How To Evaluate A Pre-Revenue Startup
I’ve heard from quite a few skeptics that it’s next to impossible to evaluate a pre-revenue startup. While it’s not the easiest job, I’ve relied on several models in my experience of being a seed-stage startup investor in the last seven years. Below I’ll share those that have been particularly useful as well as what to pay attention to when starting out as an angel investor.
To begin with, let’s look at how to recognise a startup amongst all sorts of small and micro companies out there. The definition I tend to favour, because of its simplicity, is one that refers to a startup as a hypothesis as to why a given business model could yield high (or even exponential) growth. There are plenty of models out there, even disruptive, that aren’t designed for scale - then, it’s simply a small business.
When looking at a new startup, before I use a more formal way to establish its value, I pay attention to a few factors. Firstly, an easy one to gauge: the stage of the company. I invest in seed and pre-seed stages only, for two reasons. Firstly, the potential upside is higher (which goes together with a higher risk of course!) as startup founders give a higher proportion of equity in very early rounds of funding, typically 10-30%. Secondly, I like to benefit from SEIS and EIS tax breaks which de-risk my investments significantly. For those unfamiliar with how they work, for investments with SEIS qualifying startups, you can get 50% of investment value back as personal tax savings and for those with EIS status - 30%.
Secondly, I pay a lot of attention to the founding team. Are they experienced (ideally having run or managed startups/small businesses before)? Is there a market-founder fit? This refers to founders having directly experienced the problem they are trying to solve (typically the more frustrating it was, the higher the motivation to eliminate it!) or at least, have extensive knowledge of the market they operate in. Next, is the wide total addressable market (TAM), which goes without saying given my first point around the scalability potential of startups. Lastly, the versatility of skills on the team (eg there being a product and sales-focused cofounder) and quality of the idea itself. Personally - unlike other investors I know - I tend to pay less attention to financial due diligence as at seed/pre seed stage it’s all speculative anyway.
After I’ve made these checks and I’m still keen to take the potential investment opportunity further, I typically apply a more formalised assessment model. One of my favourites is that designed by Y Combinator, possibly the most successful startup incubator in the world, founded by Paul Graham. It’s simple but effective and takes into consideration both the rational and emotional aspects of an investment decision. It takes into consideration four factors - supply (the problem or initial conditions), demand (the solution and offering), the connectors (drivers, insights or reasoning as to why the company will connect the supply and demand and create economic value), the beliefs (excitement, positive emotions surrounding the company and its people).
According to this particular model, an ideal PROBLEM will be:
large - millions of people/organisations affected,
growing - a market growing at 20%+ annually is said to be growing fast,
have urgency - people are trying to solve it immediately,
costly to be solved,
associated with a high willingness to pay by those who are affected,
somehow mandatory to be solved (e.g. through legislation)
associated with a high frequency (ideally in need to be solved multiple times a day)
comprehended in a matter of minutes with specificity and the simplicity of manners,
ideally experienced directly by founders themselves (which was the case for example with founders of Airbnb or Uber).
Not all of the above need to apply but the more do, the higher the startup scores towards me making an investment decision. Similar applies to the remaining three factors broken down below.
An ideal SOLUTION will:
trigger users’ motivation and empower them with problem-solving tools and features,
have users who are describable in detail: their needs, personas, how often they interact with the solution, the intensity of their pain, their willingness to pay, and how they can be communicated with are all obvious.
One thing to add here is that many startup ideas I evaluated are, in essence, based on solutions (often highly technical) looking for a problem, other than very specific - and painful - problems looking for a solution. Representing the latter, nor the former is really the kernel of a good quality startup idea.
As part of the YC startup evaluation model next comes the assessment of the strength of the company’s “unfair advantage”. Essentially, as an investor you’re looking to identify whether the venture in question is uniquely equipped, because of various different factors, to succeed in the marketplace it is targeting, at this particular time. These factors can include (but aren’t limited to):
the founding team - their experience and/or expertise in a given area making them perfectly positioned to solve a given problem,
the inherent market - studies show that when it’s growing at 20%+ annually and the number of target customers is large, then by default, the solution is expected to grow without much investment,
the solution (product) - becomes the unique advantage when it’s 10X better than the current competition, which could mean a 10X better user experience or being 10X cheaper,
customer acquisition - when there’s significant organic growth, by word-of-mouth and viral channels (as opposed to e.g. paid advertising campaigns on social media)
great timing - occurs when a startup is able to catalyze energy from early customers, early employees, angel and seed investors, and the media to gain social momentum for its mission,
network effects - refer to the reasons that will make the startup more difficult to be defeated by competitors as it grows and scales. As a potential investor pay attention to indicators that point to the fact the startup will become more difficult to or be defeated or threatened as it scales.
Finally, there are qualitative factors (i.e. your beliefs as a potential investor) to consider. I like the fact that the YC evaluation model doesn’t omit them like some other models do. How we feel about a given decision goes hand in hand with logical reasoning. What is more, a gut feel or intuitive hunch about something almost always precedes any rational argumentation and analysis we may decide to conduct. This doesn’t mean the latter isn’t worth pursuing, merely that both intuition and the mind play an important part in a decision-making process.