Ideas dominate contemporary society. They feed our curiosity, govern our decisions, and fuel our increasingly knowledge-based economy. The startup world houses an industry of ideas, providing mankind with cutting-edge solutions to everyday problems. However, not all ideas evolve past their formative stages. Some succeed and some ultimately fail. To investors, startups offer huge opportunities for high returns but also go with a big risk. Each successful startup is its own “Cinderella story”: a tiny, homegrown startup undergoes an evolution into a publicly-traded booming company, overcoming the great pitfalls and obstacles of the business world. Any seasoned startup investor might offer a word of caution: not all startups will end successfully.
Actually, 90% of startups will fail to grow. Success stories like Sequoia capital’s 12,000% return from their investment in WhatsApp (acquired by Facebook) should excite investors about the opportunity of getting in at the ground floor of the next big thing. However, it should also serve as a reminder that startup investing is an extremely risky asset class. The transformation to make it to a “happily ever after” story, takes a lot of effort, capital, and risk. This is where investors, also known as “business angels”, come to action. In the age of a knowledge-based economy, angel investors have increased in both involvement and number. Both experts and research suggest that thousands of new ventures annually receive billions of dollars from angel investors. Due to the rise of new platforms and the availability of information online, individuals can now add this new asset class to their investments portfolio.
This article aims to give you, the non-professional investor who is looking to enter the startup arena, some practical tips. It is tempting to allow the imagination to wander towards the superstar success stories (also known as “unicorns”), but the risk remains a very important factor in startup investing, so you must be willing to lose some in order to win in the long term.
How to select the best startup? Evaluating startups strengths and
1. Evaluate the founders- aligning purpose, people, process, and problem-solving
Lots of investors are asking me; how should we evaluate if a startup is worth investing in? I and other experts usually answer: “start with the definition of what a startup is”.
Eric Ries, the author of the famous book “The lean startup” defines it as: “ a human institution, designed to create a new product or service, under extreme conditions of uncertainty”
The word “human” is super important. My lean “sensei” used to say to me: “great people make great products” not vice versa.
The first step is to evaluate whether the founders are capable of managing people. Not just managing technology. My colleagues and I came across many founders who neglected people as the most important resource of their startups, which led to people dropping out leading to many business problems, and even to bankruptcy. After working for many years with startups, I found a definition of a new syndrome: I call it the “Founder’s syndrome”. Founders who think they know better than anyone, their people, their investors. Anyone.
Don’t invest in founders who are not willing to learn and listen to others. Their people, the “value creators”, know the best about the customers/users’ problems. The word “institution” is super important as well. It implies that also seed-level startups have or should have processes. Eric Ries also said, “Entrepreneurship is management”. It is. Entrepreneurship is not an excuse for chaos. A founder should effectively connect the startup’s business strategy (purpose), sales, product development, and operations by implementing and managing processes. If a founder is not capable of managing processes, there is no chance for his startup to grow (and you will never get your money back!).
Last but not least, is the word “uncertainty”. Startups are like a war. A “war is the realm of uncertainty” (Clausewitz). Covid 19 and many other crises in the past only prove that this uncertainty can even get worse. Investing in a startup holds a great amount of uncertainty as well. Therefore, you should evaluate if the founder is capable of leading his team to effective problem solving, by experimenting.
Lots of startups fail due to founders rushing to find solutions, burning all the investments within a short time. The worst-case scenario for a startup is not to develop a poor-quality product. It is to develop a product that nobody needs or wants (and is willing to pay for). Make sure your founder understands what is scientific thinking, what is the startup learning and development cycle (build,
measure, learn) which is the base to develop an MVP (minimum valuable product). Learning and experimentation is the base for getting your ROI.
To summarize this part and in order to make it particle for you as an investor:
1. If you don’t have the managerial experience yourself, consult experts in management and leadership.
2. Schedule a meeting with the founders (with or without the expert) in order to evaluate the mindset described above.
3. Ask them the following questions:
- What do you consider to be the most important resource of your startup? If the answer is not “the team”, ask the founder what he thinks about the team.
- How did you choose your team? Experts say that the best answer is “by their problem solving, customer-centric, and improvement mindset” not just their professional experience.
- If a team member tells you that you are wrong or gives you bad feedback. How do you react? Usually people with the “founder syndrome” will not be able to lie. If they can’t listen to their team, the chance that he/she will listen to you is low.
- How do you effectively make sure that your team is doing the relevant things connected to your business strategy? Did you define KPI/OKRs for the team? How do you monitor their progress? If the answer is “I fully control my team”, don’t invest in the startup (we don’t control our people. We coach them and lead them).
