Questions to ask when investing in a startup
For experienced investors, investing in startup companies can often be highly rewarding - not only due to significant potential for capital growth, but also the ability to achieve portfolio diversification.
And, specifically for UK-based investors, the added benefit of generous tax reliefs can arise if the opportunities in question are eligible for Government-backed schemes, such as the Enterprise Investment Scheme (EIS) or Seed Enterprise Investment Scheme (SEIS).
The reliefs available from these tax-efficient wrappers can help venture capital investors to maximise potential returns and minimise downside risk - a desirable feature, particularly when investing into startups and early-stage businesses.
As with all investments, your capital is at risk, so it is crucial to have a clear understanding of the deal. To assist with the due diligence process, the 26 key points and formalised structures outlined below could help private investors to ensure the startup investment opportunity aligns with personal investment goals and preferred risk/return profiles.
1. What does the business do and how will it create shareholder value?
Certain business investment opportunities can be more appealing than others, as some business models may have the potential to scale more quickly whilst being less capital-intensive. For example, a technology business with the potential to generate recurring revenue or a consumer-focused business with the potential to create positive social change can both hold elements of appeal.
The key point for investors to consider is how shareholder value will be created.
Firstly, it is important for prospective investors to familiarise themselves with exactly what the business does. This can help to determine whether the company's operations align with personal investment goals, and possibly help investors to evaluate the firm’s prospects for future growth.
Looking specifically into how the business creates value and executes plans can act as an indicator of the firm’s levels of efficiency and innovation. This can be useful for investors, as the company’s approach to delivering projects can be highly telling of its ability to compete effectively within its market.
If the firm’s practices appear sustainable and aligned with personal investment values and goals, this could be the first signal for investors to consider supporting the startup business.
2. In which sector does the business operate?
Building a strong foundation of knowledge regarding the sector in which the business operates can be crucial for investors. Acknowledging industry trends, growth potential, and total market value can provide investors with a deeper comprehension of the startup’s capacity to succeed.
It can also help to factor in wider economic considerations, such as how fluctuating inflation rates, interest rates and supply-side issues are likely to affect different sectors.
Startups operating in some particular sectors have the potential to benefit from regulatory change and technological advancements. These businesses can hold investment appeal due to potentially offering investors greater scope for high returns, and also the possibility to creatively disrupt industries and economies.
3. What problem does the business solve?
Identifying the problem that the startup aims to solve for its customer base is important for investors as this is likely to be the core purpose of the business.
Discovering whether the company already solves this problem well, or at least has the potential to in the future, can be a key point for investors to appraise. If an early-stage company has the tools to effectively solve problems, this could signal significant scope to cater to an unmet market need, or cater better to an existing market.
Investors could consider whether the market is already saturated, or perhaps ready for disruption, by consulting both third-party data and internal data from the startup. The validity of these sources must be questioned, but they could provide a useful insight into whether the problem that the business is seeking to address can offer access to a wide market for a sustained time period.
4. Is this a genuine problem?
Whilst the ability to solve a problem effectively can indicate a promising startup investment opportunity, a company’s potential to grow and produce a considerable return on investment (ROI) could be under question if the problem does not meet a genuine concern.
Investors can consider whether the problem is widespread - perhaps it spans a national or international scale. If so, this could indicate a genuine problem with a large customer base, suggesting potential for both significant business expansion and the generation of positive social impact.
Providing a more suitable alternative to any existing solutions (i.e. adopting a Red Ocean strategy) or perhaps creating the first solution altogether, indicates that the startup could create measurable value for a market seeking a solution to a widespread problem.
5. What is the unmet market need?
For prospective investors in a startup business, understanding exactly what solution customers are seeking can be important.
The unmet market need essentially signals a ‘gap in the market’ which, when addressed, could provide both positive social impact (due to meeting market needs), and significant financial returns for startup investors (due to this area possibly being largely unexploited). To explore this potential, investors could ensure that the startup has provided evidence of a sophisticated market mapping strategy.
6. How do the startup’s products or services help to address this unmet market need?
Exploring the suitability and effectiveness of the company’s products and/or services to solve the unmet market need is important. If the solutions are functional and directly address the problem that the target market is facing, the startup could demonstrate the potential to attract significant consumer interest and could create a promising impression for investors.
Furthermore, it is worth considering whether the products are not only practical, but also fit with more subtle customer preferences. Investors can explore the level and detail of market research, including consumer research and competitor analysis, that has been conducted by the startup. This could indicate the depth of company knowledge surrounding wider market needs and also more specific customer trends.
7. What does the targeted customer base look like?
Understanding the startup’s customer base is important, as this can provide investors with an approximation of the size of the target market and an insight into the potential for business expansion.
