How Investors Evaluate Startups For Investments

The democratisation of infrastructure services, increased government support and proliferation of low-cost scalable technology stacks have unleashed a tidal wave of startups in India. In the last six years, over 14,000 Indian startups have made the journey from mere ideas to a business. Now, with the third-largest startup ecosystem in the world, India is adopting innovative strategies to strengthen the existing ecosystem. However, the innovation and momentum shown by these startups demand a massive amount of investors’ capital. 

A wealth of literature exists as to what compels investors to acquire stocks in companies. However, not much has been said about what revolves inside the head of an investor when scrutinising startup investment opportunities. An investor’s decision-making process is based upon a set of guidelines. These guidelines help regulate their behaviour when assessing various investment opportunities and the risk-return ratio attached to them. At the end of the day, investors are pouring their money so they can make money themselves. 

Early-Stage Vs. Rest Of The World

Investing in an early-stage startup or a growing business involves high risk and a high cash burn ratio. Investors are aware that about 20% of early-stage ventures fail in the first year, 30% in the second and by the fifth year, more than 50% of them have shut down. 

Consequently, investors are more cautious and hesitant when investing in new ventures. But some venture capitalists (VCs) also know that some of these ventures have the potential to become unicorns, get listed and more than compensate for all other losses. As a result, they anticipate receiving high returns on the money invested in untested, early-stage startups than in safer, more liquid markets. 

Risk Vs. Return

The job of an investor, especially a VC, is to take on risks but not without the promise of a substantial return. While VCs might be willing to accept high risk in exchange for a high return potential, private equity investors expect a predetermined rate of return in exchange for a certain amount of risk. 

Naturally, investors investing in early-stage startups want to scrutinise the business founders, business plan, potential risks, and product viability to estimate whether their investment will reap a good return or not. A comprehensive risk assessment enables them to measure, evaluate and mitigate risk so as to generate significant returns from their investment. 

Business Idea Vs. Business Founder(s)

Investors don’t invest in ideas; instead, they invest in people. More than the business idea or concept, investors like VCs are looking for passionate founders with skin in the game. The business founders and the management team are the ones who make the business concept a reality. 

As a result, investors value the drive, experience, and expertise of the founders sometimes more than the business idea. Before pulling out their chequebooks, they want to be convinced of the management’s ability to execute their business idea, adapt to uncertainties and build a successful business enterprise.  

Product Vs. Size Of The Market

There is no denying that one of the first things investors consider when making an investment decision is the uniqueness and viability of the product. They look for products that can solve an unsolved market problem; solutions that offer a competitive edge. 

But no matter how unique the product is, if it is not addressing a significant market size, it will fail to capture the attention of the investors. For investors like VCs, a large market size signifies a market that can generate $1 Bn or more in revenue. Accordingly, investors expect the business plan to include a thorough market size analysis that includes traction and product differentiation. 

Peeling the layers of an investor’s decision-making process can be a herculean task as the process varies from investor to investor. What appeals in an early-stage startup to a VC may not be the same for an angel investor. 

At the end of the day, all investors are investing in early-stage startups or high-growth ventures to make money. Strong management complemented by a compelling business idea that targets a large market size with some traction has the potential to generate high returns. Even if it means taking a high risk can help reverse an investor’s no to yes.