Investing in Startups: 10 Checks Before Your First Deal

Getting started with investing can be overwhelming, and most of the information you can find is full of useless jargon. To help you get started with investing into startups, we’ve put together this guide of 10 things you should always look into if you are considering to invest.

Keep in mind that you are not trying to find a company that you think is amazing in every single category (Marketing, Sales, Operations, etc.). Typically, early-stage companies are looking for an investment to keep the business running as well as address different aspects (Marketing, Sales, Operations, etc.) in which they need to improve. In order to do so, these companies are willing to sell a part of their company (equity) for a much lower price (valuation) because an early-stage company’s likelihood of failure is higher.

What the company “lacks” create the opportunity for the investor, but also the risk. You should always look into and analyse the information that the company is providing. If any information is unclear, then ask questions, do additional research or seek professional advice to gain clarification.

Let’s get started!

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Remember, all 10 things listed in this guide are considered important, but it is up to you how much you emphasize each of them. Knowing what to look the hardest at, and what to accept needs fixing, is what ultimately makes or breaks the success of an investor. This relates to the risk, which we touch upon at the end of this post, and will get more into later.

In the following months, we will be posting detailed guides to each individual aspect, and you will find links to these below.

✔ Problem

The first thing you should understand about a startup is the problem they are trying to solve. Some problems might seem minor, but even a small problem that is a problem to a lot of people can be significant.

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Ask yourself, is this something that needs to be solved? Is this company making something that I want to exist in the world? Are there other people who need this? Is it a big enough problem that someone would be willing to pay for it to be solved? Learn more.

✔ Solution

Once you have pinned down the problem, look into how the startup is solving it. What is the product or service they are offering? After you have figured it out, it is important to find out, how that solution is different from others. Ask yourself, what makes their idea unique?

Another important thing to consider when looking into their solution is whether it creates a viable business model. Without one, the startup will have a tough time generating revenue and from an investor’s point of view, it will not be a wise investment if the company won’t become profitable. Learn more.

✔ Market

For a company to become successful, there needs to be a market for the products or services they are offering. Even though the solution sounds great, if there is no market for it, it will not generate revenue and therefore not give you the expected return on investment.

To understand the market, it needs to be analysed. Who is going to buy this product? How many people have this need that has to be solved? Is the market big enough? Or is it more of a niche market? What is the target market of the startup? Is it an existing, emerging, or new market?

A startup must also have a go-to-market or a marketing strategy. Without one, no matter how great the target market and their solution sounds, they will have a tough time getting to the market to start generating revenue.

✔ Competition

Competition is always something to have an eye out for as a business but also as an investor. Get to know the competitors in their market, learn their advantages and disadvantages. It will give a nice overview of the competitive landscape of that market.

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Use this overview to assess the startup’s competitive advantage. What makes them different? What do they have that the competitors don’t? How do they stack up against their competitors regarding other aspects like price, features, performance, etc.?

✔ Team

Most companies will say that their team is the most important thing, and usually, it is. A good team early on is a crucial factor in running a successful startup. With the right people behind a good idea, the company can quickly find the right path and become profitable.

But how do you know, if the people running the startup are the right ones? The team members’ background stories are the key here. What is their previous experience? What are they specialized in? What is their education? Have they run a business before and if so, how did it go? This should give a general overview of what value the team brings to the company.

Another good tip for evaluating a team is to remember, that at the end of the day, any company is just a collection of people, so ask yourself: “Is this a group of people who can accomplish something great together?”. Running a startup is super tough, and if the team won’t work well under pressure, this provides a great risk for you as an investor.

✔ Traction

Having traction means that the startup already has some evidence of market adoption. This is an indicator to the investor, that there is a real need out there and people are getting interested in the products or services provided. It is definitely a good sign when a startup can provide some data supporting their claims. It shows that the team is committed to move things forward and make things happen.