In addition to researching the size of the customer base and the targeted customer profile, understanding the route that the product and/or service takes to the customer can also be insightful. For example, the increasing digitalisation of services could potentially make certain e-commerce businesses a more promising startup investment opportunity.
On a broader scale, a range of potential distribution routes exist, including business-to-consumer (B2C), business-to-business (B2B), and business-to-consumer-to-business (B2C2B).
- B2C involves marketing products directly to individual consumers who typically represent the final destination of the product’s journey.
- B2B refers to businesses providing a product or service to other businesses, such as consultancy or marketing services.
- B2C2B represents a relatively new hybrid of the previous two approaches, where a product or service is marketed to employees of a company, sometimes for free or at a discounted rate, who may then find the product or service useful and subsequently recommend it to their own employers, often to be adopted on a company-wide level.
8. How large is the market opportunity?
Measuring the size of the market opportunity is important for investors because this can signal the potential for business expansion, revenue generation and return potential.
The size of the market opportunity for an individual early-stage business can be expressed in three main ways: the total addressable market (TAM), the serviceable available market (SAM) and the serviceable obtainable market (SOM).
- The TAM highlights the entire possible market for a product or service if nothing prevents customer acquisition.
- The SAM displays the market section that could be reached with the company’s current business model and distribution channels.
- The SOM measures the realistic portion of the market that a business can expect to serve, all things considered.
9. What are the overall market trends?
Conducting research using licensed industry reports, startup monitoring websites (such as Beauhurst) and trend monitoring tools (such as Google Trends) can enable investors to create a strong foundation of knowledge relevant to the industry in which they are looking to invest.
Whilst quantitative measures can be the most important indicator of market trends, looking into more qualitative factors, such as consumer behaviour patterns, preferences and general consumer confidence could also provide a useful insight into future market trends.
10. What levels of experience do the founders have?
Discovering whether the startup founders have undertaken any previous projects of a similar nature and, if so, evaluating the outcomes, could provide potential investors with a helpful insight into the likely performance of the people running the business.
Another important area for consideration is how many years of experience the founders have in this sector, or in other sectors. This could be beneficial for investors to know, as skills may have been developed in other projects and industries which can be transferred to benefit the current venture.
The founders’ motivations for starting the business could also be explored. If the motivations are purely financial, the company may operate with a fairly short-term profit-maximising view, which could be detrimental to sustained future growth. Conversely, founders determined to innovate and generate positive impact could be viewed as true value creators, potentially building a business which is more likely to prevail throughout tougher economic periods.
11. How well-rounded are the team to navigate through start-up to scale-up?
The management teams of startup companies are likely to be a work in progress - skill gaps may be apparent at an early stage. This is understandable, but investors should be confident that any gaps can be filled over time.
It could be useful for investors to understand how many team members are involved in the business, the specific skills they each bring, and the value they each add to the company.
Any team members with previous experience of navigating the start-up and scale-up process could prove to be highly valuable. Relevant past experience, combined with the skills of other team members, could position a startup to perform well, provided that effective communication systems are in place.
Also, it is important for investors to understand how readily new team members will be welcomed. If the business is anticipating a rapid scale-up, a larger team is most likely going to be required. The founders may therefore need to demonstrate a willingness to appoint new team members, particularly managers, to enable some responsibilities to be delegated.
12. Are the founders coachable?
Venture capital investors may take an active role when undertaking a startup investment opportunity, sharing their advice and expertise with the team running the business.
If such investors are involved in the process and the founders are willing to be coached, this collaboration could generate considerable benefit, perhaps expanding the collective knowledge of employees and founders and subsequently resulting in a more competitive startup being developed.
Importantly, both investors and founders should note that exit may take longer than five years, meaning that this mutually beneficial relationship would potentially need to be sustained and nurtured for several years in order for coaching to be successful.
13. What does the hiring plan look like?
When assessing a startup investment opportunity, investors may benefit from exploring the hiring plan that has been devised by the business.
Any vacancies identified and advertised could signal that the company is progressing and expanding, indicating that the growth plan is on track and new internal ventures are being undertaken. As well as remaining on track for growth, hiring new employees may also reduce any current workload strains on existing team members.
Looking into whether the team is set to grow quickly, whether detailed training is set to be provided and whether this plan is attainable is important for investors to consider. The hiring plan often links directly to the company’s budget and can also be strongly influenced by the regional and national labour market outlook.
14. What does the Board look like?
Whilst a Board of Directors is mandatory for public companies, it is not compulsory for non-profit organisations and private companies. However, a Board is generally still formed, typically consisting of inside directors (for example, shareholders and senior employees) and outside directors, who are generally only involved with the company through their board membership.
The collective industry experience of Board members could positively influence the strategic direction of the startup. A highly experienced Board could provide useful points and advice for the company to consider, potentially contributing to higher success chances.