- Try to see if the founder has a basic understanding of why it is important to develop management practices and processes. This can be taught by you or an expert, right after you invest.
- Making product people want- I will address this in the business model part. However, ask the founder what is his methodology to learn about the customer’s needs, how does he plan to integrate it into his product development, and most importantly, what is the minimum valuable product he is trying to achieve. Since this point is also a professional point, I recommend you to ask an expert.
4. If you think they don’t meet minimum leadership and management expectations, don’t waste your time and money with them.
2. Evaluate the founders- aligning purpose, people, process, and problem-solving
If you want to make sure your startup will be successful and get your ROI, you need to make sure it has a robust, smart, and flexible business model. (insist on getting a lean canvas before investing). Good business model contains:
- Problem to solve: is the startup actually solving a real problem in the real world? Meet with the founder and ask him the following questions: a. Can you describe the problem you are solving as the gap between the current reality and the desired reality? Why is it a problem and whose problem is it? b. How did the founders learn about the problem? c. Did they observe the reality? d. Did they interview the potential customers? And how many? e. What are the main pain points the customers are facing? f. Who are the competitors that try to solve this problem? And how do they solve it? Here I could not put enough emphasis on the founders and team ability and willingness to really understand the customers. Great (late) Steve Jobs said: “you got to start with the customer’s experience then go back to technology”. Lots of startups fail to learn and understand the customer’s needs. I highly recommend you to send your startups to go and learn in the most creative way about how the customers experience the problems in real life. If the founder is not eager to learn about the customers and serve their needs, you should not invest in him/her
- What is the customer segment: it’s not smart to develop a product for the whole world. Make sure your startup identifies the specific group of customers that will benefit the most from its product, as well the “early adopters group”, those who will be the first to embrace it and buy it.
- Unique value proposition: When meeting with the founders ask them the following questions: a. Why and in what way are you different from others on the market? b. What value proposition differentiates you from your competitors and vice versa. What do you /don’t you provide? c. Show me your market research. In simple words, if your startup does not provide a unique and different value proposition to the customer (and its product is not worth buying), his days are numbered. So is your ROI.
- Solution: the solution does not have to be a “deep tech” solution in order to be successful. Think of startups from a wider perspective. Even a new flower business, who provides a unique value proposition, can be successful (I saw it happen). Look for innovation and creativity, not for genius solutions.
- Channels: a big part of your investments will be put into marketing channels and user acquisition. Make sure your startup spends time thinking about the best and scalable way to reach the heart (and pocket) of its customers. Meet with the startup and ask them the following questions: a. What are the free and paid channels they are planning to use? b. What is their plan for organic and not organic users acquisition? c. Do they plan to use influencers? Social media? Partnerships?
- Revenue streams: pricing is the key. Lots of founders are afraid to put the price attached to their product from day one. Lots of them are giving the customers to use it for free, just to get customers. Make sure your startups believe in the product and don’t avoid this hard business decision. However, the most important is the variety of the revenue streams. If your startup will lean on one revenue stream, it will create business instability (especially in times of crisis). Encourage your startup to find as many revenue streams as possible. Make them think hard and creatively. It will increase the chances for ROI. Meet with the strap and find as many possible revenue streams: a. User subscriptions b. Partners subscription c. Commissions d. Cross-sell e. Others
- Cost structure: Many startups underestimate or even neglect the cost structure and costs calculations. As your investments go straight to covering the startup’s costs, you should insist the founders present you with 6-12 month costs estimates. Since it’s hard to foresee the costs, focus on how much it will cost to develop the MVP, cost of users acquisition, the burn rate, fixed and variable costs and try to estimate the breakeven point. It’s super important for the startup to have detailed financial projections, combining all the revenue streams Vs. Costs.
- Key metrics: measuring progress and success is a key point for growth. Try to help your startup defining its OKRs (objective and key results from the beginning), and insist that they will define the primary, most important KPIs (Dave McClure Metrics) ● Users acquisition: how do they find users? How the users will find you. ● Activation: Do users have a good first experience with your product. ● Retention: do users come back? ● Revenue: How do you make money? ● Referral: Do users tell others?
- Unfair advantage: What makes the startup hard to copy, therefore worth investing: professional authority in a specific field? Dream team? Large early adopters group? huge network? Etc..
To summarize, there are various techniques and methodologies to help investors “play the odds”. These techniques and methodologies were not discussed here at length, The practical framework for startup assessment was aiming to allow you to better navigate the uncertain seas of startup investing. environment and its terrain, where to find growth, and where to steer clear. And most important- if a startup is worth investing in.
I hope I have provided you- no matter your background- with the tools to invest in ideas, the future, and the bottom line: the next “Cinderella story”. Good luck!