Seven tips for investing successfully in a start-up (Venture Capital I)
Start-ups are a vital part of value creation in the economy and make a positive contribution to society. The availability of investment capital to finance their growth is a decisive factor in ensuring that these companies prosper.
In recent years it has become fashionable to invest and support entrepreneurs, but this trend, as well as offering opportunities, also involves risks. In principle, investing in these projects should be a good thing as it contributes to the creation of new businesses. However, the figures suggest a harsher reality. Each year approximately 5 million companies are set up around the world and 9 out of 10 of them disappear in the first three years of their existence, therefore the risks of investing in this type of business are high.
These basic tips will be of great use when deciding whether or not to invest in a startup:
- Assess the business idea with your feet on the ground. In the world, there are many people with brilliant ideas that have immense potential. However, developing the idea into a business format is not easy and it is here, in the execution process, where most startups fail. Asking the entrepreneur questions and even challenging their product and model in search of coherent answers, will give you clues to the maturity of their idea, their product and the state of execution. Why are people going to stop buying an already established product and buy this one? What is the target market and how much of it can be obtained? What is the distribution and pricing model? What regulatory or legal barriers might the startup face, are they surmountable?
- Do not let yourself be seduced by the personality of the business founder or an exciting presentation. There are some genuine marketing experts, who can explain ideas to us in such a way that our expectations of the business project are unrealistic and far from the reality of the market in which it is based. What is the founder’s main objective? How committed are they to the project? Do they want to create a medium-term value plan, or are they looking to become a millionaire by selling the company in a short time? These are important criteria to assess before investing. Most companies achieve success with vision, persistence and by seeking to generate long-term value for their customers and shareholders.
- Get to know the team in depth. A good idea thrives with a good team. We must assess their professional experience, their degree of internal cohesion and leadership model, the type of commitment they have with the company and their history of undertaking previous projects. For example, we find cases in which a startup wants to create SaaS-type solutions and the people behind the project have no prior experience in the world of software or programming. The company could prosper by outsourcing the product development, but it will surely have more difficulties than it would in another where it already has a team with these capabilities.
- Pay attention to valuations and future projections. Every day we see projects in funding rounds where the company’s valuations are very high, with multiples that rise for the mere reason that it is another new funding round, and where their growth scenarios are very far from the reality in which they find themselves. For example, the idea has spread that if the company has the suffix ‘tech’ in its business model (fintech, edutech, cleantech, healthtech) it can multiply the number of users and sales every year, thanks to the infinite potential to attract customers on the internet. However, exponential user and sales growth rates are a phenomenon that very few companies manage to achieve, and the vast majority are reduced to very limited market space. Growth in the number of users can be a good metric, but when, at what price and with what profitability? If we are considering investing in a funding round, other than the initial one, assessing how far the business plan has been achieved to date can be key to evaluating the performance of the business.
- Pay no attention to fashionable phrases. ‘Invest because a particular person has also invested’. ‘In the next funding round, a famous person or well-known company will become shareholders’. ‘Invest, even if it is only a small amount of money because the founder is well known and we are going to multiply your investment by ten in three years’. ‘This company has hardly any competition, you are entering at a low multiple and the other companies are going to disappear’. There are large investors with major assets willing to risk capital and lose it all, we must be sure that we are willing to lose everything before investing in these types of companies because, at first glance, the statistics are not favourable. It is also important to understand that in the global world we live in, competition is fierce and we should not rule out the fact that the competition can become stronger. How well do we know our competitors before investing? What differentiation strategy does this company have?
- Use of funds invested. Will they make efficient use of my investment? Ask them: “How will you use my investment?” “How long will this funding round last?” or, “How much money is really needed to generate profits?” Knowing the reasons that have led the company to raise capital before investing and assessing them with a critical eye is essential. Each company is at a different point within its sector and its life cycle. Among many other reasons, they may be raising capital to start their activity, finance their ever-increasing fixed costs or investing in marketing because sales are not growing, therefore knowing at which point the business currently stands is essential.
- Assess the exit plan. It is not only important when we start investing, but also the timing of our exit. What objectives do I expect to have been achieved after a certain period of time? How am I going to monitor this investment? As an investor, how can I exit the company when the time comes? As a general rule, investments in startups can be considered as illiquid and therefore recovering the capital invested can be a long and complex process.
Depending on the type of investor we are, in addition to having the access and time available to choose the best projects, there is also the alternative of investing indirectly through a specialist venture capital investment fund. Putting our trust in the investment skills of experts in this type of business, who can help us to overcome all these challenges, can be a good decision.
In the heat of the stock market listing of companies like Uber or Spotify, where the initial investors became millionaires, the fever for private investment in startups remains as strong as ever. We are excited to see this trend of investors increasing their capital allocations to startups and entrepreneurial projects, but at the same time, we invite them to reflect, analyse in depth and ask all the necessary questions to make sure they know where they are investing, because to be successful in this type of operation is more an art than a science and involves taking big risks in the hope of obtaining uncertain future returns.
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