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The 5Ms of investing: why are they so important to understand when investing in startups?
The number of new businesses in the UK is rising. Figures published by the ONS in November show that 414,000 startups were born in 2016, up from 383,000 the previous year.
While many will fail, among them will be the rising stars, ripe for investment and loaded with opportunity.
Those that can excel against the ‘5Ms’ checklist of management team, market opportunity, (business) model, money and momentum will generally be most successful in securing vital investment.
These five key areas represent the fundamentals of building a startup that truly fulfils its potential and whilst there are no risk-free investments in SMEs and startups, high net worth individuals who carefully consider investees in terms of each of the 5Ms can mitigate risks and maximise their odds of strong returns.
The idea behind the startup is nothing without a team capable of delivering it. Key considerations for startup investors include the management team’s business experience and its knowledge of its particular sector. Also, if the skillset is not quite where it needs to be, are the founders coachable?
As the company grows, will the entrepreneur be willing to step aside in certain areas of the business and delegate to other members of the team?
The make-up of the team is also a factor, although savvy investors are not necessarily looking for the finished article. Rather, the startup should at least have clear plans to fill any gaps in the management team as the business expands - appointing a product development director might be most pressing for a software startup, for example, while a consumer goods firm might need to prioritise on a head of sales.
Simply put, is team in place investable, and does the startup have a robust management recruitment plan?
“Admit it, you’re out of the hardware game” - Wired Magazine told Apple in a 1997 article.
Apple's much-speculated end days as a gadget-maker weren’t forthcoming however. A few years later came the iPod, then the iPhone, iPad and a continual stream of new laptop and PC models. Market predictions have a habit of being wrong.
Henry Ford faced similarly dodgy forecasting. Seeking investment for his new motor company in 1903, his bank told him automobiles were a passing fad and horse transport would prevail for years to come.
Market misinterpretation can be costly, especially as a prospective business angel looking to invest your hard-earned funds.
How can you accurately gauge the market for a startup that’s not yet trading?
Unfortunately, there is no silver-bullet formula – and homework on your part, or by advisors helping you to find an investment opportunity, is required. You must assess the size of the market the startup is aiming to disrupt or break into, the resources required to gain traction and the strength of the competition.
The startup will present you with its interpretation of these factors. Question everything: from the validity of third party data to the research methods and case study examples in the same sector. Also, consider the context of the market.
Through your experience in business, you will no doubt have a good eye for market opportunities. Does the target market seem saturated, impenetrable or perhaps absolutely ready for disruption?
Also, what evidence is there that customers will actually buy into the business?
Corporate history is littered with examples of new products completely at odds with market demand.
Even one of the planet’s biggest brands has fallen into this trap. McDonald's 1996 attempt to go upmarket with the Arch Deluxe burger, backed by US$100m advertising campaign, was a total flop. The chain failed to recognise what customers really wanted.
For similar failings read beer-maker Coors’ ill-fated move into mineral water and the great 3D TV revolution which never got going.
Investors need as much proof as possible that this new game-changing idea will fly, and not flounder, once launched.
There are numerous ways to measure a startup’s market opportunity. ‘Top-down’ and ‘bottom-up’ are two prevalent approaches - top-down starts with the broader picture by looking at macroeconomic factors before gradually focusing in on the start-up’s market.
Bottom-up starts with the qualities of the individual business. Both are valid as you interrogate the likely market opportunity from all angles.
The business model enables investors to test the startup’s viability and the prospect of a strong return on their investment. Does the firm have the resources to reach the customers needed to make the model function? Are its financial forecasts accurate?
From the business model, investors are looking for key details such as:
- Financial projections for the business, usually over five years
- The timeline to breaking even and then to scaling up before an eventual exit
- The route to market acceptance and resources needed to fund it
- A clear picture of how investment will be deployed in the business
- How well protected the idea is from being copied
- The sales channel strategy
Unless already trading, startups rely on theoretical figures to secure investment. It is up to investors to delve deeper than the numbers stated by the founders.
They need to establish exactly how they were calculated and, using their business instincts, decide how realistic they are. Putting a value on an early-stage enterprise can be a dark art.
Until the firm’s product or service is live, investors have only projections and their own estimations to go by. Detailed analysis of every expected incoming and outgoing is required.
The clearer you are about the numbers and how well-founded they are, the more informed your final decision will be.
Startups with a bright future should be able to show growing interest in their product or service, even before launch.
Is there a buzz building up around its various outreaching activities such as customer trials, conference talks, workshops and online marketing drives?
Are media contacts becoming increasingly interested in the business? Do social media indices point to a startup whose profile is on the rise?
Momentum should also be palpable among staff, with everyone on the team powering through to do lists and progressing towards targets.
Making the decision to invest in startups
Startup investment opportunities are vast and varied today and are more accessible than they arguably ever have been. Whilst this makes startup investing particularly easy in theory, the basic principles haven't changed and you need to make sure you're investing in the startups that are most suited to your portfolio needs.
With there a wealth of advice available on the topic, the most successful investors base their decisions on the outcome of looking at the five Ms of an opportunity - and by following the same route, you can do a lot to ensure the opportunities you're looking at deliver the greatest returns for you.