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Some key indicators that measure the traction of a startup can be the number of users/clients, revenue, cost per acquisition and customer lifetime value, engagement and website traffic, etc. Regardless, it all comes down to the startup you want to invest in and what type of business they run. Therefore the traction indicators can vary slightly.

The traction of the company is closely related to your risk tolerance, which we’ll get more into in a later post. In general, the earlier stage the company—and the less traction it has—the higher the risk of the startup’s failure. However, less traction also means lower valuation.

✔ Use of funds

As an investor, you probably want to know how the startup will use your investment. Usually, startups need investments to fund their growth but this is such a broad reason. Therefore it is wise to dig deeper and figure out what are the exact goals of the startup and how do they plan to achieve them with the help of the investment.

A good idea is to look for the milestones set by the company. How do they plan to achieve them? How are they allocating the funds to reach those milestones? Is the investment reasonable for fulfilling the goals? What exactly will they achieve with the funds raised?

Having evaluated the Problem/Solution, Market, Competition, Team, and Traction, you need to make sure that your funds will go towards improving the most critical items on that list.

✔ Exit strategy

Having an exit strategy is especially important when investing in startups. Investing in one can tie up your funds for some time, depending on the business of course. Unlike companies, who are on the stock market, startup shares can not be sold as quickly and easily. As an investor, it is, therefore, important for you to lay out a plan of how to sell off your stake.

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There are basically two ways for a company to exit: Acquisition or entering the stock market. In the first case, the company gets acquired by another one and you as an investor will be able to exit and possibly profit from the investment. The other option is an IPO, initial public offering, at which point the investor may chose to sell their shares or keep them as stocks.

It’s worth noting, that some companies might not have an exit strategy, but can give returns to investors in other ways. More on this in an upcoming post.

✔ Risk

Think thoroughly about your risk tolerance and consider the possible outcomes beforehand.

General risk:
Investors always risk losing all of the invested money when the startup ceases to exist. So unless you are willing to take such risk, don’t invest in a startup. Only invest the money you can afford to lose. Even if the startup becomes successful, it can take years before you see any return on investment.

Company specific risk: Aside from understanding the general risk when investing in startups, it’s also important to understand the specific risks with the company you are analysing. Look at the 8 other things you have checked off. Where are their weaknesses? Are those things you believe they can improve on?

A good question to ask a company is:

“If your company does not exist in 18 months, what would be the reason?”

This question is not intended to test the confidence of a founder or expose weakness; it’s intended to understand the imagination of the founders, and their ability to anticipate risks to their business. If a founder says, that there are no risks, it means that they are overly confident, and this puts you more at risk. Look for reflected, humble answers, and reasonable courses of action that the founders can take to address them.

✔ The deal (Investment terms)

This part requires the most knowledge from you as an investor, and unless you are an experienced investor, you definitely need to seek professional advice or co-invest with someone who knows exactly what they are doing.

Do you know how a convertible note works? What is pre-money vs. post-money valuation? What is a bond? We’ll dig into some of these things in our last post in the series!

Ultimately, the deal you can get reflects the situation that the company is in. As we explained in the introduction, no companies, especially with as early-stage as startups are, will be doing perfectly everywhere. A company that has little or no traction, will have to offer to sell equity at a lower valuation than a company that already has a lot of traction.

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In the coming weeks, we will be adding more detail to each of these check points, hoping that you, in the end, will have a good sense of whether or not you are ready to start investing.

Is something missing from this guide? We want to make it as useful as possible to our community! If there’s something you think we should explain, please leave a comment.

About Funderbeam

Funderbeam consists of three parts:

  • Free data intelligence on investors and startups
  • Tools for startups to raise funds and for investors to co-invest
  • A marketplace for investors to buy and sell their investments

Our vision is to provide everyone in the world with equal opportunities, whether you are building a company, or looking to fund the next big thing. What if the next Silicon Valley is not a place, but a platform?

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