An insider’s guide to what sophisticated angel and VC investors should look for in startups

Background

I am a young, entrepreneurial and passionate private equity and angel investor. I grew up in the US and now live in Tel Aviv. My main role is an investment professional with one of the largest private equity (PE) firms in the world. Before PE, I was an investment banker.

Until a few years ago, I thought that my strong financial and investing expertise only lent itself to investments in large, proven companies (the focus of PE and investment banking). Then, my dad asked me to evaluate a seed stage startup for an angel investment. I took the same approach I would for an established company and it worked (~3x in 2 years). This experience led me to the realization that the diligent and technical approach used for large-scale investing is extremely relevant for early-stage investing as well.

I invest alongside my dad, Gil, who is the CTO of Dun & Bradstreet. He is a true technology and operations expert who always brings great insights and asks the right questions.

Overview

There are so many brilliant and exciting startup ideas out there. Part of my love for startups is due to my countless hours spent with family and friends tossing around ideas of seemingly genius inventions or awesome services. It’s crucial to remember that a great idea does not necessarily mean a great investment.

Below is my framework for evaluating investments. The key to this method is testing each quality in a vacuum and then counting how many qualities the startup passes. If the startup has a high majority, that’s a good sign. The last step will be to look at the qualities it doesn’t pass (your cons to the investment) and see if all the pros can overcome them. The art is judging all 12 separately and then together.

FYI, this list should also be relevant for a potential founder pondering if their idea is a winner.

