Investing in startups has been thelatest craze – with good reason. These are risky investments that can turn someone into a billionaire overnight. However, as more eyes are looking to invest in tech startups, many are hesitant to make a move. This can be due to fear or simply the lack of knowledge on where to start. Fortunately,Phil Strazzulla is sharing invaluable insights on the exciting field of HR tech startups and investing in them.
Phil Strazzulla runsSelectSoftware Reviews, a website dedicated to providing expert advice on HR tech and recruiting software. Having strong connections in the field, Phil often meets with HR tech startups – and people interested in investing.
Phil recently gave a quick talk on Linkedin Live and shared his thoughts and advice when it comes to angel investing in HR tech startups. Check out the video here and a full transcript below.
Most people would probably say that people invest to make money. That may very well be true in the case of venture capital firms, where investors prefer seeing a proof of concept before making any decision. However, that may not necessarily be the case for angel investing, according to Phil. He believes that the number one reason why people get into angel investing is for the excitement of it.
“I think the majority of people that do angel investing do it because they want to go to a party and say, ‘hey, Bob! What are you up to these days? Well, I just backed this really cool MIT thing, blah blah blah. Aren’t I amazing?’ It’s sort of fun to be a part of these early-stage companies and then also get the updates and kind of follow them on their journey.”
While this may sound crazy to some people, these angel investors enjoy seeding these tech startups exactly for that reason. They don’t concern themselves too much about the economic returns of their investment in exchange for the thrill of it.
The second reason why people do angel investing is because they want to learn.
“You’re going to learn about investing, company lifecycles, how to start a business. You’re going to learn about the sort of trials and tribulations that entrepreneurs go through,” he says.
People who are into angel investing also make connections with other angel investors. Having these connections is important for them as they inform and update one another about possible opportunities or even get into deals together.
Lastly, Phil recommends that people should consider angel investing to actually make an economic return.
“Just like you think about investing in the stock market, in bonds, in gold, and in Bitcoin. You are trying to put in a buck and make more than a buck, especially on a risk-adjusted basis in the future.”
Phil discusses the different possible securities typically involved in angel investing. Investment securities are negotiable assets that hold some monetary value, typically representing ownership in a company. Investing in a company in the stock market is an example.
“Let’s say you buy a share in IBM. IBM has 100 million shares outstanding. So, you have 100-millionth of the equity in that company which gives you rights to future dividends, gives you rights to vote on stuff, etcetera.”
However, Phil says that the most likely types of securities available when investing in startups are either a SAFE or convertible note. From an angel investor’s point of view, the two are quite similar.
A SAFE (Simple Agreement for Future Equity) is a security where an individual’s investment will be converted into equity when the company gets a valuation.
“For example, let’s say you invest in a company. You put $10,000 in that company, and you put it in a SAFE. A year from now, a venture capital firm comes and says, ‘hey, you’re worth $10 million, and we’re going to give you our money at that $10 million mark. Your $10,000 will be invested into that company at that $10 million valuation – and that’s called converting into equity in the company.”
The value of the investor’s equity will rely on the valuation. Understandably, the angel investor can greatly benefit when the valuation is high because of the SAFE cap – the highest valuation the investor can get into.
“Let’s say the VC invests at $10 million. Your cap might be $5 million. And so, when this round happens, your $10,000 actually goes in at a $5 million valuation. So, it’s almost like you’re getting $20,000 worth of equity at this $10 million price. So, that compensates you for the risk that you are taking by investing in an early stage.”
Currently, the market for valuation caps for early-stage companies ranges from $4-5 million. The value is highly influenced by several factors (e.g., geography, stage of the company, background of the founder, etc.).
The risk is when the valuation is lower than the angel investor’s cap. When this happens, the company could give the angel investor a discount on the valuation.
“So, let’s say the cap is $20 million, and they invest at $10 million. You’re not getting anything, right? You’re going to invest $10 million below the $20 million. A lot of times, these SAFE notes will have a discount, usually at 20-30%. And so, you’ll go in at an $8-9 million valuation in this scenario. So, that’s your compensation for taking the earlier stage risk.”
A convertible note may also have an interest rate that pays for a payment-in-kind (PIK) dividend. This type of dividend is paid in the security that the angel investor owns.
