Startup and small business backers choose their investments carefully.
Even when the brightest prospects arise, and a rapid response is needed, they are still tested rigorously first.
A sophisticated investor will undoubtedly have their own ways of analysing opportunities, but most would agree there will always be some element of gut instinct to the decision, too.
Whilst it’s always recommended to take advice and carry out your own in-depth due diligence before making an investment, there are a number of questions that often form part of the process:
1. Does the management team have the skills to execute the idea?
In a perfect world for investors, the startup’s management personnel are the alchemists who turn their entrepreneurial idea into gold. In reality, management teams are often unable to unlock the full potential of their creation. You must assess what core skills the startup needs to succeed – and test whether it has them, or will have them, on board.
A tech firm with leading-edge software expertise, but no commercial experience, is unlikely to fly, for example. Similarly, a retailer with brilliantly marketed products, but no-one with the acumen for numbers to look after the bottom-line may also struggle.
2. Are there plans to fill gaps in the team?
Management teams may be a work in progress. At such an early stage, gaps will be apparent - and that's completely normal. But how confident can you be that the necessary gaps will be filled as and when needed?
What's more, the founders must show a willingness to welcome new members to the management team and to pass some of their duties onto others.
3. Do the founders get along?
Healthy debate between founders ensures decisions made about the business are carefully considered. Continual arguments, or a sense that they are pulling in opposite directions, however, suggest a ship heading for choppy waters.
Given that most startups will be trying to show their best side to you as the investor, look for subtle hints of disharmony behind closed doors.
4. Does the team understand its market?
Misreading the market could be disastrous for the business - and your investment. Some entrepreneurs will be looking to do something innovative in a market they have already been entrenched in during their career. Others may have little experience in the target market, but have devised a way of disrupting it. Either way, there must be a thorough understanding of the challenges ahead in gaining a foothold.
5. Is the team adaptable to change?
The entrepreneurial path rarely follows the initial business plan exactly. Unforeseen challenges and unexpected breakthroughs can lead it in different directions.
Should this be the case, will the management team be able to respond accordingly and, as they say in Silicon Valley, ‘pivot’ towards success?
6. What is their motivation?
Do you detect goals being passionately pursued that aren’t simply money orientated? Entrepreneurs chasing profits alone could suffer burnout before the exit plan plays out. Those determined to innovate, improve and disrupt markets – and have a positive impact - will be more likely to power through the tougher times.
Other misplaced reasons for launching a startup include greater freedom and work/life balance. These are the trappings of a lifestyle business rather than a scalable investment opportunity. Startup success brings more responsibility and demand on time than most nine-to-five jobs.
7. Are other members of staff on board too?
Failure to retain talent in the business is a red flag to investors. Small businesses in particular need everyone pitching in together, enthused by collective goals and a distinct company ethos. Low morale and poor retention point to problems ahead, and although not entirely uncommon, it needs to be clear that they're being rectified.
8. Do you get on with the team?
Particularly if you're looking to take an active role - as an angel investor, for instance - can you really see yourself liaising with them for the five-plus years it may take before an exit?
You don't need to have a truly groundbreaking relationship, but there does need to be a mutual respect and understanding of each other's skills and views.
9. What’s the market context?
Some of the most alluring opportunities for investors include those involving businesses that are:
- Entering a market in the throes of rapid, across-the-board growth
- Targeting a market that is absolutely ripe for disruption, in dire need of a new approach
- Creating an entirely new market, backed by customer demand for something different
An opportunity that doesn't fall into one of the above areas doesn't necessarily make it unappealing, but it can be a big tick in the box if it does.
10. Is the lifetime value of customers significantly greater than the cost of acquiring them?
Simply put, if the lifetime value of customers - however long it may be - is not truly profitable (or will not be), the prospect of healthy returns is seriously under question.
11. How big is the potential market?
Do your own homework as well as listening to the company’s own assessment. There are many market sizing methods, but three general areas of focus are:
- The Total Addressable Market (TAM), which is the entire possible market for a product or service if nothing held back customer acquisition
- The Serviceable Available Market (SAM), which looks at the specific demographics being targeted with the TAM
- The share of the market (SOM) outlined above, which the business can realistically expect to enjoy
Whilst all are important to understand, the latter is arguably the most important measure for the investor.
