What do investors look for in a tech start-up?


alex
Investment Executive
Published:
investor looking at business document

Lost? Confused? Frustrated? Navigating the investment landscape as a new tech start-up can be a big challenge for budding entrepreneurs. For investors, evaluating start-ups is often considered more of an art than a pure science.

However, that said there are a number of relatively concrete criteria that need to be in place first for an investor to take your start-up seriously.

As a successful tech investor in Wales, we’ve put together some guidance on the matter to help. This list is by no means exhaustive, nor a list of requirements but rather serves to help guide entrepreneurs on what investors think about when assessing a tech start-up:

 

Qualities of a good start-up

 

1. Solves a strong customer pain

According to CB Insights, the number 1 reason why start-ups fail is because there is no market need. It is important not only that the business solves a customer pain but a strong pain at that. Measured on a scale of 1-10 where 10 is strong and 1 is weak, a score of 8 or higher is recommended.  Reliably obtaining this information is often a challenge and probably a topic for another blog post.

A business solution that could have a strong positive impact on someone’s life (solving a strong pain) has a high chance of ensuring your customers part with their hard-earned cash. In other words the propensity to purchase your product / service should be high.

 When you are merely providing something that is a nice-to-have (solving a weak pain), your marketing costs may be very high for very few sign-ups. This can drive up your customer acquisition costs (“CAC”) which is one of the most important metrics within tech businesses. If your CAC is too high, you may need to consider your business’ viability.

 

2. Strong barrier to entry

Investors are usually investing someone else’s money whether it be tax-payers’ money, pension funds or that of wealthy individuals. Investors cannot afford to lose it. Consequently investors look for business ideas where it is difficult for competitors to enter the same market.

Barriers to entry come in a variety of forms such as brand awareness, a ‘sticky’ customer base, patents, intellectual property or proprietary technology. In order to gain comfort, investors will look for an ongoing reason why the company will be protected.

 

3. Aligned management team

This is perhaps the most crucial component of a start-up business because without the team, little else exists. Investors prefer backing a strong team with a weaker idea than a revolutionary idea without the right team.

When constructing your team, think about the following 3 things:

  1. Do you have the in-house skills and experience to execute on your business idea?
  2. Are your industry connections strong enough to unlock your business’ full potential?
  3. Is your team aligned or is one of you merely looking for a good salary and stable job?

4. Innovation

Not every idea can be the next Uber, Airbnb or Facebook but it needs to at least have the opportunity to do so. Copying existing models, otherwise known as “Me too” businesses can make money but do not usually make great investment targets. Investors are looking to back new, innovative ideas that change the way we live for the better.

The product of course also needs to be able to do “what it says on the tin.” Bold unsubstantiated claims are quickly found out after some light due diligence.

Much like recruiters screening CVs, investors review hundreds of business plans and pitches every year so things that don’t quite look right immediately stick out like a sore thumb. Rather under-promise and over-deliver and your investors will always be happy.

 

5. Technology Readiness Level (“TRL”) 7 or above

The TRL scale was developed by NASA as a universal yardstick with which to evaluate the maturity of a technological development. There are various types of TRL scales but the general same concept applies. This reference is particularly helpful when evaluating University spin-outs that are tech-heavy and relatively complicated to understand for a non-specialist.

It is said equity investors will generally struggle to fund anything below TRL 7 due to the lack of transparency as to whether the product will indeed ever reach the market. The level of funding required on these types of projects is also often unknown and can be substantial which may scare investors off. Grant funding is usually recommended for projects in the early TRL stages.

 

6. Large market

As a guideline, most innovative start-ups look to secure 1% - 5% of any particular market over a 5 year period. If you’re looking to capture 2% of the market you are considering and it is say £100m big then it means your maximum annual revenues can only be £2m. If you are raising £500k on round 1 then the economics simply won’t work as investors will be unable to generate an attractive return.

When calculating your market size, it is important to work out what your Total Addressable Market (“TAM”) is not merely the overall market. This is because if you’re selling widgets in Europe but there are potential customers in Japan, will you realistically be able to sell your product in Japan? If so, how much will it cost to generate brand awareness in these foreign territories? It’s often best to focus on a market that is close to home.

Investors may not always agree with your assumptions about your TAM but as long as you back up your figures with logic, it will help show that you understand who your actual target audience really is.

 

7. Low competition

If you cannot find any competitors, it is possible that your idea is not very good. A little competition is good as it means A: someone else thinks what you’re doing is a good idea; and B: through their marketing efforts, they will help raise awareness in the market which should contribute to your sales line.

Unless your idea is a completely new innovation which is truly disruptive, mature markets are generally not attractive as it is difficult for a start-up to compete with the large incumbents.

This is equally true of sectors in their infancy where your competitors are very well funded. If you are seeking £500k equity and your competitors have already raised £50m, it might be a good idea to consider alternative options.

In summary, you generally need to be ahead of the curve and have entered the market at the same time or slightly ahead of your competitors.

