How To Evaluate Startup Equity: Key Metrics And Due Diligence For Investors

Startup equity investing is emerging as a preferred investment platform for new-age and seasoned investors. It provides an early mover advantage to investors to reap the exponential growth that startups may offer.

However, investing in just any startup may not lead to exponential returns on investments (ROI). Let us discover the key metrics and important considerations for investors when evaluating startups for startup equity investment.

Importance Of Evaluating Startup Equity As An Investor

Before investing in a startup, it is crucial to evaluate the same. Evaluating a startup involves a deeper analysis of financials, reviewing the legal documents, competitive landscape, market size, management team, product segment and operational metrics. The goal is to identify potential growth opportunities vs. risks. To increase the chances of success with investment, investors must evaluate the business and conduct a performance assessment. It provides the following benefits:

• Risk mitigation
• Improved decision making
• Investment valuation
• Post investment monitoring

Unique Considerations Of Startup Investments

In the early stage, investors can invest in startups during multiple phases such as ideation, product development, launch, pre-revenue, or minimum viable product (MVP) stage. However, evaluating early-stage startup businesses is tricky because little information is available. Usually, these companies have nil or minimal revenue, and business establishments incur huge expenses.

Ideally, investors must choose startups in a hot sector with high dynamics and market needs. Also, the businesses they choose must have a higher scope for scalability. Customer traction and the possibility of getting repeat customers are also good indicators of growth potential for startups.

Some of the strategies that investors use to evaluate early-stage startups are:

• Berkus Method: Formulated by an American venture capitalist and angel investor Dave Berkus, it is a highly approximated method for simple valuation. Here, pre-revenue startups are evaluated for crucial aspects such as product prototypes, sound ideas, leadership team quality, initial sales, and strategic relationships.
• Scorecard Method: The rating is given to multiple aspects such as business size, technology, product, sales channels, business stage, etc. The weighted average rating is used to derive the value. This method is more elaborate than the Berkus method as it evaluates multiple factors of startup businesses.
• Discounted Cash Flow Method: It is a widely used evaluation technique for pre-revenue startups. It provides more importance to forecasted cash flows for the business to determine its worth. In this method, investors will evaluate a startup based on time, risk, and money involved in the investment.
• Times Revenue Method: The revenue of a particular period (usually a financial year) is considered, and a ‘multiplier’ is applied to this. Depending on the industry and growth potential, the multiplier can range from 1x to 10x or even more.
• Comparable Transaction Method: This is a conventional valuation method used to compare a similar startup and calculate an estimated valuation. It uses information on how other startups have been acquired or valued. This method becomes irrelevant when comparing a unique business with no precedents but is quite prevalent when comparing similar businesses.
• Venture Capital Method: Here, startups are evaluated based on terminal or exit value. This method evaluates vital profit and loss metrics, turnover, and market risks to generate a net present value. This is compared against the exit value rate to determine the effectiveness of the investment.
• Cost-to-Duplicate Method: In this method, expenses involved in duplicating the startup are considered to ensure that the investors don’t pay more than the business cost.
• Risk Factor Summation Method: This method combines the benefits of Berkus and Scorecard methods. Different business risks are graded and positively or negatively impact the calculated value.

Key Metrics And Due Diligence Process

Due diligence is essential for investors to make informed decisions. One can find investment options with higher profitability by assessing and understanding potential investments.

Investors must know the qualitative and financial measures to evaluate startups before investing. The goal should be to gain essential insight into the dynamic startup landscape. Even though one must crunch numbers, looking at the holistic aspect of the startups is also essential. While the company financials are important, investors must complete due diligence of the startup on the below parameters:

• Management Team: In early-stage startups that have yet to generate revenue, investors are ideally betting on the founders and the management teams. Investors must investigate the team's experience level, domain expertise, and individual value contribution. Some key factors are technical product speciality, better business insight, long-term vision, and management cohesion.
• Product Market Fit (PMF): An early-stage startup's PMF validates the product in the target market. Businesses that create products actively consumed by the target market will have higher success rates. It is a crucial indication of future scalability and growth.
• Product Differentiation: To mitigate threats from competitors, investors should invest in startups with product differentiation. It provides a competitive advantage and helps protect the business's market share.
• Traction: Traction refers to the momentum a startup gains in customer acquisition, user engagement, market share acquisition and revenue generation. It indicates that the startup is on the right path.
• Accounts Receivable (AR) Growth: Investors must evaluate net new AR and ensure its foreseeable growth over time. It indicates demand and interest for the product and shows that the company is quickly growing.
• Good Sales Efficiency: Even with positive growth, investors must ensure the company is not overspending. The magic number needs to be one. The revenue should be almost one dollar for every dollar spent on sales and marketing.
• Potential Return: Investors must also evaluate potential returns and how big the company can become. Returns are higher when investing in early-stage companies and lower in leader-stage companies.
• Cash Inflow: Companies must be able to run their business for at least two years with the cash they have. If the funding is tight, startups should do everything possible to make the cash last longer. It is an indication of capital efficiency.

Conclusion

Startup equity is an exciting investment avenue. To be successful, investors should look for a path to profitability against exceptionally high growth. The analysis should begin with research about the company and its founders. There also needs to be a potential synergy between the entrepreneur and the investor. 

Analysing industry trends and evaluating the competitive landscape helps investors understand the risks associated with the business model. The overall positioning of the startup and its market opportunity will also shed light on realistic returns that investors can generate. By calculating such metrics and applying best practices for due diligence, investors can increase their chances of investment success.

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