How to Invest in Startups

The Big Launch

If you’ve ever invested in a startup and the success is based on “The Big Launch”, get ready for a long drawn out investment.

 

In the past, the new product or new service lifecycle was to have an idea, do market research, build it, do a launch and “they will come” – customers that is. That is not how it has to work, at least not anymore. The systemization of launching Minimal Viable Products and getting immediate customers not just users but actual customer feedback, from day one has allowed startups to rapidly enter markets with much less risk.

 

So why do so many Startups still build a product “in stealth” or not until it is “ready to launch” before they get it out to the market? The answer is financing.

 

Seriously!

 

As investors, we have generally been sold on the dream and potential of the service or product. As such, the startup team is attached and dependent on launching a great product and getting customer adoption – this is generally how startup success is defined.

 

It rarely works out, in fact I would argue it never works out that a product is launched and becomes an overnight success without already having been in the market and in 100% real world customer development mode. No company ever launches the version 1.0 of their product or service to a 100% success rate, that simply isn’t the reality of the business world.

 

The challenge for startups is that in order to raise the money, they need to sell the dream of a great product and rapid customer adoption. As a startup investor you should see this type of pitch as a red flag and question the startup team’s attachment to their current view of their product or service.

 

An approach that is being taken more and more by successful startup investors is measure real world feedback. Not basing success on how many users a startup has but by what feedback the startup is getting from its customers, what they are learning and how fast they are pivoting based on those learning. Also key to note; is that the startup team is letting go of their original assumptions (ego), about their product and the market for it. These are the characteristics that will help ensure customer adoption and ultimate financial success for the startup.

 

I would not back a team that is dependent on a “Big launch”, (this does not mean products should not have “big” launches but they should occur after the product is already being adopted). I do back teams that are all about learning, pivoting and not about being right but rather doing what is right based on customer feedback. 

Investing in Series C Startups

Series C financing isn’t the last round of funding by any means, though it is typically what is seen as the final round. This is the round of funding where startups have started to move from beyond pre revenue, and past acquiring their first few customers.

Valuations continue to climb in Series C financing, meaning once again for the amount of dollars put in, the percentage and amount of shares received is lessened. While at this point the risk of the startup collapsing is lessened, the reward for investing late over investing in the earliest stages is lessened.

Series C round startups are generally companies that have been around longer than most startups and are what is seen as “more established”. These companies have generally begun making the shift towards a customer acquisition model, with much of their focus shifting towards sales and acquisitions.

1. Exit Tactics: Though the need to focus on exit tactics is prevalent through your entire investment cycle, the C round of financing is where exit strategies begin to be implemented. Interview people or organizations that you or the startup’s have identified as part of your exit map and determine what is realistic for your investment.

2. Management Depth: Management has the company to a series C round but do they have the depth and additional strength to scale commercialization?

3. Expenses: Has management kept expenses just as low through series B as they did through Series A funding? Do they plan to keep them as low through Series C and do they have plans in plans to minimize costs? If marketing budgets are starting to rise dramatically this is a red flag. Marketing costs shouldn’t be rising until these companies have proven company traction.

The various rounds of financing that startups undergo are generally the method used by investors to gauge their success, growth and progress. Ultimately the different rounds of financing will determine what amount of investment will get you what percentage of the startup. Additionally it does help in determining milestones and possibilities for further investment, depending on whether you are a late or early stage investor. By knowing what to look for, and where startups generally are, from an operations perspective, investors are able to avoid a fair deal of surprises that may come attached to their investment. 

Investing in Startups in Series B

The Series B round of startups is generally their third cycle of financing. Once startups have proven their business models and are beginning to look forward toward raising funds for customer acquisition a new round of financing begins.

For investors this stage represents a time in the growth cycle of startups where risk begins to transform. There is always risk involved in startups and in investing, but as the company moves forward in its progression the risks tend to decrease. However, what also lessens significantly is the percentage of the company you will be able to take down with your investment, while correspondingly valuations are increasing.

As the rounds of financing progress, the startup’s valuation rises. In other words a two million dollar raise in Series A that may cost $0.50 a share, may rise to $1.00 a share in their Series B financing. Effectively doubling the valuation. What this means is that the more rounds of financing a company receives, the smaller the portions of the pie are to investors compared to the dollars invested. Much like the public markets, a lot of the sentiment is get in early when the risk runs hand in hand with opportunity.

