Investing in a startup can yield significant returns, but it ‘s far from a risk-free, guaranteed investment. If a startup fails, you could walk away with nothing. So before diving into equity crowdfunding head-first, let’s cover some important aspects to look at—and questions to ask—when evaluating a startup you’re thinking about investing in.
First of all, what is a startup? A startup is a hypothetical company created to grow very quickly—as opposed to a small business where the aim or business idea usually isn’t to build a very fast-growing company.
But regardless of the type of venture, raising funds is an intensive process that involves extensive research, networking, and patience. And this is true whether a startup is seeking VC, going the traditional bank route, or pursuing an equity crowdfunding campaign.
VCs are picky and reject 99.95% of entrepreneurs at startup, and there’s a lot we can learn from their methods of separating the wheat from the chaff. In this post, we’ll discuss investment criteria to look at, and important questions to ask, when evaluating a startup for investment.
Problem
The bigger the problem, the better. From an investor’s standpoint, a good problem is experienced by a lot of people, and is growing fast. A good problem needs to be fixed ASAP, and lots of people are motivated to fix it.
For example, Uber’s problem was pretty much “trying to get a cab is a real pain in the ***, there should be an app for that.”
Solution
Look at the startup’s solution, how it works, and how it’s unique—and 10x better than others. There should be a clearly defined concept, a plan in place for how to demonstrate it, as well as a unique product or service, and a plan for developing it.
Traction
Traction is basically a quantification of a startup’s progress. It usually refers to revenue, but can also refer to the number of active users, downloads, etc. This is especially true when startups are in the early stages and don’t have revenue to show yet, and in this case, investors often focus on the startup’s rate of growth.
Team
As we mentioned in our last article, some VCs will buy into a particularly strong team even if they’re not completely sold on the venture. Previous experience building a startup or a large business, or selling a company for a profit, are potential signs of a good investment opportunity. Further, a team’s proven experience in the startup’s particular industry shows they understand its challenges and are well-equipped to solve a big problem within it.
Some investors also look for teams where founders have worked together before and know each other. This can signal their confidence in each other’s skills and capabilities.
Competition
It’s important to look at current and future solutions that may compete in the given market. Ideally, a startup’s solution is readily doable with an infrastructure already in place, and has intellectual property or other big barriers to entry for others trying to join in on this opportunity. If no such barriers are in place, the startup should be able to demonstrate how they plan to stay ahead of competitors.
Questions to Ask
What’s the Timeframe?
Most startups take years to realize a profit, so you have to be ready to play the long game if you’re thinking about investing in one. Decide if you’re comfortable waiting five years, or ten years, before getting any money back.
You can guesstimate how long it’ll take a startup to make a profit by looking at how much money they spend each month. This is called the burn rate, and if it’s high in the early stages, this could be a sign that you’ll have to wait for your payout.
What Rate of Return Can I Expect?
You’re probably intrigued by the startup’s mission and would like to see it succeed, but you also want to make money from your investment. The most common way to analyze a startup’s potential ROI is to divide net profit by total assets. Keep in mind, though, that because equity crowdfunding is such a new investment strategy, it’s harder to estimate realistic average ROIs for startup investments..
Will This Investment Help Diversify My Portfolio?
The number one goal for any investment portfolio is to minimize risk and maximize profit. Consider how a startup, which should be looked at as a hit-or-miss investment, will affect your overall mix or assets and risk level.
It’s not as clear-cut as with stocks that have clear class divisions which makes it easy to minimize risk by spreading it out. You can increase your odds of returns by investing in more startups, but you also run the risk of spreading your money too thin only to realize none of your chosen startups was a winner.
There are many forces at play at determining the success of a startup, including the supply and demand of money, recent exits, investors’ willingness to pay a premium, and entrepreneurs’ desperation for funds. That said, investing in startups is a great way to support worthwhile causes while expanding a portfolio.
Taking the time to carefully research your investments is vital, and keep in mind that evaluating a startup isn’t an exact science, so have your brain do your due diligence and let your heart have a say, too.
