Investing in a tech startup is a risky endeavor that can be wholeheartedly worthwhile. We’ve all heard the stats – nine out of ten startups fail while only half actually make it to their fourth year. Many will return only the money you initially put into them, but investing in one big winner could more than make up for all of your previous failures, and then some.
Most startups fail because there’s either no market need, not enough cash, not having the right team, or a combination of the three. There’s a huge upside, but it’s immensely important that you do your homework before investing. You need to examine every angle in determining if this project will grow, succeed, or fail. You won’t be right every time, but you can be informed of what choices to make.
Here are 4 things to keep in mind when deciding to embark on the unparalleled roller coaster ride of investing in a tech startup.
Ethos and Moral Compass
Company culture is an absolutely essential element of success. Over 50% of executives say that culture influences productivity, profitability, and the value of a firm. This, however, can often focus on superficial elements rather than the inherent moral compass of what drives a company’s ethics.
Ethos is the spirit of an organization, and a startup without ethos is an empty shell that’s doomed to fail. It is increasingly vital for young companies to harbor a culture of openness and authenticity with a mission-driven purpose that transcends the bottom line. Creatively fusing morals and profits in a way that espouses character and integrity can lead to employees leading by example, setting traditions consistent with company values, and enhancing relationships within the organization.
Having a moral compass is what gives a company a good name that people resonate with. It builds trust and allows employees to focus on the work at hand. There’s no confusion when everyone’s on the same page and has a clear understanding of “this is how it’s done around here.”
Humans are drawn to a great story. If a company’s story isn’t consistent or if its values don’t align with its brand, then you should reconsider investing in it. Always ask yourself “why.” Why is this company solving the problem at hand? Being able to continuously answer “why” is what keeps a company afloat. If the founders are more concerned with the “how” than the “why,” problem-solving will only get more difficult. The “why” is what will motivate you to invest in a startup.
Longevity and Risk
To invest is to manage risks. Investors need to analyze a number of internal and external factors that could influence the future of a company. Is the startup investable? Does it have high growth projections? A possible outcome? Does it have scalable business models?
Investors can control risk by negotiating a startup’s valuation: higher valuations naturally imply that there is more risk associated, meaning that there will be a need to invest more in order to increase the value. As an investor, you can use clauses in term sheets, such as reaching an agreement that the founding team needs to remain a given number of years to receive a certain number of shares.
You can also manage risk by forming a liquidation preference, implying that in the case of liquidation, investors have the right to receive X times their initial investment before any others in the organization. Other clauses include anti-dilution (the pre-money valuation of a startup can never be lower than the post-money valuation) and lock-up (establishing limits to prevent founders from selling or leaving the company before a certain amount of time has passed).
One of the best ways to reduce risk is through syndicated co-investments, which entail a business angel with an extensive record of startup investments leading a round other co-investors can back up.
Remember that investing takes patience. Acknowledge that you may not get your investment back, and be realistic about the company’s prospects. Even if the startup is successful, it could still take up to five or more years to get a return. Liquidity events such as a public offering or an acquisition could take up to ten years. Understands the risks and be patient.
Take note of trends in the societal landscape. Are the founders well-versed in their business? Are they familiar with their competitors? Do they know the industry in and out?
Having competition and being able to navigate the industry is par for the course in founding a startup. As investors, it’s vital for an entrepreneur to explicitly address these challenges rather than sweep them under the rug. If a founder can explain their business, the market in which it exists, and the biggest threats to building it in two to three sentences, then they are most likely on the right track.
If there’s no competition then there’s no market. Investors want startups to fully conceptualize the market they’re in and understand their advantages versus their competitors. If an investor or founder wants a startup to grow fast in a short period of time, the market needs to be big enough with real clients that want to buy that product or service. And that market needs to be growing.
As an investor, you should also ask yourself: is the valuation in line with the industry and region? Since valuations can vary depending on those two factors, it’s important that a startup’s valuation is in line with competitors in the same space or location.
The biggest cause of small business failure is the lack of a market need for their product. That much should be obvious. If no one wants to buy your product, the company is not going to succeed. Relevancy is key.
Teamwork is an essential component of high-reliability organizations. A team of founders and employees should be one that complements each other and is well-balanced, focused, and fully committed to the project.
Investors prefer to see that the early-stage startup team (usually comprising of the founders and perhaps a salesperson or engineer) works well with one another and has a similar motivation to solve problems. They should be able to answer the question “Why did you start this business together?” with clarity, passion, and detail.
Before investing, it’s also vital to evaluate what the team looks like in practice. The best investments often have at least one business founder, a CEO, and one technical founder, a CTO, to start, but many successful startups have bucked this trend and will continue to do so.
Investors want to see that entrepreneurs are fully dedicated to their business in a full-time capacity and that they are strongly motivated to solve a specific problem. It’s no secret that a founder with a fallback won’t demonstrate the same hunger and fight as one who simply cannot fail.
Best of luck and happy investing!
Read more: The Secret to True Brand Authenticity