Key points to consider when investing in tech startups
Tech startups arouse passions through innovative business models, disruptive products that can change industries, rapid growth and value creation, but also through resounding failures. These don’t usually make the media, except when they are startups that before going bankrupt have obtained obscene investment amounts from prestigious Venture Capital funds.
Hundreds of thousands of startups die every year in the pursuit of this particular kind of “magic” that defines making-it without their demise making the press for investors. And of course, every investor wants to multiply their investment… we would all like to have invested in the beginnings of today’s famous startups, multiplying by 100, or better by 1,000, our initial investment.
Diversification is important
Of course, we know the risks of investing in these types of companies, so the first thing to do is diversify our investment in several startups to mitigate the risks. However, this is not enough. It is important to carefully analyse each startup that makes up the portfolio before investing, and to have a capital allocation plan for the medium to long term (in case there are subsequent rounds of financing or acquisitions), in order to maximise the potential return and minimise the overall risk of the portfolio.
For the investor who is making his first direct investments in startups, I will focus on the analysis part of this specific opportunity. The analysis depends very much on the developmental stage of a company, as well as the aim of the person analysing it, so for this exercise we will choose a technology startup in its early commercial stages analysed by a private investor who wants to acquire a minority position with the objective of maximising the return on his investment. We could write books on the subject, and the possibilities are practically infinite, but we will focus on 4 major areas that cannot be missing from our analysis, and which I consider to stand-out from the analysis of a traditional or larger technology company. Let’s start.
The 4 aspects that you should analyze
1. Value proposition/market:
First of all, you should deeply understand the value created by the product offered. I am talking about going far beyond market research… I am talking about slipping into the customer’s shoes and understanding the need that the product satisfies, the existing alternatives and the trend that it responds to. And the more disruptive this product is, the more reason: will it last? Will the startup be able to improve it? Will it be able to create a portfolio of related products? Will it be able to reach many potential customers quickly and efficiently? Or at least faster and/or cheaper than the competition!
2. Business/sales metrics:
Already convinced of the usefulness of the solution, you should dig deeper into all kinds of business metrics to make sure:
the product/solution is of quality and
they have the ability to reach many customers fast.
Thus, you should review indicators of product usage by customers, purchase recurrence, public comments, error tickets… here the metrics that you study will be very specific depending on the startup/solution and the product development phase. On the other hand, you will want to know if they are able to create value with your investment. In other words, if they have 50 customers, with the funding obtained, will they be able to reach 500? More? For this we are going to focus on sales metrics, understanding the current and planned customer acquisition channels, the investment made to date and results, the margin per customer and channel, and compare it with the cost of acquiring the customer. You will look at their ability to use part of the investment in sales growth, a very good proxy for value creation for many startups.
3. Financial plan/Exit:
At this point you are going to look to the future through the startup’s business plan. However, always from the investor’s point of view. The first thing is to know that this plan will not happen as planned. We are talking about a disruptive/innovative technology startup of relatively recent creation. It will not happen. With this in mind and using the version of the plan that we consider most likely, we are going to focus on cash flow and the next planned rounds of funding. These represent death (if the necessary funding is not covered, the startup disappears along with your investment) and dilution risks, but also liquidity windows to sell our stakes at a capital gain. So, make sure that the plan envisages creating significant value from our investment for each next round, ideally by having an idea of the expected valuation at each point in time. It is also important to know whether the startup intends to develop in an acquisition-friendly market and to find out about the latest deals in the sector.
4. Team:
The most important thing is always the team, but at the same time the most difficult to assess… you will want to make sure that they have appropriate professional experience for the venture in question, you’ll want to understand how they complement each other, their vision/motivations, etc. In addition to these questions, which in most cases result in subjective perceptions, it is very important to make sure that the interests are aligned, with possibly more objective indicators such as the commitments and contributions made by the team or the composition of the shareholding, among others.
The true strength of the team will be revealed, however, after your investment. When the startup stagnates. When a giant competitor launches an excellent alternative to the market. When there is a lack of investors for the next round. When the business model needs to be pivoted… that’s when the team can be evaluated. That’s when great startups are born. The team IS the startup, and the much sought-after alchemy is its ability to adapt to change, led by honesty and value creation.
Media sources: Funds People (opinion editorial written by Gonzalo Tradacete Gallart, CFA, member of the Alternatives Comité of the CFA Society as part of the vision of a fund as seen from the vantage of a CFA professional) (Spanish only!)
