Friends and family often ask me how to evaluate a startup for investment purposes since there seems to me no shortage of startups to invest in. I always tell them that first and foremost, startups are risky and that most don’t make it. An analysis by CB Insights of 1,027 seed stage companies funded between 2009-2015, found that 0.9% became unicorns (worth >$1B) while 77% of them are either dead, walking dead (bad outcomes) or self-sustaining (not necessarily good for their investors). Net. Net — startups are risky. With that warning, let’s dive into my 4 criteria for selecting a startup to invest in.
Why only Four
I’m always skeptical about simple formulas to make decisions or do this simple thing to be successful. You should be as well.
Clearly making the important decision to invest in a company will be a lot more complex than just 4 steps. What I’m trying to do with these criteria is provide a simple way to weed out the vast majority of companies that don’t meet a basic standard for you to even consider. Once past this criteria, then the exact criteria for investment gets a little more murky and dependent on your investment thesis.. The criteria is presented in my order of importance.
No other thing, in my opinion, is more important than the talent the company has recruited to build the vision. This includes every single person involved — from the founders, to the engineers, to the admin. Data seems to back up my opinion.
A Harvard study of 10,000 startups, reported in CNN Money, found that 65% of high-profile startups fail because of co-founder conflicts. That’s a pretty high statistic. Why not just invest in a single founder?
It turns out that single founder startups are not that appealing to investors. Out of the 10,000 startups the study looked at, only 16% were single founder. Most investors want a founding team that can share the burden of building a company and have some fault tolerance if a founder leaves. It’s also almost impossible to find a single person that can do everything required to build a successful startup, especially as things start to scale.
Talent Signs You Should Look For
There are a couple of tell tale signs that indicate a good team that I have learned over the years:
- How they treat underlings: My number one sign of a bad person or team is now they handle those under them. True leaders and team builders are of service to the team and treat everyone with respect. No one is marginalized ever.
- How they treat each others: If the team cuts each other off, talks over each other or only one person talks, then that’s a bad sign. A founding team should be equal in input while having a healthy respect for each other always.
- Using “I” too much: Someone that is obsessed with “I” did this or “I did that, is not a team player. No one can build a company alone and if an “I” centric founder takes all the credit, it will slowly erode the team.
- How they handle failure: My number one pet peeve is people who can’t handle failure or say they have never failed. You’re a human. You fail EVERYDAY. Those that can’t embrace failure will crumble when it happens to them. Big red flag.
- Have a solid why: A persons “why” says a lot about their motivations. A solid intrinsic why is what will motivate and inspire someone to continue on when things get bad. Extrinsic reasons, like fame and fortune, are fleeting so when the going gets tough, those founders tend to give up. Founders with strong intrinsic whys, like obsessed with solving this problem or helping others, weather the storm.
It’s important to really understand the team you will potentially invest in. They will be the ones that will grind out a the companies strategy day after day. If the dynamic is off or there are unresolved issues, things will disintegrate fast when the stress and strain of building a business starts to weigh on them.
Timing is the second thing I would look for when investing in a business. When I talk about timing, I primarily mean market timing although regulatory timing should also be considered. The reason timing is so important is because if the idea is too early or too late, it will take a lot more capital and patience to make the company successful.
My favorite timing example is Blockbuster because it shows how a teams talent and ego can compound the effects of timing.
Blockbuster was a powerhouse in the video industry. As a kid, I loved going to Blockbuster with my family to rent a couple of movies for the weekend. It was fun to browse all the new titles and fight with my two brothers as to which movie we got to play first. The good old days of be kind and rewind.
At its peak in 2004, Blockbuster had ~60,000 employees and over 9,000 stories yet just 6 years later, it filed for bankruptcy. What happened?
Netflix timed the market perfectly because Reed Hastings understood two important things. First, Blockbuster was pissing off their customers by charing late fees. In fact, late fees accounted for 20% of Blockbusters revenue and second, people were using the Internet more and more. This perfect storm allowed Netflix to eliminate late fees and make it really easy to find videos to watch.
Timing Signs You Should Look For
Hindsight is always 20/20 when it comes to seeing trends but there are a few things to look for when evaluating a startups timing:
- Macroeconomic Signs: Is the startups target market growing, contracting or stagnant? This also includes the countries in which they will do business.
- Industry Trends: Are their signs of industry growth or contraction? A good place to look for trends is CB Insights, which has some wonderful data on startup funding and overall market trends.
- Market Need: Market need has to do more with “is the market ready for the offering?” Alta Vista found this out the hard way. They had search way before Google but no one was yet on the Internet in any measurable way to support them.
- Regulatory Environment: Usually regulatory requirements will either encourage a market (like Drones) or discourage one (like Cannabis). Always ask how regulations will affect market adoption and if a government organization regulates the market (like the FDA).
Timing can be tricky yet it’s one of the biggest drivers of adoption. When a market is hot, there is always more investment and competitors driving adoption.
Most founders that I know fall in love with their technology. The reason is simple — it’s the one thing they can totally control. While technology is important, it’s not as important as Team and Timing because if the team is so dysfunctional and no one wants the product, no amount of slick tech will save that.
