8 Biggest Mistakes Investors Make When They Know Better

The 8 biggest mistakes investors make even when they know better. Have you ever wondered why seemingly savvy investors sometimes make head-scratching decisions?

I was recently a guest at a presentation by Douglas Abrams, the Founder and Managing Director of Expara Ventures, an established VC with extensive experience in Southeast Asia. His presentation’s working title was “Why Smart Investors do Dumb VC Deals: The 8 most common errors.” This is gold dust, people! Understanding these pitfalls can help you avoid them and increase your chances of securing funding.

Reason 1 of the 8 Biggest Mistakes Investors Make – Selecting the Wrong Companies

• High risk/high return: Investors sometimes get blinded by the allure of massive returns and forget to thoroughly assess the actual risk involved.
• Small business vs. scalable business: Not every successful business is VC-fundable. Investors need to identify companies with the potential to scale rapidly.
• Number 1 vs. number 2: While being first to market can be advantageous, it’s not always a guarantee of success. Investors might overlook strong “number 2” players with better execution or strategies.
• Product vs. service: Both product and service-based companies can be attractive investments, but they require different evaluation criteria. Investors need to understand the nuances of each.
• Key elements for success: Beyond the product or service itself, investors should look for strong teams, large addressable markets, and a clear path to profitability.

Reason 2 of the 8 Biggest Mistakes Investors Make – Investing in the Wrong Markets

• Geographical market: Investors need to carefully consider the regulatory environment, market size, and growth potential of different regions.
• Industry: Some industries are simply more conducive to venture capital investment than others. Investors need to be aware of industry-specific trends and challenges.
• Hot geography/hot sector: Chasing the latest trends can lead to poor investment decisions. Investors should focus on fundamentals rather than hype.
• Market size and growth rate: A large and growing market is essential for startups to achieve scale. Investors need to accurately assess market potential.
• Market timing: Entering a market too early or too late can be detrimental. Investors need to identify the optimal window of opportunity.

Reason 3 of the 8 Biggest Mistakes Investors Make – Investing at the Wrong Valuation

• Traditional valuation methods fail for startups: Traditional methods like discounted cash flow (DCF) often don’t apply to early-stage companies.
• VC method: Investors typically use an exit valuation approach, working backward from a potential future outcome to determine current valuation.
• Undervaluation/overvaluation: Striking the right balance is crucial. Undervaluing a company can shortchange founders, while overvaluation can lead to down rounds and investor losses.
• Wrong discount rate in DCF: Even if using DCF, an inaccurate discount rate can significantly skew the valuation.
• Freakish outliers in comparables: Relying on outlier comparable companies can lead to distorted valuations.

Reason 4 of the 8 Biggest Mistakes Investors Make – Choosing the Wrong Exit Strategy

• ROI = exit valuation / investment valuation: Investors need a clear path to realizing returns on their investment.
• No exit = no ROI: Without a viable exit strategy, investors are unlikely to recoup their capital.
• Trade sale vs. IPO: Different exit strategies have different implications for investors. The chosen strategy should align with the company’s goals and market conditions.

Reason 5 of the 8 Biggest Mistakes Investors Make – Insufficient Portfolio Diversification

• 74% fail to return capital; 10-20% drive all returns: Startup investing is inherently risky. Diversification is essential to mitigate risk and maximize returns.
• Normal distribution vs. Power Law distribution: Startup returns follow a power law distribution, meaning a small number of investments generate the majority of returns. Investors need to construct their portfolios accordingly.

Reason 6 of the 8 Biggest Mistakes Investors Make – Wrong Cost of Capital

• VC cost of capital at the fund level is 25% p.a. = 6X gross multiple over 10 years: Investors need to generate significant returns to compensate for the high risk of early-stage investing.
• Individual investments must 30X post-dilution: Due to the high failure rate of startups, successful investments need to generate outsized returns to achieve the fund’s overall return target.
• Dilution round-by-round: Investors need to account for dilution from future funding rounds when calculating their potential returns.

Reason 7 of the 8 Biggest Mistakes Investors Make – Off-Market Deal Terms

• Standard deal terms: There are generally accepted norms for deal terms in venture capital transactions.
• Bad deal vs. good deal: Investors should be aware of deal terms that are unfavorable to either the company or the investor.
• Valuation, investment amount, equity offered, liquidation preference, founder vesting, ESOP, anti-dilution, pay-to-play, control terms: All of these elements need to be carefully negotiated and structured to ensure a fair and balanced deal.
• Way off-market terms: Investors should be wary of deals that deviate significantly from market norms or include unusual terms.

Reason 8 of the 8 Biggest Mistakes Investors Make – Messy Cap Tables

• Part-time founder, inactive founder, superstar strategic advisor, venture builder, technology vendor, small investors, FF&F: A cluttered capitalization table with numerous small stakeholders can complicate future funding rounds and exits.
• Clean cap table: A well-organized cap table with clear ownership and control structures is essential for attracting investors and facilitating transactions.

I hope this summary is helpful for you as you navigate the fundraising process. Remember, understanding these common investor mistakes can give you a significant advantage.

What other investor behaviors have you encountered? Share your thoughts and experiences in the comments below!