With Series B companies you are looking for the beginnings of customer acquisition. The first consumers are beginning to enter the market and the company is beginning to ramp up towards a customer acquisition model.

1. Customer Testimonials: At this stage in the businesses life, the amount of customers a startup has is generally limited. Despite the adage of “users first, revenue later” that embodies a lot of recent tech startups, most will have a limited user or customer base. Consumers drive business, and if they aren’t providing good feedback it may be a sign of deeper problems in the startup you are evaluating. Startups aren’t defined by the amount of users they have, but how the users engage the product/service.

2. Industry Partner Testimonials: When doing due diligence for the startups you are looking to invest in, take time to interview companies they have listed as their strategic partners. Ask questions to understand the nature of their relationship and see where the strengths and weaknesses of the relationship are.

3. Competitor Interviews: One key element that shouldn’t be overlooked when determining whether or not to invest in a startup is talking to their competitors. See what the established players are doing, or what other startup competitors are innovating in the same space. Knowing what your competitors or the competitors to your investments are doing helps to guide the structure of your investment.

Investment Stage Two - Series A

 

The second stage of startup investments is typically known as a Series A financing. Once a company has moved passed seeking money from friends and family, or the Seed Round, their financing tends to come from more traditional sources.  This is the round that some Venture Firms, Angel Networks or individual Angel Investors begin to get involved.

From an investment stand point, the companies you are looking into will typically be pre-revenue. What you’re looking for in these companies is evolving iterations of their products/services and an understanding of who their customer is and the costs associated with getting their customers.

As mentioned this stage is generally pre-revenue companies, so you aren’t looking for the company to be experiencing hockey stick type growth or business acquisition. What you’re looking for in these types of companies is whether or not they have proven their business model is viable. At this stage the valuation will be greater than it was during the Seed Round, but should still be attractive enough that you are able to take a portion of the company for a good value.

 

What you should look out for:

 

1. How did Management use the proceeds of the seed round? Was it as expected? Did they keep accurate records of their expenditures and projections?

2. Was has Management learned since their seed round? What adjustments have they made or  do they plan on making based on the knowledge and experience they have gained?

3.  Who else is of interest or being financed in the space their startup is in? What are their valuations and what have they currently raised?

 

Investment Stage One - Seed Round

 

The Seed Round of startup investment refers to what is generally the first round of financing that startups receive. This is the earliest that investors are able to get involved in a startup.  When looking into investing in a startup that is still in a seed financing stage it is important to note that these companies are typically still in a conceptual stage.

This stage of investment carries with it a higher amount of risk than the later stages of investment because of the nature of Seed Round startups. Being in the conceptual stage, companies can provide little more than expectations and projections when wooing investors. Due to the early stage that these companies find themselves in and the lack of a reasonable valuation, investors can often get involved at a significant stake for a lower cost than a later stage investment, especially given recent trends in early stage technology investments.

Your investment will come down to not only the style of investor that you are but your perceived significance of the startup company itself. Investing in the seed round of a startup means investing in the strength and capabilities of the team and ideas.

1. Are you confident that management has what it takes to builds a sustainable startup? The startup needs to be more than simply a good idea or else it will flounder.

2. Is management flexible enough to alter how they are going to be successful? A sure sign of impending death for a startup is a leader or team who know exactly how they are going to market and how they are going to be successful.  When looking at early stage startups confidence and tenacity are good, but ego and close mindedness are always going to be bad things.

3. Does management have what it takes to take their startup to the next level, more importantly do they have what it takes to attract investment at a higher level. 

Four Stages of Startup Investments

 

The Four Stages of Startup Investments

Startup companies are often defined simply as temporary companies searching for a working business model.  While the point at which a company is no longer a startup and simply just another company is quite the extensive debate, there are certainly agreed upon milestones that exist within startup companies. In this segment we will be examining four of the stages of startup investment.

1) Seed Financing

2) Round 1/A

3) Round 2/B

4) Round 3/C

The financing that startups receive is generally the most commonly used method to gauge their success, growth and progress. As an investor this information is used to judge possible liquidity events as well as further involvement of your investment. Over the next few posts we will detail these stages as well as where these startups tend to be from a go to market angle.

 

The Pluses and Perils of Your Investor Type

As with every trait or personality type there are strengths and weaknesses. Some things you’ll be good at and others you won’t be. This only further emphasizes the importance in recognizing where your weaknesses are and how you can counteract them.

