Chapter 18

Getting Rich by Investing in Start-ups

Investing in start-ups is one path to real wealth. The problem is that if you don't know how to sort out the sheep from the goats, it can be a freeway to the poorhouse. It's usually an all-or-nothing proposition: You either make a lot of money or lose your whole investment. Capital investing has serious risks, but if you know what you're doing, they are acceptable calculated risks.

Wouldn't you like to have been one of the hundreds of millionaires created by Microsoft? Sure, Microsoft is one in a million, but there are little Microsofts being created every day. Other than starting your own business, investing in start-ups has more upside potential than any other get-rich strategy. It can be as much a part of your get-rich plan as the stock market or real estate, but only if you do it right—and because there are a zillion ways to do it wrong, they can all make you poor if you don't know what you're doing.

Where did I learn this stuff? First, I have watched hundreds of start-ups and invested in some of them, including some losers. Second, I have started several new business ventures myself; some were winners, some were losers. Much of what I know about the subject I learned by stepping in it; my failed ventures and start-up investments have been my real teachers. The most important lesson I have learned is that all successful start-ups have some things in common, no matter how different the businesses seem to be. And there are other things the failures all have in common.

THE ONE INFALLIBLE RULE OF START-UP INVESTING

Let's get the most important rule of start-up investing out of the way up front: Don't lose your money in start-ups that really never had a chance. These are a lot easier to identify than you might think. Ignoring the rules in this chapter gives you odds that are far worse than the slots at Vegas. In my experience, 9 out of 10 startups either fail completely, taking the investors' money with them, or they never amount to anything. However, once you have eliminated the sure losers, the odds improve to better than 50-50.

On the other hand, because successful start-ups can return as much as $10 to $100 for each dollar invested, if you spread your choices over at least 10 new companies you can absorb the five losers and still be ahead of the game. Even with careful adherence to the rules in this chapter, you will be doing a really good job if as many as half of your choices survive.

Don't put all of your eggs in one start-up basket; set up a start-up portfolio. It's a numbers game, pure and simple. Even with a 50 percent success ratio, you can average more than 100 percent per year return on your total investment and change raw gambling into calculated risk-taking with a great risk/reward ratio.

Now let's look at the “never-do's” of start-up investing. Avoiding these pitfalls can save you a fortune.

THE SEVEN NEVER-DO'S

Never-do #1: Never invest in a start-up that doesn't have a carefully thought-out, written business plan, complete with proforma projections. If they don't have one, that's a clear sign that they lack the sophistication and know-how to create a real company. And you must challenge the assumptions in the spreadsheet to see if they can hold up under assault. I've discussed this in more detail in Chapter 15.

Never-do #2: Never invest in a “good idea” that is “for everyone.” If it's for everyone, it's usually for no one. Successful startups almost always focus on a narrow market that can be exploited on a cost-efficient basis.

Never-do #3: Never invest in a one-man gang. Although most successful start-ups are the result of the drive and leadership skills of one intrepid entrepreneur, successful new companies have a well-balanced, talented support team to provide all the necessary skills and experience the entrepreneur doesn't have.

Never-do #4: Never put your money into an undercapitalized company. Invariably, it costs more and takes longer. Without enough capital—and then some—the company will fail, but not before sucking you into more and more investment in a vain effort to save it before it goes down the tubes.

Never-do #5: Never invest money you can't afford to lose, because some of your picks will fail.

Never-do #6: Never invest without an exit strategy. How will you get your money back or realize your profits? If the entrepreneur does not envision a future IPO or a merger, or a possible sale of the company to a larger company, and tells you how you will double or triple your money with profits and dividends, run, because that never happens.

Never-do #7: Never invest in a start-up without a well-conceived marketing plan focused on a narrow market, with a predetermined, cost-efficient path to the potential customers.

Just by never doing these seven things, you've already increased the odds from 1 in 10 to about 5 in 10!

THE PERFECT START-UP

The perfect start-up, which probably doesn't exist in nature, will look a lot like the following. (Where I use the masculine he in the generic sense, it could very well be a she.)

