Or, How I Evaluate Startups
This is a tough one. There’s no fixed set of steps that can help one evaluate an investment in a startup. Every startup/business comes with its own nuances that make it very tough to have a cookie cutter evaluation methodology. However, it helps to have your own set of guiding principles. Even with experiential mental models, it’s tough to zero in on those multi-baggers. These experiential mental models get heightened with time. Even then it can never be perfected. Most experienced venture investors, I assume, have designed their own mental models. Yet if you ask them if they’ve regretted an investment decision, the smart ones will tell you they’ve had at least one regret. Experience, intuition, data analysis, luck, black magic – a lot goes into making an investment decision. No wonder Investing is called an Art.
I’ve had limited experience of investing in startups. Close to 5 years, so far, with no intention of stopping anytime soon. I’ve made a lot mistakes while evaluating investments and that has helped me, rather unknowingly. It’s been a process of continuous learning. With the 1,000+ startups that I come across on average a year, it helps to have a set of guiding principles. Mental models help to sift through hundreds of businesses and get into details for the few that really pique my mind. Below I share some areas that I get a detailed understanding of while evaluating startups. Each of these areas also come with some minimum criteria. Startups that don’t meet my mental model, I decline immediately – it helps save time for both the founders and myself.
You must note though, these are my guiding principles and may not necessarily be the same for another venture investor. They are still crude and require refining, hopefully that should come as I make more mistakes. Even the minimum criteria I have for each area is relatively fluid at the moment – I’m still learning and refining as I go. This is not an exhaustive list. I keep adding and deleting principles and criteria to this list.
Market: Market is the economic value of the problem a business is solving. It’s the collective value of all businesses solving a particular problem. E.g. payments market, consumer durables market, digital advertising market etc. There’s a market for everything. There are various ways of calculating a business’ market – bottom-up, top-bottom etc. I usually look at startups solving a problem in a large market – usually a market that’s larger than ~USD 5 Bn. When the market is large, the potential to build a large company is high. Large companies are where attractive exits come from. However, larger the market, stronger the competition. That’s where my other principles come into play.
Founders: Founders are more important than most investors give credit for. And this is the most difficult among all other principles. We’ve all heard and experienced that people change with time. That’s what makes this principle that much tougher to analyse. Having a great founder can make or break the business & therefore my investment. I like founders that are grounded, passionate about what they’re building, have clarity of thought, are agile thinkers, not looking for fame or chasing valuations, not undercutting anyone to get ahead. I definitely ignore the hustlers or as we, in India, call it “jugaadu’s”. That’s a tell-tale sign that the founders are in it for the short term. There are various ways to analyse the above criteria, it all depends on the type of questions they’re asked at evaluation.
Moats: Moats help keep competition at bay. There can never be a fixed set of moats that can apply to all businesses. Moreover, moats don’t last forever, competition will soon catch up. Moats can come in any shape or size. Founders must think through their model and articulate their moats. If a founder is unable to articulate their moat, we have a problem. Some companies may have product design as its moat others may have capital. Some others may have partnerships as its moat others may have technology. Some may have all of the above as its moat. I definitely don’t consider technology a moat, though. What I do consider a moat is customer loyalty. Customer Loyalty is the strongest moat any business can have and also the most fragile. There are signs in the data that tell you how fragile this moat is. The more fragile, the more likely I am to decline the business.
Competitors: Detailed information on competitors could also be a strong moat for a business. The more information you have on competitors the more you know what strategy works best. Any founder underestimating information on competitor will lose out. I usually speak to every single company in the sector of the company I’m evaluating. E.g. If the company I’m evaluating is in the personal finance market, I will meet every other business in that market to learn what each one is doing. I can then cherry pick the most ideal one. This principle is underrated and is probably the most crucial. I stress on this again: detailed information on competitors extremely important.
Industry Knowledge: As part of this principle, I speak with experts from the industry and other company CXO’s from the industry. I do this for two things: 1. I do not know everything about every industry, it helps to get the low down from people in the know. 2. It helps to gauge interest from a large company whether they believe these businesses are competition and whether the are open to acquisition. This is done to align my analysis of an industry and a business with an experts’ view on the same. It also helps to know that there could be interest in the future for a business I’m investing in.
Stakeholders: Every business has various stakeholders. E.g. an Ecommerce marketplace has its customers, its sellers, logistics providers, finance partners etc. a whole bunch of stakeholders. For a business I’m evaluating, I speak with all stakeholders involved to get an all-round understanding of the business’ performance. This evaluation principle also helps to see and understand the business’ operations. It’s very important to get a flavour of each stakeholders’ interactions with the business. This is the part where an investor really gets a sense what the founder said in a meeting v/s what’s actually happening on ground. This principle helps validate everything that a founder says in meetings. If what I see on ground is in line with the founder says and I get feeling about what I see, I take the discussion forward to the numbers.
Benchmarking and Financial Evaluation: This is the last principle I use to evaluate a startup and also where it gets real. This is the part where I translate everything from the above principles i.e. what I’ve seen on the ground, what the founder has told me, what competitors are doing, how the market will adopt the product etc. into an excel sheet. This is where I put numbers to everything about the business, evaluate the potential of the business to grow big and what my returns could look like, assuming different exit scenarios. Benchmarking serves to normalise the business’ financial projections. I compare the business’ margins/financial projections with other public/private companies looking for normalising trends. Usually, all companies within a certain segment/market have similar margins. Building a realistic financial model helps have grounded expectations from the business’ potential to scale.
Once I have all of the above in my notes and my financial projection is benchmarked and built out, the decision to invest is rather clear. Then it’s all up to convincing the investment committee – a committee that makes investment decisions based on data presented to it. Convincing everyone internally to believe in the investment decision is a whole different ball game.
I hope to serve this mental model as information to founders that can use it in the right way. Most investors have similar mental models, I’m no sage. Use this wisely. Others looking to learn how investments are evaluated in a venture capital firm, this could be helpful. If you believe I’ve missed out on some principles that you look at while evaluating startups, please write to me or mention it in the comments below.