Investing in an Early-Stage Startup: What to Look For and What to Avoid
Investing in a young company is about as high risk, high reward as it gets. It takes guts, enthusiasm and an acceptance that it may not work out as well as you’d hoped.
In startup investing there are so many variables and “black swan” events that could positively or negatively impact the success of the venture, and in turn, your ROI. The list is literally infinite in terms of negative things that can impact the investment: a lawsuit against the startup, a co-founder leaving or getting sick, financial struggles. On the flip side, a startup could land an incredible business development deal that changes everything, or discover a growth hack that scales its community size overnight.
It works best if you can create a diversified portfolio of highly risky assets, which is basically what venture capital fund managers do for a living. And it’s best for investors who are accredited (meaning those who have a net worth of $1 million or is paid at least $200,000 a year) and can afford to lose a certain amount of money without it affecting their lifestyle or well-being.
So let’s say you think this is a good idea and you decide you want to get started. What are some of the things you should look for in an early stage tech investment? Let’s start with the three “T”s:
1. Team – Who is running this show? Evaluate the whole team, not just one founder. The best companies are comprised of people who prove that 1+1+1+1+1=$100 million. When you find a team like this, don’t let them get away. They can probably make you money.
2. Technology – Why is what they have special? There’s a saying that says the best technology feels like magic. Remember when you first set your eyes on that Apple TV or got your first iPhone and you were like … wait…what?… how? That’s the level of magic that is going to get you to a few hundred billion dollars in market cap. Ask yourself… am I really amazed by what this technology can do, or is it just a marginal improvement on an existing technology? (Note: this philosophy did not really apply to Twitter, go figure.)
3. Traction – Has the company built a minimum viable product (MVP)? Have people started using the product? If you are a fan of the TV show Silicon Valley, this was highlighted in the episode “Daily Active Users.” Even if a company has hundreds of thousands of downloads, if people aren’t using the product and getting enough value out of it to come back and use it again, the company does not have enough traction. And it’s worth double checking that the daily active users are not coming from a click farm in Indonesia.
But just as vital as what to look for is what to avoid. And in the spirit of alliteration, the three biggest red flags I’ve seen from early stage tech startup investments are the three “M”s:
1. Market fit – Oftentimes, you’ll get a tech founder who is so busy putting the finishing touches on his product that he forgets he actually has to market it to stay in business. And tech gurus who create magic rarely love marketing. Marketing is for sadists. People who just love rejection and hearing the word “no”. Tech gurus love to make magic and feel awesome. So naturally going out and finding product-market fit is not their favorite thing. So make sure there is at least one sadist on the team, and he or she has found it.
2. Monetization – This is the coolest tech ever! People love it and are using it every day! We have a hundred thousand downloads! But, no one actually wants to pay for it, and we haven’t figured that out yet. Remember Napster? No one made money investing in the magic that was Napster. Although I 100% support Facebook’s decision to push off monetization until they had an iron-clad network effect, make sure there is a strategy in place, otherwise you will end of depending on the kindness of highly acquisitive strangers.
3. Marginal improvements – One of the saddest things I have heard from an enterprise tech company selling some new SAAS platform that is supposed to “revolutionize” their industry is: “we help our customers increase revenue by 10%!” This is what we call the “marginal improvement”. Yes, you are creating value. Yes, technically, you could create a billion dollars of value if EVERY company used your technology. But you probably won’t, because they probably aren’t going to use it. If you are wondering “Why not?”, it’s because there are a hundred other companies out there selling similar marginal improvement strategies, and they just don’t have the time to integrate them all. So they typically decide to do none. In Zero to One, Peter Thiel highlights the importance of creating something that is an order of magnitude (at least 10x) better than the existing solution. This is one thing I agree with him on.
Remember the three Ts and Ms and you could be on your way to making some great early-stage tech investments.
Tanya Privé is the co-founder and CEO of 1000 Angels, a highly curated venture investing platform, and CEO of CoFoundersLab, a platform where startup teams meet and grow.