 

8. Sustained competitive advantage

Often termed your “unfair advantage.” You need to give investors a reason why they should be backing your business over anyone else. Why will you win in the current market? Looking into the future, will you still be better than the competition? Often a source of competitive advantage in year 1 quickly disappears and then you might end up trying to compete on price for instance which is termed a “race to the bottom” for a reason.

Note, in the modern world of tech start-ups, “first-mover advantage” is no longer considered a source of competitive advantage and in fact a “fast-follower” position has often proven superior so it’s best to try focus on something else.

 

 

9. Demonstration of traction

The ability of an investment professional to evaluate your start-up is limited by their experience. The best person to provide intelligence on your company is your customers. This is why most investors want some form of demonstration that the market will purchase your product / service. Revenue is desirable but there are other ways to demonstrate traction.

 

10. Sector-experienced co-investment

Like dining at a restaurant, no-one likes to invest alone and in fact nowadays many funds are only able to invest if others come to the table. DBW is no different and we look for our investment amount to be matched or exceeded. Where the money comes from is also extremely important. In an ideal world a co-investor would be a sector expert with strong industry connections and be able to take an active board seat in the company.

 

11. Appropriate valuation and raise

There is often a lot of confusion on what is a reasonable valuation for start-ups.. As a general rule, like selling houses, it is best to let the market decide what your valuation is.

If you’re a pre-revenue business in the UK, a pre-money valuation above £1m often scuppers your chance of raising investment from angel investors who are oh so important at the early stages.

Business schools teach that you should raise enough capital to last the business 12-18 months and look to sell down roughly 15% – 30% of equity on each round of financing. That means by the time you exit, you ideally still own roughly 15% - 30% of the equity depending on the size of pie. This gives you a ballpark idea of what your valuation should be. If the numbers come out looking odd, you may need to revise your cash burn projections downwards and take a more bootstrapped approach until you can justify a higher valuation.

 

12. Realistic financial projections

Yes, investors all want to see the classic hockey-stick projection model… However, the financials need to be realistic and achievable at the same time. There’s no point in painting an overly optimistic picture. It is unlikely to impress and could set you up for failure the next time you look to try secure funding. Always go with something conservative and if you must, show a blue-sky scenario to illustrate the potential of the business but put this on a separate slide.

Creating early-stage financials may feel a bit like trying to predict the future. The best way to look at the exercise is to break it down into the various components. Revenue is probably the hardest to predict but costs are almost a certainty. Unit economies are even easier to construct e.g. I buy widgets for w, process them for x and sell them for y, so my profit per unit is z. Then you can look at your CAC and the lifetime value (“LTV”) of each customer. These simple exercises will help you better understand your business and lend credibility to your business plan.

 

13. Attractive sector

Not all sectors are created equal. Some sectors, such as property and construction, are very resistant to change. This often results in a long sales cycle and low conversion rates which negatively impact on how long your cash will last.

Other sectors are not very investable for many investors, such as cryptocurrency. Although it has great upside potential, it is often too difficult for investors to quantify the associated risks and get comfortable with the volatility.

Is your particular sector attractive for investors?

 

14. Robust business model

Your pricing strategy and business model need to be realistic while still producing attractive margins. Models based on trying to sell advertising are typically not investable because it usually costs more to acquire a customer than you can extract from them – the old CAC vs LTV equation.

A good test of your business’ viability is charging your potential customers as early as possible. Yes, you could monetize later but more often than not, at that stage companies find out that their customers are unwilling to pay or that the wrong product was built.

Some people say that if you are fundraising, the best person to ask for money is your customers because it ensures that you remain laser-focused on their needs and build what the market wants, not what you think they want.

Charging your customers full price is also important. Over recent years there have been many meal delivery services that were subsidised by VC funding. In a number of instances, the funding started running low and the businesses were forced to pass the full costs onto the customer. In many instances, the customers stopped buying altogether as the offering was only attractive below a certain price point which was not sustainable for the business. It’s always better to find this out early.

 

15. Clear exit strategy

Real potential exit opportunities are arguably the most important criteria that investors consider. This is especially true with early-stage venture investors because they are unlikely to have their capital returned via dividends. Therefore, the priority is usually to sell the company. This needs to be realistically achievable within a 5 – 7 year timeframe.

It is good to research what acquisitions have been occurring in the industry, who is buying and at what price. This is usually a multiple of Revenue or EBITDA. These metrics are also helpful for setting a rough valuation for your business. SAAS businesses usually attract higher multiples of revenue, especially if the business can demonstrate very high growth.

Doing your homework here will likely add credibility to your proposal and probably help you understand the sector far better.

 

Conclusion

There are clearly many factors at play in start-ups and many of them are constantly evolving. One thing that's certain is that there’s no such thing as “perfect information”, but if you can help give investors 90% certainty, they only need to take a gamble on the remaining 10% in order to make an investment decision.

Remember that your investors are not just providers of capital, they become your partners in the business. Accepting investment is the start of a relationship so make sure you choose wisely at the start and take a long-term view.

If you think your start-up is suitable for equity financing and you would like to be considered for funding from the TVI team at the Development Bank of Wales, please get in touch below.