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Investing in startups: why you need to look at the money in-depth
Carefully assessing the current and potential financials of the startup is imperative before any investment.
Understanding the money factor heavily influences the decision to invest or not - and for many, it starts at the startup’s valuation.
An absolutely crucial consideration, invest at an inflated cost and the investor weakens their chances of strong returns.
Given that investor/investee relationship could span five to 10 years as the startup progresses towards an exit, the initial valuation really should be meticulously thought through.
Putting a price on an early stage business can be an arduous task for the startup investor, however. The aptitudes required range from financial insight and interrogation skills to market knowledge and even a degree of soothsaying.
Often without any real trading data, they must assess whether the valuation provided by the founders is accurate; and if not, calculate what they believe is a fair figure on which to base their investment.
Their analysis of all financial factors impacting on the business now and in the future will help them to navigate beyond what is a major, and prevalent, threat to the startup investor: overvaluation.
Inflated valuations are common in all quarters of startup activity, from early stage incubators to the leafy avenues of Silicon Valley. Perhaps an influencing factor in recent years has been the dawn of the unicorn age.
As of March 2018, there were reportedly 279 unicorns – those businesses supposedly valued at over a billion dollars. Yet a study last year suggests that many are not really worth what the markets would have us believe.
Researchers at the University of British Columbia and Stanford University concluded that at least half of all unicorns are worth far less in reality than their mythical moniker suggests.
The study claims that many unicorn values have been inflated by complicated stock mechanics. The overvaluations are apparently the result of tools used to entice investors and negotiate higher share prices.
Prices based on preferential stock do not reflect the true value, they write. In a separate study published by Stanford earlier this year, it was claimed that the average unicorn is overvalued by almost 50 percent.
Many unicorns’ days may be numbered. For now, though, their existence could be presenting a distorted view to entrepreneurs about the true value of firms.
Headline-grabbing valuations emanating from high-profile IPOs may be raising the bar as startup founders put a price on their creations
It is up to investors to separate hype from reality.
They use various models to do so, including the Venture Capital Method or First Chicago Method – used particularly in evaluating growth companies with no historical financial data.
Investors should conduct their own research into this method before choosing it as their trusted gauge of the startup’s value.
The basics are that the value of the business if the best, ‘base’ and worst case scenarios are realised is usually calculated. These are then put through various financial modelling calculations and multiplied based on their probability of actually materialising. The final value is a probability-weighted sum of the three scenarios.
Numerous other such tools and methods exist, while competitor valuations can also be benchmarked. Also hugely important in financial terms is the projected route to liquidity. Does the plan, and all the income streams, overheads and foreseeable growth within it, allow for a favourable exit for the investor? Does the timeframe match your expectations?
Of course, to get there, adequate capital to grow the business, and an ongoing, healthy cash-flow, are both needed.
As an investor, you must have a clear picture of the plans for sourcing capital. Seeking further investment beyond your own will dilute your share – and may marginalise your influence, should you be hoping to take an active role in driving the business.
Plans to apply for grant or loan funding may have an indirect impact on your investment but should still be disclosed by the startup.
Startups have a tendency to underestimate their capital requirements, the fallout of which can be a flagging business model or weak penetration of a core target market. There should be enough capital and daily cash-flow to carry the business beyond its key goals, with room to spare to cover the inevitable-but-unexpected setbacks.
Recent research into the post-mortems of 101 failed startups by CB Insights shows that running out of cash was the second most common reason for failure behind ‘no market need’.
According to a 2016 study by online business services site Geniac, the average startup spends £22,756 in its first year on legal services, accountancy, HR and company formation. Entrepreneurs underestimate these costs alone by an average of £2,525, it says.
Staffing, research and development and marketing are among the many other capital-sapping aspects of the business that should be recognised.
Failure to accurately plan capital spending can lead to readjusted growth targets or more time in the red than expected. Such outcomes lengthen the road to liquidity – and therefore the wait for your return on investment.
Scrutiny of the capital expenditure plans can offer up clues to challenges the startup may face in future. For example, the staffing costs may fall short of the levels needed to retain talented staff in that particular sector or territory.
The funds allocated to winning customers may be undercooked or, worse, may far outweigh the lifetime value of the customer.
Between the lines of the financials, investors may find other indicators of whether the company is investible.
The amount of personal wealth put in by the entrepreneur may hint at their commitment to the business, or whether your investment is genuinely to fuel growth rather than plug debts or day-to-day cash-flow issues.
In summary, the money factor is embedded into all aspects of the startup and should be scrutinised closely by prospective investors.
As explained in this post, overvaluation is one of the dangers of not adequately analysing the financials of the business, and investors should be fully confident in the company’s financials - especially that the valuation is fair and as accurate as possible - before they part with any funds.