Investing is no different. A team full of ROI Investors may overlook a brilliant technology because the numbers aren’t where they want them. A team of Passion Investors may not choose a company with strong numbers because they don’t believe the technology is disruptive enough. Alone or as a pack a single investor type is weak. Filling out your team with different investor types helps to mitigate risks and open your eyes to different investment opportunities.

 

The ROI Investor:

Plus: Numbers.  You understand where the numbers come from and what they mean. Balance sheets, proforma’s, forecasts and projections are your bread and butter.

Perils: The team becomes secondary. Since your focus is placed so strongly on what the numbers report there is a significant chance you miss out on the potential that the team behind the startup represents.

 

The Passion Investor:

Plus:  Innovation. You don’t see a balance sheet, instead you see the disruptive technology behind the numbers.

Perils: As a Passion Investor your investment goes far beyond just a dollar value and can require significant amounts of time and energy. Due to this you have an inclination to hold on to your investment longer than numbers may suggest.

 

The Support Investor:

Plus: You go beyond the idea and the numbers and invest in the potential of the team. Knowing their past and experiences, more importantly the past and experiences of the CEO helps to guide your investment.

Perils: Your intimate knowledge of the team behind the startup is a double edge sword. Knowing the team on such a level and the loyalty you have for them can keep you from exiting an investment when you should.

 

The Contribution Investor:

Plus: Your attachment to the outcome drives your investment. Your desire to help the community (demographic, geographic etc.) helps these startups get up and running.

Perils: Often these startups are not labelled as strong financial investments and require structuring from other investors to be profitable.

The Contribution Investor

 

 

 

Investors will often talk of their soft spot. This is a cause or idea that you will support regardless of whether or not it’s a “good idea”. It may not make a lot of financial sense, but it is something close to your heart, a cause you hold close. This style of investment often times involves many senses of the word “investment”.

It isn’t just about the money involved, but what else you can bring to the table, bring to the cause. Money often times takes a back seat to what the causes accomplishes, the good that it seeks to do. For some investors this may be putting money into a sports team that needs investors, to helping a non-profit survive and keep its doors open.

 

If you are a Contribution Investor these are the three traits that you will typically exhibit.

1. Feel Good – If you are a contribution investor one of your driving factors is your want to do and feel good. You’re putting your investment (be it dollars, emotional or physical effort) into this startup and what you want in return is that emotional trigger of knowing what you are doing is helping in some capacity.

2. The Ends Justify The Means – With this trait you understand that the bigger picture is what matters to your investment. Your concern is what your investment will accomplish or seeks to accomplish.

3. The Community – The outside ramifications of your investment are important to you. So while you understand who the management team is, and the numbers behind it, you value the impact it has on the community surrounding the startup. Be that geographical, demographical or the ecosystem that this startup feeds into, you understand and are concerned with the impact it creates.

The Support Investor

The Passion Investor

 

 

If the ROI Investor is focused solely on the money and numbers, the Passion Investor branches off in an entirely different fashion, focusing on the idea behind the startup.

You are the early adopters in the investment game. You are the players that are willing to jump in, get your feet wet and see the potential behind the idea before checking the numbers.

The strength of the Passion Investor comes from the lens with which they see innovation. These are the investors that will search out disruptive technologies and ideas and back them financially. They see how the ideas are going to change the market and jump in to help push the idea forward to market. A Passion Investor sees what an idea could be, not what the numbers say it is. 

Not to say that financial return isn’t a concern for these individuals. More that their interests on focused on the future, what the idea can provide, not what the numbers suggest it will. If you are a Passion Investor this is typically what you focus on:

1: The Why – This is all about belief, regardless of practicality. When you look at the company and its management team you are looking to see if they are focused on why they are doing what they’re doing, not how or what they’re doing. Your passion is going to be highlighted by your belief in what the team is trying to accomplish.

2: The People - When you examine a startup company and initially look to the people, the management team and not the proformas you are more than likely a Passion Investor. You want to know where the team has been, what their experiences are and what their strengths are.

3: The Action – When you’re a Passion Investor you get involved in a company in a fairly unique way. All the successes or failures and small bumps along the way get you more and more excited about your investment and the team. It is this activity that helps you hold on to a company, to see its breakthrough moment.