12 qualities to look for when investing in a startup

1. Barriers to entry
   • A few common barriers to entry are strong customer loyalty (Apple, Starbucks, etc.), proprietary tech (Tesla, Lightricks, etc.), high entry capex requirements (SpaceX) and founders having market expertise (David Neelman founding Jetblue and Azul)
   • Barriers to entry don’t mean that a competitor can never enter, but more that it will be a grandiose task that’s expensive, long and hard to accomplish.
   • A key question to ask is “can someone else make this product / service quickly & relatively inexpensively and can they be equal (or better) to this startup?”
   • Without barriers to entry, the market can become commoditized and the company will probably find itself spending a lot on marketing and lowering its prices.
   • This bullet may be contrarian but be wary of the first mover advantage theory. It’s usually not a very defensible barrier and if the company is telling you this, it probably means they don’t have any other barriers.
2. Profitability
   • While it may be hard to be profitable at the beginning, you can still understand if the underlying business has strong financial qualities. Every industry is different so I can’t give a specific numerical figure but you need to make sure that the costs to sell the product and operate the day-to-day business are not too big a chunk of the revenue.
     • In some cases, the company is expanding and not profitable, but you can look at the economics of one geography where it already is at relative scale to see if the business works.
   • If it’s a SaaS company, make sure that their marketing and R&D expenses aren’t too high. It may be the case that the startup will need an unrealistic sales volume to be profitable.
   • A mistake startups often make is thinking they will be very profitable at scale. Remember, that you need to make it to scale.
   • Lifetime value (LTV) to customer acquisition cost (CAC) – this point deserves a whole post but, for now, a few important things to look for / remember:
     • A few months (or even 1-2 years) of data is not really trustworthy. It’s very hard to extrapolate how much a customer will spend when you haven’t analyzed their behavior for long enough. Also, your first customers have completely different behavior than your customers once you’ve normalized in the market.
     • Make sure you understand how many years it takes for the customer to become profitable (AKA brings in more money than his CAC). Often times, a company will say they’re LTV / CAC positive, but this is on an LTV of 7 years. If it takes 7 years for the customer to become profitable, she is probably not worth it.
3. The team
   • Usually your gut will give you the best answer. A few things I look for are:
     • Passion
     • Modesty and openness to seek out advice
     • This is probably a contrarian tactic but I try to avoid “serial entrepreneurs” – I believe that if the company hits a road bump, they’re more likely to quickly move on to the next thing instead of fighting to the last second to save it.
4. Competition
   • A crowded market is really tough to win. Even if the product is better, you often need to spend so much money to acquire customers that it’s just not worth it.
   • It’s very hard to know who will be the winners of a crowded market. Think about the example of buying glasses online. A bunch of companies are trying and in the near-future, it will probably be a huge market, but I’m not going to try to guess who the winner will be.
   • Don’t fall for the “all you need is 1% of the market” line – those 1% probably won’t buy from the company if there are better options.
   • Even if there isn’t competition today, if there really is a need in the market, there will be. No company is 10x better than its competitors forever. Make sure the startup is ready to move fast and capture market share while they are still by far the best.
5. Limited working capital requirements
   • Working capital = current assets – current liabilities
   • Issues often arise with working capital in high inventory businesses. It’s very hard to scale if you need to buy a ton of product yourself and then sell it x amount of days later. Don’t forget that you need to pony up the cash to pay for that inventory while you try to sell it.
   • In some businesses, there’s a gap between the amount of days you have to pay the supplier and the amount of days the customer has to pay you. If this gap is too big, the company will have issues paying its bills.
   • Too much working capital requirement leads to a need for a ton of equity funding or debt (which is a burden for startups).
6. Market of investors
   • It’s important that the startup has an established market of investors for the future, whether that be VCs, private equities or strategic acquirers. You don’t want your invested money to get stuck or the startup fail because it couldn’t find anyone else to fund it.
   • A few of the many reasons for strategics to acquire a company are new customers, new geographies, growth, technology, the team and achieving synergies.
   • Note that VCs and private equities are often hesitant to invest in markets that they don’t know too well
7. Existing customers
   • I’ve found it extremely helpful for startups to have specific customers at founding or launch. For example, a B2B software startup should hopefully have a few companies lined up that will test their product in beta and purchase subscription packages when the software is ready.
   • Having customers not only helps be a launchpad to the startup, but also turns it into an already operational company with income. Even if the company doesn’t become worth a billion dollars, they have a way better chance to acquire a respectable amount of clients and have a stable business.
8. The need
   • The customer should badly want this product / service. The startup shouldn’t find itself needing to over explain the idea. It’s a great sign if the audience usually cuts them off half way and says “I get it and I can’t believe that doesn’t exist”.
9. Funding requirements
   • The startup hopefully won’t need a ton of funding to become profitable or get to scale. If you hear a pitch and think “this is going to be really expensive to make happen,” it’s probably a bad sign.
10. Scalability
    • Many points on this list touch on the ability to scale but in addition to those, make sure that the total addressable market (TAM) is large enough.
    • Try to avoid startups where scaling means hiring hundreds of employees or spending hundreds of millions of dollars.
    • Understand the financial value / cost of scaling. If a company has a factory and is at 100% utilization, that’s great, but to grow you need to build a new factory, which may not be worth the capex cost. This example also works with needing M&A to scale.
    • Airbnb is a great example of strong scalability. They just need to put an ad in the geography they want to enter, the suppliers and the customers quickly understand the product and sign up themselves without too much operational involvement from Airbnb.
11. Dependency
    • The startup shouldn’t be dependent on one customer or platform. Just as diversification in investing is important, it’s needed within a specific company. A couple examples:
      • There are countless stories of Walmart accounting for the majority of a company’s sales, then Walmart stops buying from them and they go bankrupt.
      • If a company gets 90% of its revenue from Snapchat and usage in Snapchat goes down, your revenue goes down with it.
12. Knowledge of the market
    • If you’re an investor, you should have a pretty good grasp on the market in which you’re investing. The best situation is having already been knowledgeable about the market, usually this happens by being a previous customer or from working in the industry.
    • Be careful of taking the founder’s word on things. Do some research yourself and see who the players are and how big the need really is. If you’re lucky, there are industry reports that you can read, which usually are helpful.

Conclusion

The above qualities should frame your approach to evaluating startups. It’s important to note that you’re usually not going to find a startup that hits all 12 (if you do, reach out to me because I’ll invest alongside you), but hopefully you get a high majority. Be diligent with each quality on this list and don’t only invest based on a good idea or 3/12 qualities.

A few notes:

1. Early-stage investments are very risky and you should be prepared to lose your investment.
2. This advice does not represent my firm’s views and I came up with this on my own.
3. Feel free to comment with any questions regarding the content or your potential investment and I’ll give you my take!
4. I’ll be writing more so add your email in home page to follow my blog or click “notify me of new posts via email” here every so often for new posts.
5. If you liked this blog, you’ll probably like that of my good friend’s, Geffen Posner, which can be found here.