“So, if you have $10,000 of a convertible note and you have a 10% annual dividend, you’ll get another $1,000-woth of that note every single year until this financing event happens called qualified financing. Usually, it’s a company raising $750,000 or more in a price round.”
Everything previously mentioned discusses angel investing. On the other hand, venture capital firms have a different approach. Their priority is to get their money back first, and they typically invest in preferred stock. They usually end up getting their money back or getting a percentage of the company.
The last type of stock is called common stock. These are the types of stock that founders and employees would typically have. Although it is more probable for angel investors to get into SAFE and convertible notes, they could also possibly get themselves some common stock. This can be done by directly purchasing common stocks from another individual with these common stocks, such as a former employee, for example.
Phil shares his experience when it comes to returns on angel investing, particularly on series A investments (the first round of financing).
In a hypothetical scenario where a person is a top-tier investor investing in a diversified portfolio of startups, Phil gives a quick breakdown of what the expected returns are. Around half of those investments will not break the investor even.
“About 30% of your series investments are going to go zero like you’re literally not going to get a dime back,” he says. “Another 20% are going to return less than your money.”
The other half of those investments will actually give the investor their money back – and more. Phil emphasizes that this scenario is specifically for a top-tier investor.
“Again, this is if you’re like a top decile series A investor. Then, you’re going to have another 45% that will be normally distributed between 1X return of getting your money back and a 10X return if they’re doing super well,” Phil explains. “And about 5% of your interests will be 10X or more. And what a lot of firms have found is that if you’ve invested in Uber, Facebook, Twilio, Shopify, Pinterest, LinkedIn – this number can be like 1000X.”
Phil also explains that it is important to think about the risk involved. “The risk starts really, really high at the seed stage, and it goes down sort of logarithmically….”
Since angel investors get in at such an early period, investing in a company at the series A has already drastically cut the risk involved. It is important to consider the returns when choosing companies to invest in. Phil says that success in these companies is very low, and a prolific investor has to choose companies that would yield around 100x just to make up for the other terrible bets and still make a profit at the end.
Phil shares what factors he considers when an investment opportunity arises:
Phil shares that one of the most interesting things about investing in a company at the ground level means that the angel investor typically meets and talks with the CEO. They are also usually provided with a deck containing diligence materials that their management team has put together.
The content of the deck offers the investor a degree of protection because it puts the company at an extreme amount of liability in the event that they were fraudulent. Regardless, Phil emphasizes that the angel investor still has to trust the entrepreneur they are considering getting into a deal with because they still have the upper hand in terms of acting fraudulent. Though the company may put themselves liable, an investor would not typically exert the effort to sue if the legal fees would end up costing more than the investment.
“I think at the end of the day, you really need to trust the person. Understand: why are you doing this? Why are you taking the risk? Why are you somebody who has the grit, the intelligence, the creativity to actually be successful?”
Although blockchain is something Phil is still learning, he believes that blockchain can be possibly used within the stock option arena where people can have smart contracts for vesting for company events and such, thereby decreasing fraud and allowing more control in their stock.
Another possible application for blockchain in the HR sphere is a transportable capital chain that employees can bring along with them, almost acting as a blockchain resume as companies reward them tokens for various achievements that can characterize their professional careers.
Even though huge investments have been made in HR tech recently, Phil believes that HR tech is challenging for the fact that the target audience for such software is not the most tech-savvy group. Fewer entrepreneurs and venture capital firms are investing in the HR tech space. However, that does not mean the space is stagnant. HR tech companies are finding new industrial aspects to optimize, such as mental health, diversity, and inclusion.
More HR tech companies are expected to succeed in the future as the space is constantly developing. “It’s maybe not the best market, but because it’s not the best market, there are unique opportunities.”
Observing a number of mergers and acquisitions in HR tech, Phil expects things to continue if the interest rates stay high because then the stock is worth more. Companies can raise their stock and use the money to go and buy smaller companies to acquire.
Finding riches in the niches, it is important for mergers and acquisitions to focus on uniqueness and value to make the strategy more effective. Uniqueness is especially important when a company has several other competitors that do the same thing.
All in all, Phil believes that HR tech startups are an exciting space for investors to consider, especially if those investments only take an extremely small amount of someone’s net worth. Dipping toes into this can be an invaluable learning opportunity, and if they’re lucky, they will not be hesitant to deploy more capital when a golden opportunity comes along.