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Investing in Start-Ups – Real life Experiences

The first time I was approached to invest in a ‘start-up’ I was flattered. I must be important! I must be in a new club and I will be part of the next Google.

The fact is that making money on a very early start-up (pre significant revenue) is (at best) a lottery ticket. I made the mistake of concentrating on the idea. Surely that’s the main thing to look at ?

Now twenty years on and a few successes and a lot of not-successes my view is different, very different.

First – There are No new ideas. If someone tells you that then walk a mile. Actually run! Execution is king, positioning is king and the management is king.

I have been presented with so many business plans developed using a revenue growth multiplier by quarter. Each growing based on some exponential function. Next quarter = 1.3 x previous quarter and then extrapolated 20 quarters.

Most engineers have never sold and most engineers seem to start companies with their pet engineering project.

A good founder will be able to explain who his poster-child customer is and will be able to quantify in dollars, pounds or euros the financial motivation of the customer to buy the start-up’s product. Most can’t. Avoid the start-up that does not have a highly detailed picture of this poster-child. Is he a sophisticated customer? This needs to be enough to select this person in the dark!!!

How will the prospect generation / filtering / pitching / closing be performed – what will be the customer acquisition cost ? This CAC is another of the key criteria. Ideally some trial will have been conducted to make an objective assesment.

Avoid pitches which have more technical content than sales strategy. Software is just a function of money. It will take two or three times the time and cost that is pitched. Focus on the business. Act stupid – because customers want benefits and not features.

Product-Before-The-Product

Start the pitch with the start-up treating you like a customer. As if they have finished the product – how much will this new gizmo make you (in the case of B2B). If it is B2C then the big boys will crucify you if you scale .

As for valuation

Remember – if you invest at a valuation of $5m, then you will need to make enough in, say, 5 years to

  • Make up for the high risk of a 10% success rate just to stay even
  • Make a profit that is more than a Nasdaq over 5 years – by a margin !!
  • Allow for dilution or lack of exit liquidity

So lets say we invest at a pre-money of 5m. Then the 10% hit rate takes our target to 50m. Now lets add a return for the risk premium of 5x and we are at 250m.

Lets back that into revenue and assuming some solid and continuous growth we might look at a p/e of 20 or a price/sales of 5. That gives a target revenue of 50m – Ask yourself how can they grow to that ?

The last thing I want to mention is the fear of missing out

It is easy (I’ve done it) to view not investing as some form of impotence. As if not investing is the weak option. Believe me WALKING AWAY is usually the best option. Unless all the above have been really and conclusively addressed.

So – in conclusion

  1. Don’t be flattered
  2. There are no new-ideas
  3. Understand the poster child customer
  4. Do the maths on exit valuation and sales revenue needed to support it
  5. Not investing is not a failure WALK AWAY is a great option

More later, but in the meanwhile – stay safe and don’t let someone with a flattering Powerpoint spend your money.

As Elon musk said “everything works on powerpoint !”

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