Founders work their fingers to the bone to attract investment. Nevertheless, no less work falls on the shoulders of investors as they encounter many problems and challenges, mainly with choosing a favorable investment prospect.
Let’s break down what strategy investors should follow to land the investment successfully with Oksana Pogodaeva, managing partner of the investment fund HR&ED-tech.
When investors look at an opportunity, they tend to make initial decisions by scanning the executive summary of the entrepreneur's business plan or pitch deck.
What are they looking at?
Three Elements Investors Review before Selecting a Startup to Fund
There are three essential elements to begin selecting a startup:
1. The Team
According to NEXEA, 32% of the startup’s success depends on the team, and it’s vital to pay attention to this during the startup’s launch (pre-seed and seed stages). I always say that we, early-stage VC investors, invest not in a project but in the people behind the project.
The team should have at least two members with a business background and a technical specialist. On top of that, both founders should have a stake in the startup, especially the majority share, to avoid difficulties with the founders' motivation to develop the startup.
When a startup transitions from the idea stage to the pre-seed stage, it is a must to have two entrepreneurs on the team. One founder cannot only effectively handle all vital business needs - such as development, marketing, sales, customer acquisition, fundraising, business model, and so forth.
2. A Business Model That Initial Sales have Validated
It’s not always necessary to focus on the startup’s monthly monetary profit: the amount of data left by potential customers and the customer retention rate can be important indicators.
According to Preferred CFO research, lacking a well-developed business plan is one of the top three causes of startup failure. In particular, 78% of projects suffer from it.
Other things being equal, an in-depth study of the business and its market are vital resources to have before launching a product or looking for investors.
3. Current Project Stage
The startup should have either a working minimum viable product (MVP) or a finished product. In the former case, the product must have essential functions. Many processes can be maintained without funds to launch them, and ideally, the startup should have its first sales.
Investors may then have a question: at what stage is it best to enter a startup? The choice of the stage is a question of the amount of free money that investors are ready to let into the venture and their sensitivity to risk.
The Pre-seed round,** when the founder’s idea is implemented, and the seed round, when there is an MVP, are some of the riskiest stages in the project. Money is crucial for startups no matter their current developmental stage. In the pre-seed round, startups value connections in the network, experience, and business consultations the most. So, investing in pre-seed and seed stages is better for those who are more risk-savvy.
Startups starting with series A and above are more stable. In other words, investing in them is more predictable and less risky than pre-seed and seed investments, but the winnings may be lower. However, based on the analytical company CB Insight, in 2018, 30% of the companies that received funding at the seed stage reached the exit stage through IPO or M&A.
In the venture market, syndicate deals are typical - when multiple investors enter a startup together. This allows investors to enter projects at later stages with smaller checks and risk sharing. Such deals are a good option for novice investors as the syndicate may include more experienced colleagues with professional expertise that will prevent wrong decisions.
Evaluating the Prospects of a Startup
There are three critical indicators that help with assessing the investment attractiveness of a project:
1. Unit Economics
First, investors like to focus on unit economics, a study of the profitability of a single product or customer and how it converges. Simply put, unit economics involve deciding if the cost of attracting a customer pays off.
A startup’s unit economics study is important and it can be controversial/polarizing. It helps decision-makers to understand whether or not the project has growth opportunities. Evaluating the economics of a startup saves money, time, and effort. Simultaneously, startups have little data in their early stages, so calculations may be far from the truth.
Moreover, various external factors influenced the results: failure to meet the sales plan, incomplete statistics for calculating customer acquisition, additional costs for processing and introducing the customer into the service, a competitor shot it, and it became more challenging to capture the market, and so on.
2. Understanding the Market and Its Needs
In this case, the startup team should’ve thoroughly studied the market, determined its niche, and clearly understood to whom the product would be sold in the future. A startup that has a great idea but can’t draw a path to profitability often fails. These companies should do their due diligence before sourcing funds so that they can understand where exactly the funds will go.
According to NEXEA, 90% of new ideas after A/B testing are failures or worse than those already implemented in big tech organizations such as Google and Facebook.
3. Due Diligence
Due Diligence makes for an objective understanding of the potential investment endeavor. It includes an investment risk assessment, an independent assessment of the investment object, a comprehensive study of the company’s activities, and a thorough check of its financial condition and market position.
In 2023, many techniques and methodologies have been developed that allow investors to make the best decisions with their funds.