1. The Entrepreneur

The entrepreneur's character and personality is the major limiting factor in start-up success. Ideally, he will have all or most of the following characteristics:

• He will have had experience working for a company that required the same skills he will need this time.
• He will understand that he is not just developing a hot idea; he is starting a business that must be built from scratch like any other business, with all the standard, routine business functions needed by any company, such as accounting, sales, marketing, collections, information technologies, and so on.
• He will have strong skills in one of the critical areas needed by this and any other business, such as communications, marketing, sales, relevant technology, accounting, capital raising, and so on.
• He will have leadership skills, and will build a team of talented people who share his dream, respect him, and supply the essential skills he doesn't have. At a minimum, he must have a computer-savvy controller to produce the financial statements needed to analyze the start-up's progress, a marketing VP, a sales manager, and an office or operations manager.
• He must have a supportive spouse, or no spouse at all, and to a great extent that's up to him. No one can be at his best on the job when he is being hassled at home. Start-ups require so much time and dedication that the spouse must understand the pressures the entrepreneur is under and provide a safe harbor so that if he comes home, his emotional batteries will be recharged instead of further drained. To earn that support, despite the long hours he must work, he must not become a compulsive workaholic. He must set aside dedicated, predictable time for spouse and family and never fail to keep his family commitments. If a wife knows that she can have Friday night as a date night, she will not hassle her husband during the week, and if the kids know that Dad will always be there for recitals and games, they will feel supported.
• He must have a big, strong ego, as opposed to a big weak one, so he doesn't feel threatened when it turns out he has made a bad mistake and needs to change course. Big, weak egos make people so defensive about the inevitable mistakes made in new businesses that they won't make essential course corrections, and they will lead the company down the hole that leads to business hell.
• He will be a reader, keeping up with relevant information in his industry and the marketplace as a whole. I hesitate to invest in an entrepreneur who doesn't read The Wall Street Journal, including the editorial and opinion pages.
• He will be a realistic optimist (or an optimistic realist, if you prefer). That means he can face the facts as they are, and if they are negative, he will believe he can change them.
• He will be intellectually honest, which is different from just being honest. An honest person won't lie to you, but an intellectually honest person will never lie to himself. Self-deception is the cause of countless business failures. Self-liars always fail, because they will not admit it when they are wrong and change course in time.
• He will have clear, well-articulated long-term goals. Course changes and refined and altered objectives are fine as the company gains experience in the real world, but without a clear objective in mind, the entrepreneur will be at best a tactician, not a strategist—and tacticians don't build successful companies.
• He will not drain the company's capital to support himself. He will have independent income, or some savings, or a willingness to live on short rations so he is an asset, not a liability, for the company. He and his family must be willing to live modestly and not care about the dishonest facade of success. There will be time to show off when the company has really made it and there is plenty of money.
• He probably will have failed at least once, and is a lot smarter for it and has demonstrated his resilience and stubborn persistence. That's good!
• He must not be greedy. He must be willing to share the equity to attract and build a top-flight management team, and that must be their focus, not just a salary. Also, managers who are willing to work for equity in the form of stock, convertible bonds, and options have the right motivation to build a real company so they can get rich too.

2. The Product

The best products and services to bet on usually aren't revolutionary; they are simple improvements on an already accepted product or service—a better, faster, or cheaper way of doing old things or providing useful services. It doesn't have to be a hot consumer product; sometimes it is sold to businesses. It needs to be the solution to a problem, and it is a lot easier if you don't have to convince people they have a problem, just that you have a simple-to-grasp solution to a problem they already know they have. The best, safest, and also most profitable start-up companies don't have to be dramatic or in the hot market du jour. They are usually dull and prosaic, and often very low-profile.

