Investing in startups can be tricky and can seem daunting, particularly if you’re new to it. Can you make money? Absolutely! Can you lose all your money? Yes. Investing in startups is a risky strategy and you should be aware of the risk from the outset.
This article aims to demystify the process. We have developed some broad guidelines based on international best practices to provide some direction. It’s important that you add your own flavor(s) to the process as well.
So what differentiates the good startups from the bad? What should you look for in a startup before making that investment? We generally use a process called the 5 M’s. You’ll find that some investors quantify each of these variables, sometimes giving the startups a score out of ten for each in their assessment. We will leave the methodology details up to the individual, but the broad principles should remain the same.
This is probably the most important aspect of any startup. The team is at the heart of the startup, the idea is secondary. Any investor will tell you they’d rather invest in an A team with a B idea, than a B team with an A idea. It’s the teams ability to execute on their strategy that matters and it’s this that will determine if the startup will succeed or not.
To your advantage you have the opportunity to meet the people behind the business. This almost never happens before you invest in a listed company. Get to know the team, understand their ability to execute on their business and their skill-set. Do they compliment one another? The passion should be tangible, if its not there every hurdle will seem like a dead-end.
It is often said that great companies happen when passionate teams pursue big market opportunities.
Investments should ideally be scalable. That is, given your investment, the company can take advantage of economies of scale to reach a broader market. Operating on a relatively stable cost base but with the ability to increase revenue.
Understand the difference between the various ways of measuring the market size: total available market and served available market. How much can they get and how fast is it growing.
Momentum could have many different meanings. Most founders will bowl you over with their passion but its important to understand where the company is at and how fast they are moving forward. They will typically fall somewhere along the following spectrum:
Idea – Prototype – Complete Product – Signed Up Users – Paying Users – Profitable
Get them to talk you through the milestones they’ve achieved and those that lie ahead. It is often good practice to observe how quickly they reach their next milestone(s) before investing. Think of it as dating before the marriage.
Match / fit
Investing in a startup is like getting married, but breaking up could be worse than a divorce. Make sure you’re a good match. How do your skills and professional network compliment the business? Apart from the money, do you add value to what they doing? The startup will take you on an adventure; make sure you know what you’re signing up for.
Money always plays a part, whether it’s the amount you invest (and the equity you get in return) or your expected return on investment. Make sure your financial objectives are aligned with those of the founder(s). Make sure they have an exit plan in mind and this is not a lifestyle business.
Remember you’re probably going to be locked in for several years, if the startup is not going to give you sizeable returns then don’t bother. The startup needs to have the ability to return a minimum of twenty times your money, 20x as it is called. The majority will fail, but spread your bets so you have a better chance of finding the one that shoots the lights out.
Abu Cassim is founder of Jozi Angels, an angel network based in Johannesburg, South Africa. They exist to grow the startup ecosystem and facilitate the growth of innovative startups. Through their broader network they have sourced the hottest startups and facilitated several investments. Their members are approved investors serious about providing capital and coaching to early stage companies.