How I Evaluate Startups for Seed Funding
In the investing world, a common question asked is “how do you evaluate startups before investing?”
Honestly, there is no one “right” or commonly accepted answer to this question because everyone has their own preferences or tolerance for risk.
Make no mistake, investing in startups is a risky proposition because as we know, many startups will fail, taking any investment funds with them.
How many fail? There is a lot of conflicting data out there, with some reporting that as many as eight out of ten startups will fail.
However, as Conor Cawley alludes to, the answer we can give for sure is “many.”
Over years of investing, I’ve developed my own criteria for evaluating startups and deciding whether or not they are worth the risk to me for investment.
Here’s how I evaluate those companies and reach a decision:
What draws me to a startup investment…
You’ve got to think long-term about how it is that the investment will get you paid.
In the case of startups, that is through IPOs or acquisition, so I look for companies which are a good target for those things.
This leads to the question, what makes a company an attractive target for acquisition or IPO?
Every investor will have their own criteria, but here are some that are commonly looked at:
This is the obvious, measurable metric, but not all revenue is created equally. Here’s an example; let’s say Company A has $30 million in revenue, while Company B does $20 million.
Which company is more valuable?
The answer is that you need more information.
On the surface, Company A looks attractive for having one-third more revenue, but let’s assume that the company is in construction and makes all of their revenue from one-off projects.
Company B on the other hand, makes its revenue from monthly subscriptions.
If their numbers show that they keep their monthly renewal rates high, then this company could be more valuable than Company A.
Many investors will have a revenue amount in mind as their minimum criteria before making an investment.
When you hear “it’s like Uber, except for X industry/service” this is one indicator that someone is looking to build a business with a scalable model.
Businesses which have simple, repeatable systems are a good target for acquisition because they should be easily picked up by a new owner.
If a business relies heavily on a single person (say, a CEO) to operate, this is not so attractive because it will take work to extract that person from the business.
This is one of those somewhat nebulous criteria which will mean different things to different people.
For example, momentum might be seen in the form of user numbers, partnerships, orders or business development deals.
The company should overall have a popular product or service that has good prospects for growth.
Invest in what you understand
One of my big rules is that I will only invest in businesses that I understand and trust.
They aren’t necessarily within set niches that I’m personally interested in, as long as I understand exactly how they work.
When Iceland’s banking system collapsed in 2008, the post-mortem analysis placed a lot of blame on the bank’s purchasing assets which were ill-advised and which often, they had little understanding of.
Interestingly, while the three big banks collapsed, some smaller companies survived. T
he owners of Audur Capital partially credited their survival with “only investing in things that they understand.”
One of their operating principles is described below:
“Risk Awareness: Tomasdottir sees a difference between being risk averse, or unwilling to take risks, and being risk aware, which means unwilling to take risks that are not completely understood.”
My 4M screening criteria
I have a set of “4M” criteria which I apply before deciding on an investment:
Management – This is a criterion that most serious investors will look at, in fact, you may hear people make comments such as “I could invest in this if they replace the CEO.” I like experience in the field and a track record of success. The founders of the company may be new, but who have they brought onto the management team in order to bring some experience?
Market – There has to be a large market for the product or service and plenty of room to grow.
Metrics – I like to see healthy metrics, although what these are depends on the type of business. For example, if it were a subscription model as discussed earlier, retention rate of subscriptions is a key metric. For other sorts of businesses, it might come down to a consistent monthly revenue which stays above a certain level.
Monetization – This is always an important consideration. I like to see at least 100% growth year-on-year.
Investments I avoid
This bit is relatively simple – I avoid investing in anything that does not yet show revenue.
I’m investing in viable companies, not ideas.
Perhaps the company that is more at the idea stage today will be a better investment in a year’s time, if they are showing consistent revenue.
Secondly (and to reiterate what I’ve said previously), I avoid investments that I don’t understand well.
How much to invest
Every investor will have their own preferences or ideas about how much to invest per investment, but I follow the Power Law.
This basically states that as an asset class, investing in startups is predicated on the success of a small portion of your investments as a fraction of your whole startup investment portfolio.
In my case, my total budget for equity crowdfunded startups is $10,000 and I spread it around accordingly.
My largest investment is in Keen Home for $2,000. My smallest is $200 in 8Tracks.
Some people will follow a complex formula to figure out what they want to invest, but it comes down to preference.
When it comes to startup investing, you should never have more money invested in this asset class than you’re prepared to lose, because of course there is a high failure rate of startups.
So in my case, I could lose the $10k, however I have it spread around several different startup investments.
What to expect from a portfolio
According to a report, Siding With the Angels, by the British Business Angels Association, 56% of the investments fail to return capital, 44% generate a return higher than the initial investment, and 9% generate in excess of 10 times the capital invested.
I expect that my portfolio will match those statistics.
Venture Capitalist Marc Andreessen once tweeted, “remember, startups and VC are a game of outliers, not averages.”
If you invest in startups, there is a high chance that some will fail, which is why top VCs tend to spread across many different businesses.
Where you see a successful VC platform, the chances are that they’ve looked at thousands of possible investments in a year and have been quite rigorous about how they make a final investment decision.
Pattern recognition and experience helps, but it’s still not typically easy to make the decisions.
This is one reason why it’s important to have some clear criteria for yourself before going into an investment.
You might still have some “misses”, but you can avoid making a decision that is based on “feeling” rather than data.
There is no doubt that investing seed funding into startups is a risky proposition.
This is an asset class that is only for people with the risk appetite who won’t find themselves in financial trouble if their entire investment amount is lost.
There are a couple of keys to remember:
- Power Law says that your returns will come from a small fraction of your total investment portfolio – this means you need to spread it around.
- Have clear criteria for making an investment. Consider some of my “must haves” above such as the “4Ms” of management, market, metrics, and monetization.
The flipside, of course, is that if you strike a unicorn, a small investment can turn out to be very lucrative.
What if you had been an early investor in Facebook, Uber or Air BnB?