Written by: KingsCrowd
Using online investing platforms — such as StartEngine, Wefunder, Republic, or Netcapital — is an excellent means of finding a promising startup to invest in. Considering that 90% of startups fail, it’s critical to understand the metrics and characteristics that you should examine when researching these investment opportunities. This valuable knowledge will help you strengthen your investment portfolio by increasing the odds that you will invest in the winning 10%.
In this guide, you’ll get critical and in-depth insights into startup vetting best practices. Towards the end, we’ll offer some of the top questions you can raise about a company to determine whether it’s worth your investment.
Know a Startup’s Valuation
Valuation is the estimate of how much a startup is worth. There is no set system for determining valuation, so it can be somewhat arbitrary. Startup founders tend to price their companies by looking at other similar companies’ valuations and a combination of recent revenue, market projections, and speculation.
With early stage startups, revenue should not be used to judge whether a valuation is fair or not. These companies are usually too young to have significant revenue yet. Growth stage and late stage startups will more often have revenue figures that investors can reference. In these cases, it’s good to examine the company’s revenue-to-valuation multiple and to see whether it is fair for the industry the company is in.
Valuation is a key metric because it is directly tied to any potential returns an investor might receive. In startup investing, investors should be sure that the company they are considering can justify — and exceed — the valuation it has set for itself. If it fails to do that, the investor will likely never receive a return.
What’s the Startup’s Market Size?
Any startup has its ideal consumers whom it thinks will find value in its product offerings, whether it’s a service-based or business-to-business (B2B) company. Startups with a very large target market often make stronger investments, which is why investors should always examine a company’s market size. Market size implies the number of prospective buyers of the business’s products and the revenue obtained from the sales.
When determining a startup’s market size, it is also critical to understand its total addressable market (TAM) and total obtainable market (TOM).
- Total addressable market (TAM) – Also known as the total available market, TAM is the overall revenue opportunity that a company can record if it has 100% market share. Companies analyze their TAM to determine the level of effort and funds that their new business requires.
- Total obtainable market (TOM) – This is the total market demand for the specific product that a business provides. It is used to estimate the portion of revenue a company captures in a particular product segment.
A market’s growth rate is also crucial to evaluating a startup’s market potential. Market growth rates are often presented in the form of compound annual growth rates (CAGRs). These percentages represent an estimate of how much the market will grow each year over a set period. Low percentages — 5% or lower — often indicate very mature markets where little innovation is happening. It may be difficult for startups in these markets to take market share away from established incumbents. Markets with strong growth rates — between 8% to 18% — indicate that there’s plenty of consumer interest and lots of room for companies to establish themselves. Growth rates of 20% or higher can be signs of emerging markets. These markets are often very new and have a lot of potential. However they can also be more volatile, and predicting company success in an emerging market is more difficult
As an investor, a startup’s market sizing (based on the TOM, TAM, and growth rate) gives you an idea of a startup’s growth potential based on its target market. The larger the company can get, the better it is for an investor. The most promising startup is one that targets a large and rapidly growing market.
Evaluate the Team
The individuals behind the business are an essential factor when it comes to evaluating startups. They are the people who started the company and have the full story and idea behind the business. The founders should bring vision while being major drivers of innovation and success at their companies.
It’s best to start with understanding the founders’ background story, why they started the company, their vision for the company, and their value in the company. If a founder doesn’t have a compelling “why” for creating their company, they likely won’t be able to see it through. Additionally, founders’ past work experience, education, and skills should also be assessed. Look for signs of passion and tenacity.
After founders, it’s good to examine the other key team members. Is the c-suite fully built out? Are there any major skill or knowledge needs that are unfulfilled? The management team must have proper sales and marketing skills, technical abilities (especially for a tech startup), deep market awareness to develop the company’s strategy, and product management skills.
Differentiators: The Key to a Competitive Business
A differentiator is a distinctive factor about a company’s product or services that gives it a competitive edge. For example, is your potential investment startup providing a social media app? If so, why? And how will it be distinct from Facebook or Twitter in order to actually compete with these social bigwigs?
Differentiation determines a product’s defensibility. That means a product that is highly distinct, such that other competitors can’t create something similar that can directly compete or replace it. Product uniqueness is not the only factor that determines its defensibility. Patents and capital intensity also play a key role in preventing product duplication, enabling a company to thrive in the long term.
A business’s differentiation strategy has a significant role in its future performance. Without any similar products in the market, a company has the power to control market prices. The best startups have strong differentiation and defensibility. A brand with easily replicated products or services will struggle to reach a grand success in the future.
There’s more to a startup than just a great business idea or business plan. Many experienced investors look beyond a business’s great pitch and idea. What they look at – and you should too – is the traction that a company has behind its great idea.
Two main factors can be used to assess a startup’s performance:
When looking at a business’s financial performance, focus on the income statement and cash flow statement. Financials also touch on the business’s debt, profit margins, and burn rate. Burn rate is the speed at which the company is spending capital relative to any revenue it’s generating. Companies with strong financial health often make better investments.
You can gauge a business’s product performance by determining the number of current and new customers it gets. A business with a stagnant number of customers indicates a lack of growth or strategic marketing. Outcomes of a project’s pilot program are also a helpful determinant of product success or failure. You can also leverage consumer reviews as an excellent indicator of the perceived product quality among consumers.
Critical Questions to Ask Before Making an Investment
Even after examining the above five metrics, an investor can still have several pressing issues and inquiries regarding a startup. If you find yourself confused or seeking further clarity into a company’s operations and future plans, it will help to use the “comments” or “discussion” section of the raise page.
Reputable founders and teams are always ready and glad to share insights and answers about their company respectfully and clearly. A lack of response or activity from a startup’s team is enough to raise concerns and should be a red flag. Some good questions you can ask include the following:
- How do you plan to expand your product/service offerings?
- What plan do you have for customer acquisition?
- How do you define your success in terms of market share? What are your market share goals for each of the next two years?
- Do you plan to expand your team? Which vacancies and areas of expertise will they fill?
- Do you have any partnerships in place? Do you plan to?
- Where do you see the company in the next three years?
- Do you have an exit plan?
Doing Your Due Diligence
Investing in startups is an excellent way to diversify your portfolio while also supporting exciting companies and founders. However, it is crucial to do your due diligence before every investment you make. Examining a startup’s valuation, market potential, founding team, differentiators, and performance will help you determine if this company could yield a return on your investment. A major strength of online investing is that you can use a raise page’s discussion or comment section to ask questions directly to the company’s team. This is a major asset that you should always use when you are confused about a startup.
KingsCrowd's Merlin Ratings Platform analyzes more than 300 startup data points to provide trusted insights, analytics, and ratings to help investors vet startups across the online private markets and make informed, data-driven investment decisions. Try Merlin free for three months just for being an Advisorpedia reader!