15. How will the Board evolve?
Considering how the Board is expected to evolve in size and expertise and how frequently communication is expected to occur can be important areas for investors to explore. This is because the Board often has significant influence over business decisions, and investors can sometimes play a part in this decision-making via the Board.
16. Does the startup have strategic advisers?
Essentially, strategic advisers are long-term business consultants who tend to specialise in a particular industry or field of expertise. Their role can involve a range of activities, from coaching employees to assisting with the development of business goals and strategy.
For a startup navigating the development process, strategic advisers may not be required, but they can be useful, especially for business owners with limited previous experience in their industry or role.
17. What is the business model?
Looking into the startup’s business model can be an effective measure for accredited investors to take when investigating a venture capital opportunity. Understanding how the company plans to generate sustained revenue is an important question to ask prior to investing. If the lifetime value of customers is not truly profitable, the prospect of healthy returns can be under serious scrutiny.
Scalability could be identified as one important feature of a credible business model, referring to the ability of a company to grow, acquire customers and multiply revenue without proportionally increasing costs.
A business that can successfully scale their operations could benefit from economies of scale, meaning that fixed costs are spread across a higher number of sales, potentially resulting in improved unit profit margins. The focus on scalability can separate high-growth startup opportunities from lifestyle businesses, which often do not place significant focus on expansion.
Investors may be provided with a summary of the business model via a tool such as Business Model Canvas, offering a one-page view of the company’s strategy and acting as a useful reference point for ongoing analysis of the startup.
18. Who are the main competitors, both direct and indirect?
Conducting a form of competitor analysis could prove helpful for investors to interpret the startup’s position within the market. Evaluating whether existing firms have a particularly strong hold on the market can be completed by researching market share and market concentration figures. This can help investors to anticipate the relative difficulty for the startup firm to successfully enter the industry and grow their market share.
It could also be useful to evaluate indirect competition, as well as direct competition:
- Direct competitors offer essentially the same products and compete for the same target market.
- Indirect competitors target the same client base, but with different products and services that can satisfy the same customer need.
19. What is the company’s unique selling point and value proposition? Is this clearly identified and compelling?
A unique selling point (USP) is the characteristic of a product or service that differentiates it from direct competition, which can be highly important for an emerging business to secure customer traction. On a similar note, a company's value proposition outlines the specific solution that the business provides and the promise of value to customers.
To find out whether a company’s USP and value proposition are clearly defined and compelling, investors could audit the website, possibly looking at product descriptions or ‘About Us’ sections. Alternatively, meetings with company founders could also outline these considerations.
Additionally, investors could consider whether these points of differentiation are aligned with customer values and preferences, and whether they offer innovative solutions to genuine consumer problems.
20. Does the company have defensible intellectual property?
Intellectual property (IP) refers to creations of human intellect, including intangible assets such as copyright, patents and trademarks. The role of IP is to add value to a business, but in order to be effective it must be protected by legal rights.
Where possible, the business should take steps to protect its product or service from being exploited by competitors. It is therefore important that any necessary intellectual property rights are in place to protect the original creators and prevent others from financially benefitting from their IP without authorisation.
A startup with defensible IP and know-how could signal potential to offer effective value propositions which are backed by relevant legal documentation, a key point for investors to note.
21. What is the valuation?
An accurate valuation enables investors to understand the underlying value of their VC investment. Overpaying for an investment can have significant ramifications in the future, so investors must be absolutely confident that a fair valuation has been reached.
A number of different systems exist for calculating valuations, including the following:
- Venture Capital (VC) Method - this involves investors first calculating the post-money valuation to then work out the pre-money valuation, incorporating elements of Mergers & Acquisitions valuation components.
- First Chicago Method - a probability-weighted valuation of a company using different cases, and assigning a probability weight to each case.
- Scorecard Valuation Method - this method introduces individual weighted percentages based on a detailed number of quantitative and qualitative factors which are categorised into different groups.
- Berkus Approach (also known as the Stage Development Method) - a startup enterprise is valued based on a detailed assessment of several key success factors, including basic value, technology, execution, strategic relationships, and production & consequent sales.
It is generally suggested that using at least three startup valuation methods to estimate a pre-money valuation is appropriate. If all provide roughly the same number, the three can simply be averaged. If one is an outlier, then the other two can be averaged, or alternatively a fourth method can be used in an attempt to bring three figures in close agreement.
22. How will funds be used to create value?
Discovering how the startup plans to use the capital raised via investment is important. Investors should be confident that the funds are to be allocated effectively, in a way that creates the most value. Potential investors could inquire about these plans and possibly gain an insight via discussions with the company founders and/or management team.
Established businesses will be able to provide trading history and other evidence to back up their projections for investments. However, the growth forecast for a startup is based on theoretical figures. Therefore, to be investment-worthy, the business should state clear plans for investors’ capital that aim for maximum impact to be delivered.
