Deciding to invest in a startup — where to begin?
Investing in startups is hard. It’s difficult to predict the future and to assess the capabilities of a team when they’re at the nascent stage at which we generally invest. You never know how far a company may go by judging it at first glance. My biggest fear is turning down a company that becomes the next Xero or Rocket Lab — and frankly, when those ideas were raising seed capital, they probably sounded pretty crazy to most people!
There is no magical way to know the potential outcome of an early-stage startup. At Icehouse Ventures, our team is presented with hundreds of startup opportunities each year. We follow and adhere to outlined investment criteria to help our decision making. This enables us to screen deal flow efficiently and concentrate our efforts on prospects most aligned with our investment thesis.
Over the past year, I have developed my skills on how to evaluate startups, specifically, trying to pick winners. Ultimately, it comes down to investing in an amazing team in a massive market. We like to say we invest in brave kiwi founders building global companies. I’ve elaborated below on the two biggest areas we focus on in our discussion — the market size and the team.
1) The Total Addressable Market (TAM)
For a company to be “venture investable” it needs to have the potential to be really big. There is a good reason for this, we operate funds that are diversified across lots of companies, most of which won’t work out. Startups are very risky and most fail so we expect that all of our returns will come from a few outliers in the portfolio. To cover the losses of the companies that didn’t work out, the returns from the successful outliers need to be big. To receive a sizeable return you need a market leader that is growing into a very large, expanding market. How big is big enough? That’s a good question and hard to answer definitively.
Some argue that you want to see a line of sight to the company being able to produce $100m of revenue per annum without being near touching the sides of the TAM. Some say they want to see the market growing at least 20% per year. The reality is, sizing a market is a bit of a messy business. Trying to define the difference between TAM and speculation is an art more than a science a lot of the time. One simple way of thinking about it is, we want to invest in companies that could one day be worth billions not multiple millions. To do this we need to be correctly investing in big trends playing out globally or invest in a company changing a very large incumbent market. This obviously makes for a lot of fun office chat.
2) The Founding Team
We aim to invest in founders that know something that few know about the world, or think about the world in an unconventional way. We invest in unique insights and teams that we think can execute on those insights. It feels wonderful speaking with someone who is full of passion, drive and ambition to change something in the world. You can often tell if they have the fire in them ready to change the world and build an empire. It’s the sparkle in the eye.
Our early conversations with founders help create conviction for us as investors. We want to understand the why behind what drives the founding team. We want to believe that they have the potential to lead a 1000 person company one day. We look for magnetic founders we think can attract other high-quality talent to join the team. This magnetism isn’t always overt or extroverted. Some of the most compelling founders have quiet confidence and clarity. I always like to figure out what the founder’s motives are and what’s driving them to embark on possibly the bravest journey of their life.
3) Other: The Solution, Competition and Milestones
Every pitch involves someone explaining their unique solution to an identifiable pain point. We often ask is there sufficient evidence of this customer pain point at scale? Will the solution be a novel game-changer that will disrupt the market or will it just provide minor improvements? It’s always beneficial when the founders have clear and compelling metrics to initiate a conversation around early demand.
Competition plays a huge factor in the evaluation of a startup. If the market is far too saturated and the idea isn’t going to change customer behaviour, then it becomes less attractive. Of course, there will always be competitors in the market, both direct and indirect. It therefore becomes a matter of the startup making themselves become an outlier in their industry.
Are the milestones the founders have outlined achievable and realistic? Further to this, will these milestones entice a venture round after the first capital raise? Additionally, we like to find out if there’s enough current cash in the business to have a margin of error to achieve their milestones.
General investment criteria for early-stage startups is not limited to the considerations outlined. There is a lot to evaluate and this takes time. Sometimes closing a deal can take many months after all the hours spent on due diligence. On occasion, we end up passing on a company after having invested a significant amount of time with them. However, as mentioned, you never know where a startup may end up. There will be moments where we look back with regret but also moments where we celebrate because a company we chose to invest in is rapidly rising to success. Decision-making is always difficult, especially in startup investing, but there are certain factors that can make the process easier.