Startup investment guide: What are the steps to assess whether a venture is suitable for investment – Times of India

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Murali Loganathan, Director Research, PrivateCircle.
When it comes to startup investing, there’s a lot of uncertainty about whether it’s worth taking the plunge, and if you’ll be able to clock significant returns. Especially when investors do not have the luxury of past performance indicators and metrics to evaluate sub-sectors that are not even developed. In this blog post, we’ll outline few simple steps you need to consider evaluating whether a startup is a good investment choice for you and how to go about the process.
When it comes to investing in startups, it can be difficult to know where to start. Investors usually lookout for entrepreneurs who have a clear vision, a well-thought-out business plan, the tech/solution approach, and the ability to execute on ideas. Before considering how we can evaluate founders or startups, let us first understand why startups investments may or may not be suitable for all investors.
Why You Might Not Want to Invest in Startups?
There are three main reasons to avoid investing in startups.
First, understand that startup investing is similar to public markets, where you own a piece of a business in return for higher future value. You may be familiar with some industries like FMCG/IT Services/Banks etc., but startups can be category creating, making it difficult to find precedence, past performance comparison and lack of standard industry level operational metrics to evaluate. Second, there are many formative factors that remain in a flux or even undecided when you are making a decision to invest. There is a not a comfort zone that startup investments will offer. It may offer thrill, uncertainty in odds and a sort of a “betting high” that you may not enjoy. Third, investors are in general not privy to all the information about the startup before making an investment decision. This includes understanding the business and its potential, risks and rewards, existing incentive structures, founder idiosyncrasies and other existing investor pressures for example.
There is no easy answer when it comes to evaluating startups for investment, but with the right sources of information and research, the decision process can be made a lot easier.
Why should you invest?
There are good reasons to consider investing in startups.
1. Greater returns – Getting in at an early stage can be an advantage to the investors to achieve high returns and possibly larger ownership pie. Startups often grow rapidly increasing chances of higher return on investments. If your chosen startup does great it will provide you returns far higher than public markets. In fact, private market returns are scales higher. This lingo of 50X return is common. Suppose you had 100 rupees and invested 2 rupees each in 50 startups. If only one of them is potentially going to return you 50X, it covers the risk of your entire portfolio. Even if the other 49 startups went kaput you still have your original capital at least. In fact, these number are closer to reality than many realize. If 2 startups succeed, you are already doing 2X returns on the portfolio.
2. Portfolio diversification – Even if investors have major portion of investments in public markets or other asset classes like real estate, earmarking a portion of investments to private unlisted sector including startups is a great way to diversify and clock better returns.
3. Wider range of options – Startups are not restricted to a domain or an industry and are developing in a variety of sectors and markets. Whether it is technology, health, education, or agriculture, all kinds of founders are looking for investment.
4. Investment with an impact – Startup investments also offer a unique opportunity to be part of something that is impactful, new, untried, potentially hyper growth, innovative, cutting edge and path breaking. In India such opportunities are aplenty. The line of attack taken by startups on solving similar problems may inspire you to do more research and understand the true potential and giving you a super opportunity to ride along the progress of the startup. If you think a startup has potential, it’s important to assess its feasibility of the technology and business.
5. Several exit paths – Aside from investors, large corporations are also on the lookout for startups for strategic investments and making sure of their future competitive advantage. Instead of waiting for these competing startups to grow, major corporations can acquire / merge them with their business. These transactions also provide secondary exit options to investors instead of waiting for the startup to list in public markets.
What are the challenges investors might face?
Several challenges that investors have to grapple with post investments in startups include high risk, and long period of holding their investment. Of course, this depends on the type of investor as well, who have different risk appetites and preferences on the time to stay invested in the startup. Let us look at a couple of different categories of investors. Individual angel investors who come in at very early stages of the startup, can hold for anywhere between 4-6 years. Startups take time to find product-market fit and get a clear grasp on the nature of problems it needs to solve for sustained growth.
Whereas for institutional investors may commit larger tickets once they see growth potential at these later stages. These may include Venture capital and private equity firms, who have time frames between 6-10 years and primarily look at several exit events including MAs and IPOs.
That said investments into startups need not be through equity route alone. There are several options available in today’s market, where individual investors can look at investing into startups through the debt route for better returns than say deposits. Again, it comes with its own risks on invested capital.
How to build a list of potential startups to invest?
There are two orientations that investors can adopt to building their own potential list of startup investments.
First orientation is being part of a network that is already actively investing into startups in the areas that the investor is interested in. These are actually available through syndicate platforms and from their own personal network of people who regularly evaluate and invest in startups. This can also happen through wealth managers who are actively looking to support angels and high networth individuals to enter and exit startups. Several private and public banks have such wealth management teams actively working for such support.
The second orientation that investors can choose is by being completely independent in their pursuit and relying on intelligence about sectors, companies and trends that are working in favor for specific startups. This orientation obviously needs comprehensive research and intelligence made available to investors. Again, these are available through platforms globally and also in India. Investors may have to rely on both networks and intelligence in combination to arrive at a steady flow of quality startups coming their way for investment asks.
What are the top 3 things to consider when assessing a startup before investing?
When it comes to assessing whether or not to invest in a startup, there are a few key things that need to be taken into account.
Identify the startup’s primary problem. The primary problem of a startup will vary depending on the specific company and the unique set of challenges in the sub sector and user base that would be paying for the product/service. However, some common problems that startups face include finding an effective way to address or grow or create a large market for their product or service, building a competent team, marketing for growth, developing a sustainable business model, and overcoming difficult technical hurdles.
Review the evidence to see if there’s a viable solution. Investors can generally assess whether a technology solution developed by the startup is likely to be successful based on the following factors.
1. Substitutes that are already working and growing but solving only a portion of what the startup is solving for
2. Size and complexity of the technology and the general costs involved in such development
3. Barriers to entry for newcomers if some critical pieces are solved, the feasibility of developing and deploying the proposed solution.
Several proxies can be used if the startup is pre-revenue including user base and growth, engagement time, inbound inquiries etc. If the startup is already making money, indicators like cost to acquire new customers, lifetime value of customers, entry costs for new geographies or channels can be useful.
Evaluate if the current team is capable of developing strategically and tactically in the face of capital and competition pressures, and technology / regulatory / societal /environmental challenges. Also, these days assessing startups on talent, if they are able to attract and retain talent for their growth, is becoming important especially in the face of competition.
Finally, make a decision based on your assessment of the situation and evidence. If there is overlap between the startup’s business with your own experience, you can clearly add value to the startup. There are several areas like sales and go to market, financial planning and even hiring that investors can help with. Having a clear understanding of the startup needs and your own outcomes will help you make an informed investment decision. Seasoned investors may prefer to dig deep on the financial models, growth projections, funds utilization and ratios to compare and evaluate startups.
Therefore, before investing in a startup, it’s important to do your research from credible sources of information. This will help you assess the market, the team’s vision, founding team experience, and their track record and decide if the startup is worth investing in. It’s also important to be prepared to invest a significant amount of time and money, as startups can be bulky and risky investments. However, if you’re confident in the company’s potential and are prepared to put in the effort, investing in a startup can be a rewarding experience.
Conclusion:
With so many startups launching every day, it can be tough to decide which ones to invest in. However, you can make an informed decision from doing diligent research about whether a startup is worth your time and money. First, assess whether a startup is solving a real problem. If it is, the startup has potential, look at the team and their track record in building businesses and develop a view. Consider if the technology/sub-sector exposure is worth having a play on your entire portfolio.
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Views expressed above are the author’s own.
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