What to look for when investing in a startup

What to look for when investing in a startup

Small businesses are the flesh and blood of the economy. They provide the bulk of job creation and contribute to around 46% in economic growth. Startups share the same characteristics and bring extraordinary growth prospects to the table. Startups have proven to be a tremendous investment as shown by the recent successes of Snapchat , Facebook and the like which went from a dorm room idea to a publicly listed multi-billion dollar company.

While Facebook is a prime example of such success, having attracted the attention of multiple investors among them Microsoft , it remains a risky investment. Taking a dip into startup investing should be done careful and after thorough research and consideration. Here are elements one should take into account before making a decision and committing to an investment.

Management

Behind each business is a team of founders and employees striving to put their company on track. Who these people are is one of the most important aspects of the deal. They are at the helm and can make or break the company through their decisions.

Venture capitalists prefer startups with two to three founders because they complement each other and share the burden of building products and attracting customers. A solo entrepreneur might fail under the heavy load and lose confidence. But more than three makes decision making harder.

The age and experience of the founders also plays a big role. Statistics show that older and more experienced founders succeed more often than their younger counterparts. The social and professional skills one learns throughout his or her life make a significant advantage in coping with stress, taking the proper initiatives and making the right decisions.

Other elements to consider include the previous experience of founders and employees in the startup’s sector as well as their level of qualification. If the staff is familiar with the ins and outs of the industry, they will avoid many traps and be able to take shortcuts.

Startup Stage

What is the level of maturity of the company? Is it just an idea or does it already service customers and produce revenue? Answers to those questions are crucial. They will determine how far you are from success and how big is your potential risk. If the startup already has a few customers it means it has a good product. It is also already generating some revenue, which can be used as a base to grow.

Startups in the idea stage are a riskier investment , as they might have not figured out yet the basics of putting a company in place. Hiring the right people is a tricky endeavor as is finding the first customers. Getting the wheel spinning is a big hurdle in its own right and should not be ignored.

If the company already has investors it might already be accustomed to dealing with them by providing frequent financial feedback regarding the state of the business. It might be already meeting with them on a regular basis to discuss the difficulties and the solutions. All this should make it easier for you to get onboard and make sure your investment is safe.

As with multiple founders, multiple investors can help each other to make sure the startup is on the right track. They can share the workload and provide more to the company such as coaching, counseling, etc.

Overall Economic Conditions

Is the economy growing? Or are we on the brink of a crisis? Before jumping in, an investor has to know the state of the economy and where it is heading. A healthy economy makes everything smoother. Hurdles are smaller, customers are more willing to expand and invest or at least capable of paying their suppliers.

The 2008 financial crisis shook the world and sent many countries into recession. People lost their jobs, companies went bankrupt and investors lost their money. Big corporations reined in expenses and investments for many years after the crisis. Such depressed economic conditions might make the growth of a startup harder if not impossible.

So when is it the right time to invest? Is it better to keep your money in check? Following the news and economic data releases can give an idea as to where the economy is headed. The Federal Reserve publishes regular statements detailing the view of its members over how they see the economy.

Sector Economics

Is the industry doing fine? Or is it on the edge of a cliff? As with the economy as a whole the state of the market the startup is targeting is important too. Industries rise and fall sometimes independently of the overall economy. In 2000 the dotcom bubble burst and sent the whole tech industry into the ground. Companies worth billions shrank overnight seeing their stock price fall and promising sprouts were left in the dust.

Is the industry new? If it is, uncertainties might materialize as to how it might grow and establish itself as a stable market. A new industry is as much an opportunity as a risk. A startup operating in a new industry can become a future leader instead of fighting with existing businesses.

A startup’s valuation can potentially multiply depending on the sector it operates in. In certain sectors cash-rich companies constantly acquire valuable startups. The technology and biotech sectors and more recently Fintech and automobile are good examples of this phenomenon. In other industries capital and acquisition opportunities are slower to come by. These sectors are viewed as dull and less prone to change and wealth creation.

Law and Regulation

Different industries have different legal requirements. Knowing the legal and regulatory framework is a must. Highly regulated industries like finance, banking, gambling and pharmaceuticals bring additional challenges to starting and growing a company.

A strict legal framework can prove to be a tremendous hurdle for a team of young and inexperienced entrepreneurs. Even big companies with large legal departments sometimes struggle to comply with existing or new rules. Complex regulation adds to operating costs and delays product arrival on the market.

Competitive Advantage and Existing Competition

Does the company have a competitive advantage or does it offer copycat products? Sudden successes often open the doors to wannabe billionaires who think they can strike it big just by starting a company. A competitive advantage can be a revolutionary product, a quick and proactive team or a superb customer service. Having an edge is what will help the startup snap market share.

There are industries that are completely disrupted by technological change. New scientific breakthroughs can completely wipe out companies that have been doing it the old fashioned way, opening the way for startups which have adopted the technology. Companies with a competitive advantage are faster, more efficient or cheaper. Startups already have an advantage in being more nimble and more willing to adapt and change since they are not dragging any dead weight or legacy workflow.

Old monopolies are hard to break. Behemoths often have their own strongholds that they are prepared to defend to the death. Additionally, due to their size they usually do have the means to fight back. If a few major corporations dominate the market it might take more than a little enthusiasm and effort to break in.

Certain industries require huge amounts of capital and suffer from slim profit margins. Breaking in or even staying afloat requires big production volumes to achieve economies of scale. In this kind of industries companies tend to flock together and merge. This is particularly the case for manufacturing and shipping.

What do you bring to the Table?

An investor primarily brings in capital to pay employees, buy equipment, etc. The amount of capital must be adequate for the company’s needs. If all the capital collected is below that threshold, your stake is at risk. The startup will not be able to truly develop and will simply burn the cash to cover its expenses for a short amount of time.

Apart from the capital, investors often provide moral and commercial support. Investors often mentor entrepreneurs. They provide counsel to young managers who generally lack real world professional experience. They provide networking opportunities and commercial leads which result in contracts and repeat business.

Current acquaintances or business partners can become customers of the startup you are targeting. Actively getting involved in the startup development will ensure that your investment flourishes and grows. Getting clients that pay well and offer recurrent business is one of the most important factors influencing the survival chance of the company.

What’s Next? Where is the Exit?

Once you are sure that startup is a worthy investment you have to assess your way out. Also referred as the exit strategy in investment banking, the next step is to get out after a while and go back to step one. What is the company really worth if you value it at half a billion but no one is willing to buy it from you?

If there are no other investors to take the company to the next level after you have done your part you could be stuck with a company on your hand. The location of the company can play a big role. In some places like New York and San Francisco, venture funds are scanning the horizon for opportunities to invest in.

Another exit strategy is to target an Initial Public Offering (IPO) to list the company on a stock exchange. Once publicly listed, the company’s share can be bought and sold more easily. However listing on an exchange requires that the company reaches a certain size and attains certain requirements.

The market abounds with opportunities for people who know where to look. However risk must be kept in check. No opportunity is perfect and there might always be some caveats. But the better you know them, the better you can deal with them and find solutions. Keep in mind that risk and reward come hand in hand and should be view in tandem when making decisions.