How Investors Evaluate Start-up Ideas?
A lot of people are of the opinion that obtaining venture funding can be very difficult for a startup business. This is true to some extent. However, it is also true that a large number of founders in the market do not know what a start-up is. Every company which comes into existence is not a start-up company.
A start-up is a company that has been created with the purpose of being able to grow very fast within a short period of time. Such companies should be able to add scale within no time. If the company is not created to grow rapidly, then it should not be classified as a start-up. Instead, it can be thought of as being a regular small business. There is nothing wrong with being a small business. It’s just not the kind of business that professional investors are looking to invest in.
In this article, we will try to understand some of the characteristics which are used by investors to evaluate potential start-up companies.
- Finding a Good Problem to Solve: In order to know whether a start-up firm will be able to survive and grow in the long run, investors first try to focus on the problem which the start-up is trying to solve.
It is very important that the problem should be faced by a large target market. If a very small sub-section of the population is facing the problem, then the potential market may be too small. Also, it is important to ensure that the market is already in place for the start-up.
If the start-up company is attempting to modify the behavior of its potential customers, then such behavioral modification can be difficult as well as expensive. It is also important to ensure that the market for the product is in the growth stage itself. This is because companies that enter such markets automatically start growing at the default rate of growth in the market. This is not likely if the market is stagnant or shrinking.
- Building a Competitive Edge: The next thing that investors tend to look for in the start-up is a competitive advantage. There have been several cases where a bright entrepreneur has built a product or has defined a market. However, instead of being able to reap the rewards, these entrepreneurs ended up losing market share. This generally happens because competitors with deep pockets are able to execute the idea better than the start-up who initially thought of the idea. To prevent this from happening, the start-up needs to have a product or service which cannot be easily replicated. This is the reason why investors tend to prefer tech start-ups.
Tech companies can create intellectual properties which help them sustain the competitive advantage that they obtain by developing the product first. There are other ways to build a competitive edge. However, those methods involve the use of branding which can be an expensive proposition. The company needs to find a competitive niche. Their product must be either the cheapest, fastest, or best in some other way. Products without sustainable competitive advantage fail to attract investor interest.
- Structuring the Company to Grow Rapidly: The next step is to create the company in such a way that it can grow at a rapid pace. There is a great deal of discussion on automation, asset-light business models as well as scalable business models. All these topics have been discussed in detail in different articles. For now, it is important to note that start-up companies have a fundamentally different structure as compared to small businesses. Entrepreneurs must study high growth formats and must structure their business accordingly if they hope to obtain investor funding.
- Customer Acquisition: Lastly, investors are highly interested in the cost of acquisition that the company is paying in order to acquire customers. This is because, over the long run, companies may be required to scale up their business by adding more customers. This will have to be done rapidly.
Companies that have a business model wherein a large amount of money is used to acquire newer customers are not preferred by investors. This is because such a business model may attract the wrong kind of customers.
Customers will come to the company, not because they like the value proposition of the product being offered, but because these products have been made artificially cheaper by the seller. Needless to say, when the seller tries to sell at full price, a lot of these customers will switch to other service providers.
It is important that the company’s customer acquisition model be organic as well as inexpensive. This helps founders identify the real degree of interest which customers are showing in their products or services. Another reason that start-up companies should refrain from using monetary incentives to increase customer acquisition is that there is always a possibility that a company with deeper pockets can beat them at this game.
The bottom line is that start-ups have a very specific set of characteristics that investors keenly observe. If founders study the business models of the companies which have been previously funded by investors, they will see that there is a clear pattern that they can follow in order to have a better chance of raising capital from investors.
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