Startup investments are some of the most rewarding that you can make – in more ways than one.
On the one hand, they're rewarding in a non-financial sense, because you’re not following the herd and buying shares in a large established business. Rather, you’re following your own judgement to get in early with something you believe has the potential to grow.
And, this also means that there’s the potential for greater financial reward. If the startup is a success, its growth will be much greater in potential terms than that of an older business. If you’re an early investor, you will own a greater proportion of the equity than you could hope to with a bigger company. Remember, all big companies began as startups.
Of course, the risks are greater, but that’s the price you pay for the possibility of greater rewards.
The problem is, how do you choose the right startup? There’s no shortage. In 2017 in the UK, there were 382,000 new businesses and 414,000 the year before. It’s not like investing in an established company quoted on the Stock Market, there’s no trading history to examine or press articles to consult. You will largely have to make your own appraisal.
One way to do this, is to look at the Ms test. George Deeb, a growth expert at and author of 101 Startup Lessons--An Entrepreneur's Handbook, writing in Forbes magazine, lays down 4Ms to examine: Management; Market; Model; and Momentum. We have identified a fifth M, which should also be included – Money.
Let’s run through them.
The best business idea will amount to nothing without a management team that can turn it into a reality. Many startups are university spin-outs, an attempt to commercialise ground breaking research and in the early days these fledgling businesses often had management teams made up largely of academics. The results were often disappointing when the lack of business experience told. Now, investors are likely to insist that a board includes people who have a track record of running businesses at a senior level.
A startup needs management with specialist expertise but also commercial experience. Other skills required will depend on the nature of the business, it could be in production, sales and marketing or in finance. If there’s a gap, there needs to be plans to fill it.
Even if the necessary skills are there, are these people likely to get on or is there a chance of dangerous personality clashes that could cripple the business?
Finally, there also has to be some reassurance that the management team have made their own financial commitment to the business. If they haven’t risked their money, why should you risk yours?
For any business to succeed it has to have a market. It also has to be able to sell profitably into that market. A startup could, for example, aim to set up a chain of coffee shops. There’s certainly a market. Turnover of the UK coffee shop sector grew by more than 7% to £9.6bn in 2017. But, it’s also a crowded market with the top three coffee chains accounting for 53% of it. It would be difficult for a newcomer to make an impression.
If, on the other hand, a startup has a new technology to bring to market, there may not be competition, but will there be demand? This is hard to judge and business history is littered with examples of people calling it wrong. In 2008 the chief executive of video-rental chain Blockbuster was recorded as saying: "Neither RedBox nor Netflix are even on the radar screen in terms of competition. It's more Wal-Mart and Apple." Blockbuster filed for bankruptcy in 2010 and last summer Netflix was valued at US$152,7bn, just above Disney.
Gauging market opportunity calls for a lot of research into the size of the market the startup is aiming at, the strength of the competition and the resources needed to make an impact. The people behind a startup should present a business plan which includes an analysis of market opportunity. This must interrogated thoroughly and any figures it contains should be audited.
Less scientific, but always useful, is to ask friends and relatives – would they buy such a product or service?
An article in the Harvard Business Review cites Michael Lewis’s book The New New Thing, in which he refers to the phrase business model as “a term of art.” Like art, it’s something many people feel they can recognize when they see it but can’t quite define.
There may not be an agreed definition, but the model should basically state what a company is going to do and how it’s going to make a go of it: how it will generate income and turn that into a profit?
This will ideally be backed up with an identification of sources of revenue, the customer base, its products or services and details of its funding.
At the very least, as investor will want details on:
- Financial projections for the business, usually over five years;
- A clear picture of how investment will be deployed in the business;
- The route to market acceptance and resources needed to fund it;
- The sales channel strategy;
- The timeline to breaking even and then to scaling up before an eventual exit;
- How any intellectual property will be protected.
Momentum is also something that cannot be defined but can generally be recognised. Ideally, it is something that startups should have. It comes in the form of a growing interest in their product or service, even before launch. This can be generated by activities such as customer trials, conference talks, workshops and online marketing drives.
The investor should be alert to any growing media interest in the business, along with any relevant social media indices. There should also be a sense of purpose and enthusiasm, not only among the management, but all the way through the organisation.
Finally, is there enough funding allocated for a sales and marketing drive after launch to maintain momentum?
No startup is going to get anywhere without money and, as an investor, they want it from you.
Before you invest, you have to be satisfied that the business model, market analysis and management team are all likely to work together to make this a sound investment and that there’s the necessary momentum.
It’s also important to question whether the new business is asking for enough funding. Many startups fail because they are under-capitalised.
Also, any investor must ask themselves: even if the business has a good chance of success and of making a profit, is the projected return going to compensate you adequately for the risk of investment and is it going to exceed the returns available if you invested your money elsewhere?
Making an investment
Startups make for exciting and rewarding investment opportunities and, thanks to the rise of online crowdfunding and co-investment platforms, those opportunities are more widely available than ever.
Investing in startups is now easier than it ever has been, but don’t let that lead you into thinking that each startup investment does not need close examination before you commit. These five Ms will help you to do that.