12. Are there any holes in the company’s market expectations?
Has the startup thoroughly investigated every aspect of its prospective market? Some considerations include how sustainable its marketing approach is and any potential changes in the market in future.
Furthermore, are assumptions about customer purchasing decisions realistic and well-founded?
13. What are the financial projections?
Investors often look for a five-year picture, showing the conservative, expected and aggressive outlook of the business.
Most importantly here is looking at the break-even point. If not already, when will the startup begin being profitable?
14. What returns can I expect?
Established businesses will be able to provide trading history and other evidence to back up their projections for your investment.
However, a pre-start firm’s growth forecast is based on theoretical figures, which you must question in detail, drawing on your own experiences to assess how realistic they are.
15. How did the business come up with its valuation?
There are many systems for calculating valuations, including the Venture Capital Method and the First Chicago Method. Whichever has been used, you should also run its figures through your own go-to method.
Overpaying for an investment will have major ramifications down the line, so you must be absolutely confident that a fair valuation has been reached before you invest.
16. Is there a genuine need for this new product or service I’m investing in?
If not, the company’s ability to gain its desired market share is under question.
Ideally, small to medium enterprises (SMEs) should be able to demonstrate a strong track record in getting other products to market, and a startup must have robustly analysed the market opportunity and customer dynamics to build up a compelling case for the new offering.
17. Is the business scalable?
Scalability separates investable startup opportunities from lifestyle businesses which are unlikely to deliver the level of returns many investors expect.
Ask yourself: does the business model enable the company to multiply revenues without significantly increasing costs?
18. What will my capital be used for?
To be investment worthy, the business should have clear plans for your capital that will ensure it delivers maximum impact on the organisation’s development.
It might be marketing, HR or anything in between, but the company should know exactly where each pound raised in investment will be allocated.
19. What other capital requirements does the business have?
Taking on further capital could dilute your share and influence on the business.
Will government grants or business loans be sought to speed up progress? The company should have a clear vision of the capital it needs to fund its journey beyond every key milestone on the route to scaling up, with room for manoeuvre should unexpected problems - or opportunities - emerge.
20. Is everything in place to make the business model function smoothly?
The business may provide you with a summary of the model and plan in the form of a tool such as the popular Business Model Canvas. This offers a one-page view of the company’s strategy and is a useful reference point for your analysis of the investment opportunity.
21. Is the company’s distinctive offering defendable?
Where possible, the business should have taken steps to protect its product or service from being copied by competitors. Any intellectual property should have been adequately protected (or be in the process of happening).
22. How healthy is cash flow in the business?
Are there assurances that your investment is not merely to plug a gap in the management of day-to-day costs?
23. When will liquidity occur?
Particularly for early-stage companies, exits can often take years longer than anticipated. Investors must evaluate whether the stated liquidity plan is realistic and viable, and suitable for their own portfolio requirements.
24. How well has the product or service been received so far?
Focus groups findings, beta tests and social media chatter are all good gauges of customer demand for a startup’s new offering. More established firms may have live commercial data to share, and ultimately you want to be able to build as big of a picture as you possibly can, using multiple sources.
25. What else can I offer as well as my capital?
Many business investors want to play an active role in helping their interests develop and grow. If you are one of them, consider how open the management team would be to your advice and intervention.
26. Everything looks good – so why am I still not opening my cheque book?
Sometimes, even with every box ticked, there are niggling internal doubts. If left unchecked, they may get louder, especially when the inevitable tough times arise for the startup.
Although not necessarily able to be tackled by new investors, sophisticated investors are usually well tuned into the precursors of business success and failure. Their instincts have served them well in the past and will usually come into play as they consider investment.
As an investor, if there is some hidden force stopping you from backing a business, try tracing it back to its source. What exactly is fuelling your resistance to invest? Can the management team allay these fears or doubts?
Getting started with investing in businesses
Although investing in businesses can bring with it a level of risk greater than many other asset classes, the potential returns can be considerable. Undoubtedly appealing, the ability to invest in businesses - particularly startups - has increased considerably in recent years and now almost anyone can get involved in the opportunities.
But this doesn’t remove the fact you need to complete your own due diligence and ensure the opportunities are right for you in every sense. Take advice, do your research and ensure the business you’re looking at is the right one for your portfolio before you start your journey investing in businesses.