23. Will future funding rounds be needed?
The company should have a clear vision of the capital it needs to fund growth beyond every key milestone, with room for manoeuvre should unexpected problems or opportunities emerge.
It is important for investors to question whether future funding rounds are required. If the firm takes on further capital, this could dilute the shares and influence of original investors.
Although, future funding rounds could equally signal the opportunity for original investors to invest more capital, potentially increasing their stake and influence, with the aim of generating more considerable returns and further helping to maximise the startup’s chances of success.
24. What is the exit strategy?
Understanding the potential exit strategy and target hold period is an essential part of the due diligence process. Typical exit strategies include:
- Trade sale to a larger company
- Secondaries private equity acquisition
- Initial Public Offering (IPO) - listing on a publicly traded market
- Share buy-back
Most startups are acquired by trade purchasers or larger private equity firms. Some do achieve a liquidity event for investors through an Initial Public Offering (IPO) but this is less common.
Typical hold periods can range from 3 years to 10 years. Ideally, the business needs sufficient time to create shareholder value. Some can take longer to gain traction than initially expected. It's therefore prudent to factor this into any portfolio return calculations as a longer hold period will affect the Internal Rate of Return.
Startups that have the potential for strategic acquisitions can be appealing as the exit multiple may be enhanced as the business may be attractive to a larger company targeting growth via mergers and acquisitions.
25. Are any tax reliefs available?
Whilst risks associated with investing in startups can be more considerable when compared to traditional investments, these risks can be mitigated, to some extent, by supporting companies that qualify for generous tax wrappers.
Two of the most well-known UK schemes that provide venture capital and private equity investors with notable tax benefits include the government-backed Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS).
- Established in 1994, the EIS has raised £25.6 billion of investment for approximately 36,720 early-stage companies. Investing via this scheme can provide investors with up to 30% income tax relief, capital gains tax (CGT) exemption and deferral relief, 100% inheritance tax (IHT) relief and loss relief.
- Introduced more recently, the SEIS has attracted over £1.5 billion of investment for approximately 15,870 early-stage companies since 2012. With the SEIS, investors can claim up to 50% income tax relief, receive CGT exemption and reinvestment relief, 100% IHT relief and loss relief.
Companies are highly likely to indicate whether the investment is eligible for tax benefits, ensuring investors remain up to date with useful information and making the case for investing in an early-stage business even more compelling. Utilising tax reliefs available via schemes, such as those outlined above, could help investors to enhance potential financial returns and minimise overall investment risk.
However, investors should choose to participate in an investment because it is inherently compelling regardless of any potential tax reliefs available.
26. What are the likely risks and returns?
Understanding the likely risks and potential rewards of investing in a startup is a critical part of the investment process. Investment risks and potential returns should be clearly outlined.
Some of the main risks of investing in startups can include:
- Typically requiring a long holding period, often around five years, possibly signalling lower liquidity.
- Being particularly exposed to wider economic and regulatory movements, which can sometimes be detrimental to start-up and scale-up progress.
- Facing an elevated risk level due to investing in businesses at an early stage, when a working product, customer base or steady revenue stream may not yet be achieved.
Some potential rewards of investing in startups can include:
- Significant scope for superior financial returns due to investing at an early stage, which could be further enhanced by qualifying for UK Government-backed tax incentives such as the EIS and SEIS.
- The ability to help young ambitious companies realise their potential, potentially facilitating wider positive social, environmental, and economic impacts.
- Contributing to a more diverse investment portfolio via the range of industries, geographies and company maturity levels that investors can access via startup investments (which can, in turn, help to reduce overall portfolio risk and volatility levels).
Adding venture capital investments to your portfolio
Done properly, investing in startups can help experienced investors to build a well-diversified investment portfolio with the potential for higher returns than many other investments, such as traditional equities and bonds.
Additionally, the fact that some startup investment opportunities qualify for generous tax reliefs means that venture capital can be appealing to experienced investors as part of a wider tax planning strategy. However, it is important that investments are chosen on their potential to deliver growth and returns, irrespective of any tax wrappers. The investment should be compelling in its own right - decisions should be investment-driven first and tax-driven second.
Over the past two decades, regulatory changes and technological advances within the financial services sector mean that VC investments have become much more accessible. For suitably qualified investors with a clear understanding of the risk/return profile of a given opportunity, investments in startup businesses could provide an exciting addition to a well-rounded investment portfolio.
Ultimately, the 26 points outlined above could assist investors in selecting startup investments that best align with their overall investment strategy, risk appetite and personal mission.
GCV Invest is a private investor network for experienced investors. We specialise in providing investors with access to carefully selected alternative investments including some of the UK's most compelling startup investment opportunities.
You can find out more about GCV Invest here.