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How do you decide which startup investment opportunities are right for your portfolio?
Choosing where to spend your hard-earned investment cash is a decision which requires care and precision. There's so much to take into account - as there are with any investment decisions - that it's not something you can do lightly.
With many often first attracted by the potential returns available, some then begin looking at startups based on what they've heard about an emerging sector with immense potential.
Others will look within their network to see who's launching a business with exciting projections, and you may well have positioned a handful of startups on your radar that, at first glance at least, seem to tick all your boxes.
But whilst the thought of receiving stellar returns may already have you reaching for the cheque book, in-depth, painstaking research is needed to ensure you get involved the right startup investment opportunities for you.
Only fools rush in
A golden rule in investing, especially in startups, is to not simply accept things as they seem on the surface.
You must do your homework, understand why the company is poised for success and only commit to ventures that pass your thorough testing.
Part of this process might include trying to analyse the business from the entrepreneur’s perspective.
PayPal founder Peter Thiel’s book From Zero to One is a handy route map into the mind of the entrepreneur. Such perspectives are particularly useful for investors from a large corporate background who may have never been involved in growing a startup.
One useful passage describes the importance of the secret within businesses. Thiel writes:
"The best entrepreneur knows this: every great business is built on a secret that’s hidden from the outside world."
Find this secret and you may have dug deep enough to fully understand the startup and the likelihood of its success.
Investing in people power
Actor Ashton Kutcher, an investor with a £200m portfolio and a co-founder of venture capital firm Sound Venture, says of his startup investment strategy:
"I’m proactively funding brilliant people trying to solve hard problems. Focusing on this simple goal of identifying and enabling amazing entrepreneurs to create a better tomorrow is the crux of my investment strategy."
This may sound somewhat idealist, perhaps for investors with more limited budgets than a Hollywood A-lister.
Surely the prospect of a healthy return is the foremost consideration? But it is important to remember that the journey from initial investment to hopefully-successful exit could be several years. You should be enthused by what the entrepreneur is trying to achieve.
Whether that involves solving hard problems, like Kutcher’s ideal startups, or maybe disrupting an industry you are passionate about, there should be something beyond the balance sheet you find exciting.
An A-grade team
For Jeff Jordan – a prominent Silicon Valley investor and board-member of several startup successes including Airbnb and Pinterest – the team beyond the entrepreneur is also key.
Speaking to business broadcaster CNBC in 2017 he said:
"It's the quality of people working on the problem…The execution of the company is dependent on who your team is, how well they're organised, do they understand the vision [and] the North Star of decision making."
A perfect model
The business model itself is clearly an absolutely vital consideration, too.
In weighing up the startup opportunity, the fundamental aim is to understand the overall risks and expected returns. Poring over the business model will help you to go some way in achieving this.
What is an appropriate return for the risks presented? Related considerations include the capital structure – whether or not your share is likely to be diluted in the future – and the exit potential.
The business model and its manifestation in the business plan should be both realistic and compelling to the investor.
Underpinning everything is money.
Key questions related to the financial element of the startup include capital requirements – will there be enough funds for the company to realise its goals? Alternatively, does the enterprise plan to use your funding wisely to drive growth?
What about cash flow? Even thriving businesses can go bankrupt if cash flow is poorly managed or maintained.
Momentum is also an important measurement as you decide to invest or not. Internal metrics, or ‘key performance indicators’ (KPIs), are a useful gauge of momentum - as long as the founders are transparent and honest in their reporting of them.
Evidence of momentum might also be found in any intersections between the product or service and its intended customers. Numerous on and offline examples can be investigated.
The startup’s target market and its plan of assault should also be keenly analysed by the potential investor.
If you want to get involved in advising and guiding the startup towards success, you may be drawn to enterprises taking on markets you are familiar with. Your expertise could prove instrumental in enabling it to reach its goals.
Failing to meet a market need is the most common reason for startup failure, according to data analytics firm CB Insights. It analysed 101 startup postmortems and “no market need” was found to have had a hand in 42 per cent of the failures – ahead of “ran out of cash” (29 percent) and “not the right team” (23 percent).
There are numerous market sizing methods used to assess startup opportunities, including by taking a top-down view, calculating an entire market size and then working down towards an estimate of the startup’s potential market share. Investors also often refer to “bottom-up analysis”, which tends to be a much more labour intensive, but accurate, calculation.
It involves calculating where the product could be sold, factoring in sales of similar products and devising a detailed picture of how the startup’s offering is likely to perform in the market.
Diversity is key
Sophisticated investors considering startup investment are commonly advised to add upwards of 10 or 20 enterprises to their portfolio.
Furthermore, this portfolio should be diverse in itself. A healthy startup portfolio may well include companies in different industries, at different stages of development and led by different types of entrepreneurs.
Making the decision on startups to invest in
In summary, as an asset class, startup investing can be relatively risky, but in the long term, picking the right company can be extremely rewarding.
Choosing the right opportunity requires lots of research and analysis. With many investors referring to the ‘5Ms of startup investment’ and taking external advice to help them through this process, the end decision is yours - and you need to feel as confident as you can that you're making the right investment for your portfolio requirement.