3. The Marketing

Marketing is an essential skill for a start-up. Marketing isn't just advertising, direct mail, or selling; it's an amalgam of a lot of disciplines. When I launched Hi-Q, a brain-food supplement, we had to figure out how to sell it. We tested direct mail, and it worked OK but not well enough, so we are testing direct-mail appeals. We are testing a 30-minute radio infomercial, preceded by numerous 10-second promos to draw listeners to the show, a personal talk-show appearance on the same station, one-minute radio spots, and a simultaneous major direct mail campaign. We are also looking at point-of-sale display racks in health-food stores and a book on nutrition and the brain. We'll test everything in a small retirement community, throw out what doesn't work, and then pour money into everything that does work in city after city. Now that's marketing!

PICKING LOSERS

Most potential investors who come to me to excite me about some venture don't have the slightest idea how or whether the entrepreneur meets the preceding requirements. They haven't asked these questions, and they probably don't even know what questions to ask. They are just excited about a product or idea, and believe the company will make them rich because “everyone needs (or will want) one” or “there is no competition.” It is rare that these enthusiasts really know whether or not they are investing in a real business—and much more often than not, they aren't.

THE PROFILE OF A SUCCESSFUL START-UP INVESTOR

If you as an investor don't have most of the following attitudes, you should probably put your money into T-bonds.

• You must think long term. If you think there will or must be a quick profit, you will be wrong. This is a dysfunctional attitude. It also means that you must be a patient, long-term investor, with no fixed deadline when you will need your money. You must be willing to look at least five years ahead.
• You must demand monthly financial statements and be willing to read every number. I am amazed at how many start-up investors don't insist on this rudimentary requirement, or wouldn't even understand the statements if they got them. If the company won't give you statements every month, it tells you that either the company doesn't know how it is doing, or it is doing badly and doesn't want you to know. If all you get is optimistic reports from management, not backed up by good financials, you know that they aren't being honest with you, or maybe even with themselves. If the plan is to go public or sell to a bigger company someday, the buyer or underwriter will require statements going back to day one. Trying to reconstruct accurate financial statements going back to the beginning is a nightmare, and you can forget about an IPO.
• You must get the stars out of your eyes. They obstruct your vision. You don't have to become a money-grubbing Scrooge, but you must know not just the upside but also the downside of the company. You must treat this as an investment, not an exciting romance. Money will not love you, but you must at least care about it, and you must be objective and realistic about it.
• Have a piece of the real action. Don't just loan money to the start-up because it is your son or daughter or cousin Bob, or a pewmate from church, or a product that excites you. Insist on making any loans convertible to common stock, or at least on options to buy common stock as a kicker that are exercisable at a very cheap price. Remember, start-ups are usually an all-or-nothing proposition. If the company fails, you will lose everything. If it succeeds, it could be worth a lot of money, so you should have an upside commensurate with the risk. This is called the risk/reward ratio, and it should be at least 10 to 1—that is, the potential profit should be at least 10 times the potential loss. This is the only way I know to buy stock wholesale and someday sell retail. Successful venture capitalists always do this.
• Get collateral if possible. This may not be as good as it sounds. If the entrepreneur is someone you love, such as one of your offspring, and the collateral is a mortgage on their home, it is of no value if when push came to shove you wouldn't be willing to foreclose.
• Be sure the company is raising enough money. Optimism is an essential characteristic of an entrepreneur, but it can kill a company if optimism causes the entrepreneur to believe his own starry-eyed projections and grossly underestimate how long he will have to be paying the overhead until the cash flow turns positive. Look at his estimated cash needs, double them, then double them again, and it might be just enough.
• Check out the entrepreneur for previous failures. If he has failed once or twice, that can be a positive if he learned from it. Ask him what he learned from his failures. If he failed because of a lack of intellectual honesty and won't admit it, run!

FOCUS

What is the primary focus of the company? Is it on a product or idea, or is it on building a real business with a high-probability, well-thought-out plan for becoming a wealth vehicle? If it isn't the latter, it is doomed to fail. The founder's eyes must be firmly fixed on the long-range goal, which is to maximize the value of the stock for the stockholders. If that's not the goal, you don't want to be a stockholder.

It all comes back to where we started: Avoid the obvious losers, and that's not hard to do.