Been struggling with identifying investment opportunities? Even after you identify a promising startup that fits your criteria, success is far from guaranteed. According to the U.S. Bureau of Labor Statistics data, 30% of businesses fail during the first two years of being in business, 45% within the first five years, and 65% of businesses fail within the first ten years.
Identifying startups with the potential to turn into multi-billion dollar enterprises in the future requires incisive pattern recognition, a skill that is best developed through professional experience. However, leading investors often use an investment framework to identify top investment opportunities. This article discusses the key elements of such a framework that can help distinguish winners from duds in a sea of investment opportunities.
Here are some important filters you should use to identify top investment prospects:
Business Acumen
Simply put, business acumen is the combination of knowledge and skill required to operate a business successfully. When interrogated about the business model, a successful startup founder might have answers to the obvious questions, but you should aim to go beyond that to ask them about their vision for the company. You can even ask them scenario-based questions to check their clarity of thought and ability to adapt to the unknown.
Entrepreneurs with business acumen usually have a robust understanding of finance and operations and can make informed decisions about product development and go-to-market strategy. Therefore, the founders’ business acumen is a key non-negotiable factor in your evaluation of startups.
Product Marketability
Product marketability is another important facet of a successful business that you should use to evaluate startups. A new venture has to demonstrate that its product will gain traction in the long run. A product or service has strong marketability if consumers are willing to purchase it at a price that will generate profits for the business. When evaluating a product’s marketability, you should consider how a product or service can address a problem customers face or add value to their lives, as well as whether customers will purchase the product at its set price.
It is also imperative to ask entrepreneurs to demonstrate a proof of concept before making your investment decision. ‘Proof of concept’ is a litmus test that you can use to assess if a startup’s hypothesis will produce its desired outcomes. If you are not convinced of a product’s marketability and don’t see an iron-clad proof of concept, you should forgo the deal.
Market Size
You need to pay closer attention to startups with high growth potential. Besides product marketability and capacity to operate with a low CAC, another element that you should factor in your evaluation of a startup’s growth potential is market size. Simply put, you need to be convinced that enough potential customers would buy the startup’s product or service.
If a startup can reach scale in a sizeable market, it can operate with economies of scale and eventually achieve profitability. Many investors have spoken about their keenness to fund high-growth companies with a limitless market. On the contrary, many investors often turn down strong businesses because there isn’t a big enough market for their product or service. A limited market size is an impediment to achieving the kind of scale and profits venture capital investors seek.
Product Differentiation
A startup’s high growth potential is largely dependent on the competitive advantage it gains by differentiating its products and services from the competition. A new market entrant seeking to compete with industry giants without differentiating its products will likely fail. Understanding how a startup positions its product in the market is an important factor in making an investment decision.
However, even amid tremendous competition, a business can employ clever marketing strategies to gain an advantage over its competitors. Despite the healthy competition, MVMT Watches was able to sell its timepieces by marketing them as high-quality without high prices.
Staff and Delegation
Running a business is not a one-person endeavor. Successful entrepreneurs recognize the key operational areas where they need support and employ the right people to assume these roles to help their startup get off the ground. For example, for a startup in the SaaS (Software as a Service) business, it’s important to have a technical expert as part of its founding team.
Additionally, it is important to judge whether an entrepreneur can give autonomy to the core team or struggles with delegation. Often, startup founders fail because they centralize power and become gatekeepers for all decisions. Investors should intuit a founder’s attitude and evaluate whether the startup can foster a healthy and balanced work culture that will attract top talent.
Exit Strategy
Investors should always consider the following questions before investing in startups: How much am I investing relative to my net worth or the quantum of my fund? What are possible exit strategies for this company that will generate returns for me and my LPs (limited partners)? What is the potential ROI (return on investment), given the history of players in this market?
In order to evaluate revenue potential, ROI, and exit strategies, many investors often rely on the financials provided by the startup, such as a balance sheet and projections. Using these tools can help you justify your decisions. However, investors should keep in mind that startup investing is inherently risky. The financials drawn up by the company at the initial stage of operations may look very different from the actual business outcomes they achieve during the journey.
Using this Framework for Investment Decisions
While there are definitive indicators that point to high-potential startups across industries and geographies, investors should consider this investment framework in the context of the startup’s business and industry of operation. Besides relying on the universal indicators of success described in this framework, investors should conduct deep industry research and partake in customary due diligence processes before making investment decisions.
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