This does not mean that you can discount the technology component of a startup or product. What I suggest is that you take a careful look at the technology stack (if software) or the physics (if hardware) to understand the technology risks.
Using our Netflix example from before, it’s obvious that the technology to support streaming required high speed Internet. Without that technology, the video streaming experience is downright horrible, bordering on unusable. Even Digital Video Recorder (DVR) technology, which was the precursor to streaming, had a tough time being adopted since the interfaces were awful and now that streaming is so much better, DVR’s are becoming obsolete. Bye, bye Tivo!
Technology Signs You Should Look For
Technology can be tricky to evaluate because a tech founder will always be overly optimistic about how easy something will be to implement. My general rule is that smart people can figure out pretty much anything given enough money and time. The question is how much money and how much time?
- Are others doing something similar? This will sound cruel, but it’s true. Most ideas are not unique and either someone has done it before, is doing or tried it and failed.
- Is the company using an established technology platform(s)? It’s one thing to invent something from scratch, it’s something else entirely to piece together technology in a unique and novel way. The former is a lot easier and preferable since it takes away the technology risk.
- Does something need to be invented? Most products that rely on new technology invention have a higher failure rate and take longer to adopt primarily because getting people to use something new takes a lot of education.
- Can the core idea be patented? Patents are an important part of a companies IP protection strategy. However, patents are not the be all, end all. More important than a good patent portfolio is the ability to execute. More on that in technique.
Pay attention to the technology because it is a competitive advantage yet don’t fall in love with it. Many a great technology has been invented that went nowhere. I’m looking at you Betamax, LaserDisc, Newton, and Google Glasses.
Technique encompasses how a product or service is brought to market and scaled. I did debate whether or not technique is more important than technology. In the end, I realized that technology edged out technique only by a hair. The reason is that a broken technology will never scale while a solid technology can cover up some technique issues.
I would say that technique is the most under appreciated aspect of launching a company. It’s the main reason a solid product does not scale into what it could be. The reason techniques are under appreciated is because it’s all the boring, unsexy stuff that most founders either hate doing or don’t know how to do.
A great example of this is a company called Dijiwan, which folded back in 2012. The tl;dr version of why they failed is:
A good product idea and a strong technical team are not a guarantee of a sustainable business. One should not ignore the business process and issues of a company because it is not their job. It can eventually deprive them from any future in that company.
What I read from this is they did not have a solid technique in which to scale what they built and it ended up being fatal. Digging in a little deeper, you get the sense that the boring stuff was stuff they did not want to work on. Neil Patel explains:
An under-the-hood look at Dijiwan makes it clear. They overlooked key aspects of business process and the “boring stuff.” The CEO thinks, “It’s my job to lead.” The CMO thinks, “It’s my job to market.” The lead developer thinks, “It’s my job to code.”But a startup can’t segment its responsibilities like that. Things are far more organic in a startup, meaning that roles and responsibilities will overlap. Small things can turn into large things. Some of the most important components of a startup are those pesky issues of business process, business model, and scalability.Successful entrepreneurs understand that they must work on their business, not in their business. Getting caught up in the minutiae of presentations, phone calls, meetings, and emails can distract the entrepreneur from the heart of the business.
Neil’s analysis is spot on. I have a startup friend who thinks that startups are 90% doing the boring work on your desk. The glitz and glamor is rare. Startups are just good old fashion hard work and grinding it out.
Technique Signs You Should Look For
This one is a little more tricky to tease out depending on the stage the company is at. What I always start out with and dig into is the companies go to market strategy. This is the first and most important technique area to focus on. Some others to consider include:
- Is the go to market strategy realistic? Having a plan is one thing. Can the plan be executed is another.
- What are the scaling issues the company will run into? Growing pains are what happen when a small issue blows up into a showstopper at scale.
- Does someone on the team have operations experience? It’s important that someone have experience on what it takes to run a company. Nothing trumps experience when scaling.
- Do processes exist that allow the company to scale? This can be as simple as having a deployment process for new code, specifications for hardware or a sales funnel.
Evaluating a companies technique will take more digging but it’s important to figure out if the team has a plan and a process to be successful. The plan does not have to be perfect but it should at least exist.
How Should I Weigh All These Criteria?
The world is littered with the carcass of failed startups and we need to learn from them to be better investors and startup founders. If you look at the reasons startups fail, the majority tend to fail because of founder issues, bad product market fit, broken technology and finally processes that prevent scaling.
So for me, I weigh the criteria as follows:
- Talent: 60%
- Timing: 20%
- Technology: 15%
- Technique: 5%
I’m sure as time evolves, my weighs will evolve and so should yours. Companies, founders, markets, and technologies are fluid and what worked in 2000, did not work in 2008 and certainly won’t work in 2016.
The Most Important Thing to Remember
I would be remise if I did not mention the most important thing about investing in startups — only invest what you can afford to lose. That is vital since startups are risky and investing in them is risky as well. So as soon as you write that check, mentally say goodbye to your money. Happy investing!
Also published on Medium.