The Best Strategies for Early-Stage Investing

It’s a common dilemma for many high-net-worth individuals who show any interest in early-stage investing: Everyone wants to pitch you on their idea.

Early-stage investing can come in different forms—from seed capital for family and friends to angel funding and venture capital (typically $5 million and up).

There can be terrific benefits for investing in new ventures, both personally and financially. At some point, however, an ad hoc approach doesn’t make sense. Not only does it make fielding requests – and saying no – all the more difficult, it likely won't produce the best investment results. A better strategy is to put parameters around the kinds of companies you’ll consider, based on your investment goals, secondary objectives, risk tolerance and broader portfolio.

Here are 5 questions to ask yourself to help build a framework for early-stage investing.

Why are You Interested in Backing New Ventures?

For most early-stage investors, taking a flyer on a fledgling company isn’t purely about making money. In fact, there are generally far less risky ways to earn an investment return. Consider the odds of success, or lack thereof: roughly half of businesses fail within five years and two out of three go under within the first 10 years, according to the Small Business Administration.

Then again, many early-stage investors can’t help but be intrigued by the idea of spotting the next Unicorn. In 1995, the venture capital firm Kleiner Perkins Caufield & Byers invested $8 million in a small Seattle company that sold books on the internet. Four years later, that investment in Amazon.com had earned a return of 55,000%, according to Forbes and Fundable. The market value of Amazon.com was recently nearly $950 billion.

Even so, for most high-net-worth individuals, the motivation behind early-stage investing is less about returns and more about other factors. Such investments can be an opportunity to make a social impact, give back to a community, scratch an entrepreneurial itch, make connections in a new industry, or simply help out a friend or family member.

There is no right or wrong answer to the question of “why” you’re investing, but understanding your motivation is a key first step in creating a strategy.

How Much Can You Invest and In What Increments?

Another key step is determining how much of your investable assets you should allocate to start-ups. Every investor, regardless of net worth, should start with a budget. There are no hard-and-fast rules for how much is appropriate, as it depends on any number of factors, from overall wealth and lifestyle to general views on money.

That said, most advisors recommend that individuals invest only money they could afford to lose. To be sure, early-stage investments should come from funds that are set aside for experimental projects and can be stoically parted with without an impact to your financial wellbeing. Start small and as your experience with successful exits and comfort levels grow, gradually increase your investment levels.

While you’re thinking about dollars, also weigh the pros and cons of making many small investments versus focusing on one or two investments a year. The benefit of the former is that it spreads the risk and gives you the opportunity to try many different approaches. The benefit of the latter is it allows you to spend more time vetting would-be investments, may open more doors to be actively involved and can have a greater impact.

What Kinds of Ventures Interest You?

This gets back to the why of early-stage investing. If returns are your top priority, you’ll likely do best to stick with what you know. If your expertise is in global retail, for example, you probably don’t want to jump the rails and become a player in biotech. On the other hand, if early-stage investing is a means to get to know a new industry – and returns are less of a priority – by all means focus on what interests you.

Regardless of where your interests lie, it makes sense to think about where you can add value beyond writing a check. You’ll get more satisfaction out of the deal, and you can dramatically increase the odds of success for the companies you back – whether you take an advisory role, make introductions to key people in your network, or help in other ways.

What’s Your Timeline andCommitment?

Early-stage companies are early in their maturity and often don’t begin to yield returns for three to five years, if at all. Early profits are reinvested for future growth. Returns can take the form of preferred profit sharing, buyouts from larger investors or from a sale of the company.

Perhaps the biggest investment in early-stage companies is your time. Depending on the experience of the management team, young companies often require one-on-one mentoring and exposure to a wider network. Note that many other forms of investment are designed to be a transaction of invest-and-forget, and repeat. With startups, you may be called to offer advice on financial matters, personnel issues, legal situations and marketing strategy.

Investing Alone vs. Co-Investing

As an individual investor in a startup, your risk and reward increase. If you think you have the time, and unique expertise and connections to help a new venture succeed, this may be a viable option. The benefit is more control and access to the company and a potentially bigger return down the road. But because you’ve chosen to go it alone, you will spend more personal time working on this project. You may also be called on for future capital for expansion or risk dilution of your equity.

There are many other different ways to fund early-stage companies alongside other investors. Most regions have established angel investing networks in which investors pool their funds and their expertise to make investments together; there are also national and global networks.

The benefit of these groups is that you can spread your risk and limit your time within an established system for funding startups. Often the diverse expertise of your peer investors will be a safety net for the management team of the startup. The drawback is that you may not have as much access to the company and, therefore, not as much control as you want.

As with any investment decision, every approach has its pros and its cons. The important thing is to recognize these differences, build a strategy that meshes with your goals, and fund new ventures with a clear idea of what you hope to achieve.