The idea of investing in startups or being part of venture capital sounds much more exciting and successful than often is. For every standout success like Amazon, PayPal, Facebook or Google, there are thousands and thousands of failures. The vast majority of early stage companies fail and only 20% are even profitable. And if a business is merely profitable it does not mean you will receive a positive return on your investment. Most early stage investments are in the form of equity. You are buying a part of the company, it is not loan. If the business fails, you lose your investment. Before you risk any of your portfolio investing in startups consider these six factors.
First, you must understand the underlying business and be able to add value to help it become more successful. Businesses have growing pains and it is preferable if your partners have the requisite skills needed to navigate these challenges. If you are building a house you want to have a designer, a carpenter, an electrician, and a plumber instead of four plumbers. Partners with the same set of skills may not provide the range of experience needed to scale the business, revise the product, or improve sales. Also you need to know when to expand your team. The partners may fill most of the necessary roles in the business but you want to make sure any gaps are filled with competent staff with the technical skills needed to resolve problems that emerge and drive future growth. This team also needs a passion for the business to sustain it through the inevitable tough times. If there are too many silent partners or distracted partners it will soon begin to wither and die.
Second, the startup needs a clear plan to grow based on a revenue. Many companies fail because they spend their startup capital too quickly before revenue justifies such expenses. There are certain costs that need to be paid to grow to the next level, but all too often an injection of capital leads to overspending. This can be from over hiring staff or increasing overhead expenses too quickly. Having access to cash allows a business to be nimble as does having a lean staff. A rapid expansion funded by startup capital instead of revenue can quickly derail appropriate levels of spending.
Third, the business must be targeting a market that, if successful, will lead to very high returns. Investors frequently talk about trying to find a business that can lead to a return of 10 times the original investment. It is harder to grow a business to earn a 10x return if it is focused on a small niche market or is in a sector with modest profit margins. A company might end up being successful, but the return on investment is so modest it was not the best use of your time or your capital.
Fourth, the company should have some type of moat that differentiates the business and provides it some form of protection to make it unique. This could through a novel product, technology, or service. This helps to prevent the business from being replicated by a wealthier competitor. Also if the business owns any intellectual property like patents you want to clarify what it protects and who owns the intellectual property before investing. You do not want to invest in a business only to find out that the underlying intellectual property is owned by a separate company or solely by one of the partners.
Fifth, the startup team must show a track record of being responsible with the capital received to date. There will be certain mistakes along the way, where the business invests money that does not yield the desired result, but strong financial oversight and paying attention to costs is required. The team also must know the underlying numbers of their business, such per unit costs, the acquisition cost for new customers and profit margins, and a clear plan for how they will grow profits. As an investor you want to know how the business will use the money you invest, it must be towards growing the business, not covering previous debts or personal expenses or as a cash out for the founders. The total amount of money raised also needs to be enough to provide the financial runway to allow the business to grow to the next level to be in a much stronger financial position. If there is not enough funding and the runway is too short, the potential for failure is higher. You may not be able to count on another opportunity to raise additional funds if broader market conditions deteriorate.
Six, there must be clear exit strategies for the business, so you can see a return of your original investment. This could be through selling the business, taking it public on a stock exchange, or growing it to the point where it will pay significant dividends or distribute profits. Also be cautious of the business only has one exit strategy such as going public or selling to one major competitor. Businesses go through cycles and will hit some rough patches so there needs to be multiple avenues to survive for a future exit. As an example, if you are flipping a house and the real estate market sours, your property also needs to work as rental until sales improve and then you can sell to exit. You need to run the numbers on the property as both a flip and a rental, before you buy it. You do not want to find out it is not a viable rental after the real estate market has declined.