Prior to making an investment decision, the inevitable evaluation process to determine whether a venture would be a worthy investment can be extremely time-consuming.
By SAM KEISNER, Partner at Go10x Ventures
Beyond the apparently perfect financial models and appealing founders’ pitches, there is a high moral hazard risk, making it extremely hard to spot the next unicorn disguised among a herd of horses! It is extremely important to make founders understand that you are investing in them because you are smart capital that will accelerate their growth and their understanding of their own businesses rather than ‘helicoptering’ money.
We have outlined a few points you should look out for when investing, starting from when you first hear about the investment opportunity to what the expected outcomes are, both financially and strategically.
First of all, gut feelings play a key role in deciding whether to invest or not. Start-up pitches are a great opportunity to hear about the ideas and the problem tackled but, more importantly, to quickly assess the capability of the team. In fact, what makes a venture successful is not the idea per se, but who manages and develops the idea into a real business. It is important to invest in the businesses’ most crucial asset, its people.
If the venture manages to leave a positive first impression, the basic due diligence process starts, covering both the qualitative side and the quantitative one of the business.
In a qualitative sense, you need to understand ‘why’ you are investing in this company:
— Team: Having a reliable and skilful team is THE foundation for building a successful start-up. Therefore, it is important that they are not only passionate about the project they work on, but their integrity and ethics will determine whether the investment will turn out to be a successful one or not. In addition to this, it is important to keep an eye on the stakeholders within the company to avoid the potential free-riding problems of executives.
— Customer Analysis: Innovations take place at the speed of light in all industries and you need to continue to stay in the loop to gauge whether the product is likely to do well. A start-up will succeed only if there is a demand for its products and services, this can be achieved by filling a market gap and leveraging their competitive advantage. A common problem is that founders often make assumptions about their customers, they, therefore, run the risk of not delivering a product that their customers actually want. Hence, conducting in-depth market research is definitely helpful to assess the feasibility and scaling-up opportunities of the business. Another practical way to do this can be conducting interviews with potential customers and partners to collect feedback on the project.
— Business Plan: Among the key strategic pieces of a business plan, such as product overview, development plan and marketing strategy, the plan must also include a SWOT analysis, a clear overview of what makes them different and their future growth plan. The latter should clearly indicate the venture’s key visions and goals, it is important to be mindful of this as the business progresses, and not to deviate too much as distractions arise. In fact, what matters in early-stage investments is the long-term prospect of the firm, and a great future outlook can only be achieved by having a sustainable and well thought out plan.
— Traction: The greater the forward momentum of a business is, the better its performance will be in the future. A great way to evaluate whether the product will have steady growth would be to work with the founding team to launch an alpha version of their product and test this on the market, then get some valuable feedback and iterate this into the product that is to be launched. Likewise, it can be helpful to look at existing businesses with similar models or value propositions to extract this kind of data in a similar way.
On the other hand, numbers play an important role and the submitted data must be considered carefully:
— Cash Flow Assumptions: Depending on the stage of the venture you are investing in, the approach to the financial model may differ. For pre-seed investments, they will be based on assumptions that must be carefully considered to identify any over-optimistic prediction, it is important to try to collate data to validate these assumptions, and where this is not possible, build sensitivities into the model around these assumptions. For growth companies, the existing data can be more reliable and representative of a future pattern, although should still be analysed similarly where new products or markets are being explored.
— Detailed Cost Breakdown: Having a detailed expense forecast, especially in the short term, is extremely useful to understand how the invested amount will be spent to achieve the pre-set goals in the business’ growth plan.
— Current Investment and Capital Structure: A thorough document showing the company’s debt and equity structure is fundamental to assess the long-term cash flow performance of the firm, which will directly impact its profitability.
— Monetisation Strategy: It is often important that the business should be able to generate a return from its product offered at a unit-economics level. This means that they should not only plan to generate profit in the future but also to be self-sufficient in the now (for this reason, having a validated business model would be beneficial for both parties).
The aforementioned criteria are all essential in assessing investment and, depending on the situation, it is necessary to dig deeper in some of them by conducting further due diligence which can involve financial, legal or industry experts. This is necessary for example to identify issues such as IP rights, technical problems or legal procedures to set up the venture.
Yet, there are two underlying factors that we have not analysed, business ethics and exit strategy. The alignment of the firm’s value and ethics with your own is with no doubt a factor that must be considered. Business ethics is what leads to its long-term presence, having a culture and set of values which guides the behaviour of employees and sets the framework for all the future actions is the building block for any start-up. It is important that this sits in tandem to the ambitions, culture and mindset of their investor to ensure a healthy working relationship going forwards. This may seem to be something abstract and hard to assess, but any founder of a successful venture would agree that the underlying principle was what granted the firm’s success, alongside the hard work.
The nature of investing in early-stage companies means that it is illiquid and there are high risks involved – the precise reason why the returns can be incredibly high. It is therefore important that exit strategies can be assessed at an early stage, so that all teams know what they are workings towards. The most common exit strategies include Trade Sales, IPOs and Management Buyouts, which will make your investment liquid after a certain period of time. A good way to have an idea about the size of the exit would be to have a look at similar companies and establish whether the predicted strategy is achievable. In addition to this, having an expected ROI in mind would benefit the decision-making process when assessing the investment amount, once the associated risks have been considered.
To summarise, the four key aspects that need special attention when determining your investment are team expertise, feasibility of the business plan, understanding your customer and sense-making financial analysis. Hopefully, this will turn out to be the magic mix for a rewarding investment.
CoFounder series with Go10X Ventures on angel investment continues weekly.