Investing in startups via equity crowdfunding is an inherently risky business. Yet with great risk comes great reward.
We’ve all heard stories of investors that got in early on today’s biggest corporate names. The newest, and easiest way for practically anyone to get in on early-stage companies is equity crowdfunding.
The best way to participate in this upside while mitigating the inherent risks is diversification.
Diversification rests on the basic premise of not “putting all the eggs in one basket.” If an investor were to put all their money in one startup and that business fails, they are left with nothing to fall back on.
However, if the investment is diversified across 15-20 different startups, the probability of all of them failing is reduced substantially. Even if 7-8 of such investments fail, the returns from the remaining investments can help to make up for the losses and provide returns. This is exactly how the VC model works, which typically expects 1 to 2 big wins per 10 investments, with the other 8 or 9 doing okay or failing.
How to Build a Diversified Portfolio in Crowdfunding
As we already mentioned, the key to becoming a successful early-stage crowdfunding investor lies in diversification. It is critical for investors to create a diversified portfolio and avoid unnecessary risks. To build a sound portfolio, investors can follow certain guidelines.
Do Your Homework: Investors shouldn’t invest in every opportunity that comes their way. Each option must be analyzed carefully, and due diligence should be performed to pick and choose the businesses worth investing in. Some of the available capital must be held back and deployed only when an excellent opportunity arises. As a research-focused investment ratings platform, KingsCrowd was founded to make this easier. Check out our related article: “Due Dilligence is the Key to Startup Investing Sucess” for more information on this topic.
Invest in What You Know: Understanding is key. Investors should invest only in sectors and companies that are known and well understood. If the need arises to venture into unknown sectors, careful due diligence should rule the day. We can help with that.
Focus on Process not Profits: The basic criteria for portfolio diversification is to not put all the eggs in the same basket. Investments should be spread across 15-20 different companies, dealing in different businesses and sectors. This will help to minimize the risks of failure.
How much diversification is ideal?
Simply put, diversification increases the odds of a successful portfolio. Startups are inherently risky, and they may or may not succeed. Every time an investor is putting money in a startup, she is taking a risk as the business is impacted by multiple factors.
It is, therefore, necessary for investors to diversify to de-risk their investments. Diversification must be done across industries, sectors, technologies, founders, and stages of operation of companies.
In an ideal scenario, the odds of any startup being successful are lower than a typical investment in a large-capitalization stock (for example). Spreading ones’ bets across 20-30 different equity crowdfunding investments is probably the best move for the active crowdfunding investor. Investments can and should be spread across new ventures, established companies, early-stage startups in different industries like technology, renewable energy, food and beverage, fashion etc.
The Bottom Line
Diversification is the cornerstone of startup investing success. Many early-stage companies are bound to fail due to lack of experience, the absence of target market, misalignment of the product/service due to it being too forward-looking or too conservative, lack of needed additional funding, and other factors.
Even after performing stringent due diligence, it is not possible for investors to be totally sure that a startup will succeed. Therefore, to stack the odds in their favor, it is critical for investors to diversify crowdfunding investments across at least 20 different companies. This will help to make sure that losses incurred from the 5 to 15 failures can be more-then-covered up by the profits gained from (hopefully) 5-7 successes.