how few companies receive funding from a VC or otherwise. Data suggests that less than 3% of U.S. companies obtain startup financing in any form.[1] This suggests that VCs and others that invest regularly in the asset class are very picky when reviewing investment opportunities. And you should be too.

Didn’t You Just Say That Asset Allocation Matters More Than Stock Picking?

Yes, that is still true. But asset allocation does not mean blindly investing in every opportunity that comes your way. In order to approach VC-like returns, you must take into account all of the variables a VC does, which involves due diligence and setting aside investments that don’t provide an appropriate risk-reward profile.

Early-stage venture capital represents a potentially attractive asset class, having returned 22.65% compared to 9.93% for the S&P 500 over the last 30 years.[2],[3],[4] But there is no reason to believe you’ll have the potential to earn these types of returns if you skip due diligence or invest in everything that comes your way.

Terms Drive Returns. They Matter… A LOT

Even if you invest in the same company as a VC, the only way to generate the same return is by investing on the same terms. You shouldn’t settle for terms that significantly alter your return profile, especially if other investors receive better terms at or around the same time you are investing.

Let’s take Preferred Equity as one quick example. There are numerous misconceptions about preferred equity among most who are new to venture capital, especially those whose investing experience is primarily drawn from the public markets. Common stock is what’s traded on the exchanges so that’s what I should own as well, right? Wrong.

VCs almost always invest by purchasing preferred equity versus common stock. Why is this the case? In the world of private company investing, the connotations associated with preferred stock in the public markets are not applicable. In this world, preferred stock guarantees that if there is a pay out, the preferred stockholder will get paid before the common stockholder (i.e. they quite literally have “preference”). If things don’t go according to plan, being a preferred stockholder can mean the difference between getting your money back and not. Please see Exhibit A for a more detailed description and walkthrough of why this is the case.

Preferred equity also typically comes with additional investor rights and protections that you do not receive as a common stockholder and which can also significantly alter potential return profiles. To be clear though, preferred stockholders generally don’t have a preference over traditional debt or convertible notes (another form of short-term debt), so don’t forget to check whether a company has outstanding debt obligations.

Bottom line: as an investor it makes no sense to invest in startups if the terms at which you’re doing so are off-market or are terms that experienced investors would turn down, such as buying common stock or securities which can artificially cap your returns. The risks are simply too great.

This Is a Lot to Keep in Mind

There are seemingly countless factors to consider when evaluating startups. SeedInvest endeavors to bring transparency and simplicity to what has historically been an opaque and complicated process. The SeedInvest team is comprised of former professional investors who helped manage billions of dollars in private investment funds. We conduct independent, multitiered due diligence on every offering before allowing companies to list on our platform.[5], [6]  Unlike other platforms, our goal is to not simply provide a streamlined investing and fundraising experience for the investors and entrepreneurs with whom we work, but also to help ensure investors in our network are treated fairly based on the level of risk they are assuming.

Exhibit A [7]