Start-up Investment 101
The role of an angel investor or venture capitalist isn’t an easy one. Imagine selecting a few start-ups from the hundreds that reach out every year, identifying among them the opportunities that will provide the “big” returns worth of an investment. lucrative, but tough.
While funding start-ups anywhere in the world, it’s difficult to differentiate great opportunities from the not-so-great ones. There is considerable risk that needs to be factored into the decision-making process, often resulting in investors being rather stringent with their capital. Some may argue that is truer more so now, than it was a few years ago.
In order to make responsible investments, its advisable for any investor to have a set of criteria that allows start-ups to be evaluated on common ground. While these criteria can vary according to industry, geography and risk appetite; it’s vital that every investor or VC has a “checklist” to go through. Based on my experience, I’ve put down what I feel is a comprehensive list of boxes that can be considered before making any investments.
Team
The founding team is the driver behind any company’s success. Their experience and knowledge can also accelerate the rate at which success is achieved or potentially slow it down. It’s crucial for the founding team to have not only domain knowledge and expertise but also the passion needed for an idea to cross the chasm. Since the team is the face of the business to both, investors and customers, there needs to be a sense of confidence that will inspire people to place their faith (and money) in the business. Click here to read how to find the right balance of EQ and IQ in a team.
Size of Market
Market sizing helps outline the scope of the opportunity. It determines not only a market base that needs the product but also the potential growth the business can witness over time. Investors also need to determine the growth of the market. Market sizes can be small to begin with but evolve to much larger number over time, thereby increasing the market opportunity for an emerging company. Inversely, what is a large market today may not be so in the coming years. Market sizes changes constantly and it is important to evaluate any and all information that can provide a clearer forecast of where things are heading. Read this post on sales can be optimized for scale from the get-go.
Product-Market Fit
There are several ways start-ups can demonstrate product market fit. Some specific metrics that can help quantify a product market fit include a high NPS, growing MRR, low churn rates, high gross margins and a strong customer lifetime value. It’s interesting to note that first-mover advantage can often be replaced by first to product-market fit, highlighting the importance of accounting for this business facet while investing in a start-up. Product-market fit can also often be achieved by the constant evolution of a product based on customer feedback, rather than focusing solely on meeting product demand.
Revenue Model
How a company makes money determines how your investment will provide considerable returns. It (arguably) indicates the be-all and end-all of your start-up. It shows how the team will get paid and how the business will turn cashflow positive and self-sustaining over time. Revenue models need to be simple to understand, providing complete transparency in who makes money how. A revenue model is also indicative of how the business is designed after considering all the stakeholders - the consumer, the industry and the strongest competitors. Flaws in the business and revenue model can be an instant red flag, hampering the ability to raise funds from VCs. Read a few best practices on start-up pricing here.
Differentiation
Differentiated innovation is what the world wants to invest in today. Breaking down the type of innovation in a business is crucial. A start-up can be differentiated on multiple levels – price, product, target customers, and even technology. Investing in a highly differentiated product can be highly rewarding but has inherent risks. Segregating opportunities based on the type of differentiation will help level the playing field while determining which business is a fit for your money.
Competitors
It’s always helpful to get a sense of competitors while investing in a company. Investing into a crowded space may make sense if the business is truly disruptive but investing in yet another me-too may not be the best way to utilize your money. Fintech for example is a very crowded space, but the industry is still evolving, continuously revamping how it is perceived and received across the world. Alternatively, in a world dominated by Grab, Uber and Lyft, it may not be wise to invest in another ride-hailing service. However, this is entirely subjective as alternate perspectives can and do exist. There are investors who are vary of highly competitive spaces while some like to bet big on disrupting an already disrupted market.
Key Clients
While this specific criterion might be relevant for companies that are slightly further along, it is still a crucial one. A demonstrated ability to execute and sustain an idea is worth a thousand words to investors. Having a great idea is one thing but the ability to show it in action and how it would work in the real world is priceless. In my previous roles, our main criteria in selecting start-ups included evaluating the big-name clients on the roster. It provided a significant sense of reassurance that this idea and product is feasible, and there is potential upside. Need to know how to perfect the enterprise sale? Look no further.
Risks
The concept of investing in highly innovative solutions sounds exciting but also opens an investment portfolio up to a certain amount of risk. A fair assessment of risks is necessary in order to determine a cost -benefit ratio. Risks could range from legal, technological, human capital and other potential liabilities. In addition to a comprehensive risk assessment, there should also be a risk mitigation plan that addresses any and all barriers to the business.
Capital Requirements
Understanding the business’ capital requirements will also help in evaluating the feasibility and longevity of any venture. Allocation of funds to specific functions such as marketing, product development, sales management or geographical expansion can help indicate what the main sources of growth will be in the future. Incorrect allocation of funds, such as high founder salaries (although this is subjective) can sometime prove to be a hindrance in streamlined operations. As a start-up, founders are often torn between raising funds or bootstrapping a venture. Click here to see how they choose between the two.
Investment Philosophy
Lastly, but most importantly, all investors need to chalk out their investment vision, structure and philosophy. Classifying areas of interest are a great first step. With multiple investment opportunities available today, its very easy to get swept away by the waves of information being thrown at you. Selecting key focus areas will help identify and evaluate companies using the same metrics, enabling better informed investment decisions.
Good to read:
Fast Company: Pitching VCs as a 22 year old founder