The Start-Up Guide: What Do Investors Look For?
“Investors are pinched between two kinds of fear: fear of investing in start-ups that fizzle and fear of missing out on start-ups that take off” – Paul Graham, Co-founder, Y Combinator
The perspectives of investors vary towards start-ups at different stages of their journey. Investors’ prime job is to look for and invest in start-ups that can provide them with the expected returns. They neither want to lose out on an opportunity nor incur losses on their investments. On the other hand, funds are like the life blood of any new age start-up or venture.
Every kind, source and amount of funding is critical for a start-up. In India, young start-ups raised 3.5 billion dollars in the first three quarters of the year 2016 through 815 deals according to a YourStory research. This represents the strong inclination of entrepreneurs to raise funds in India to either start or scale up their venture. Investors see India as one of the biggest markets for start-up investments.
“Entrepreneurship is now mainstream. There have been around 4,000 startups founded in 2015 in India, a 400 per cent increase from 2010. Everyone knows someone who’s a founder. No wonder that newspapers now have pages dedicated to the VC industry” – Vani Kola, Managing Director, Kalaari Capital
To begin with, every entrepreneur looks for arranging funds from their savings- also known as the bootstrapping stage. Flipkart which has grown into a big billion business today was a bootstrapped company from 2007 to 2009 handling approximately, a hundred orders a day.
Next, entrepreneurs seek funds from their family members and friends. Funds from family friends may give an entrepreneur the required courage to go ahead and plunge into the risks that come with the typical entrepreneurial life.
A similar thing happened with Richa Kar, Founder of Zivame. She raised INR 35 lacs from her friends and family including her savings. Such type of funds may take the form of a gift, loan or equity. The friends and family members may expect nothing or many things. They might expect some interest on money lent with the principal amount or even part ownership in the start-up:
Before the investors came
1. Gift – Close friends and family members may give money as a gift. They usually do not expect any real output out of this. They consider it as a favour that may not give them any tangible returns in the future. So, an entrepreneur doesn’t have to pay the money back.
2. Loan – This is one of the optimal ways of transacting with friends and family members for investing in a start-up. They may expect the money to be returned with a decent amount of interest on the principal amount, which can also be locked in with a formal, legal document.
3. Equity – For some friends or family members, an entrepreneur may not pay back the money in cash and instead make that person a business partner, as per their expectations.
Also Read: Why Market Research Is A Must For Start-Ups
As any entrepreneur moves ahead in their journey, more funds are required to create a prototype of the product and come out with a Minimum Viable Product or MVP and test it out in the market to assess basic assumptions. At such a stage, entrepreneurs rely upon seed funds usually provided by angel investors or small venture capitalists.
Angel investors are usually wealthy or rich people/successful businessman who invest their own money into a prospectively rewarding business opportunity. On the contrary, venture capitalists (VC) are the organisations that invest more in mature start-ups and, typically, come with larger funds. VC funding is preferred after the product has achieved some traction.
At an early stage, start-ups usually do not have a significant track record. Naturally, this makes the job of angel investors extremely difficult, i.e., to evaluate them for investment without a proven track record. Considering this, there are three key elements that investors focus on while judging any start-up in its early phase:
1. Idea – The early stage financer looks at the uniqueness of the solution provided by the venture. The solution provided must be centred around solving a relevant pain point in an interesting and innovative way. OLA envisaged the idea of aggregating the taxi services in India which was one of its kind – which is a challenge that many face. Ola made the process of searching and hailing a cab extremely easy and convenient for consumers across the globe.
2. Opportunity – Angel investors are interested in start-ups which have an idea that is scalable in the industry. Opportunities arise from a considerable gap that exists in the market (that the idea aims to plug; eg: washing machines shifted us from a hand-washing clothes world) or from the introduction of a new product altogether that simultaneously creates and fills that demand (eg: The Apple computer or Mac products are often touted to have done that). Startups with the mountable idea in the market have the possibility of providing good returns to the investors.
3. Founding Team – The founding team of the start-up is valued a lot by the investors and plays a big role in the decision to fund or not. Investors perceive that a prodigious founding team even with a mediocre idea can create a big billion business. Rather, even if the idea fails, a great founding team can come up with a new idea and make it work. Sequoia, a big VC firm, mentioned that Kunal Shah and Sandeep Tandon, who co-founded FreeCharge in 2010, are an improbable set of founders with deep conviction in their approach. They are incredibly grounded, creative and an open-minded founding team, willing to learn about building a mobile and internet business.
Bottom line is:
“What an investor wants to see – an entrepreneur working on a big problem, with a good business model and satisfied customers.” – Nikesh Arora, Former President & COO, SoftBank
When a product is accepted by target consumers, getting good initial traction, entrepreneurs usually think of scaling up to the next level. After a venture consumes the seed fund in developing the first product and reaching out to their first set of consumers, they require more resources to expand, for which they look for a round of series funding from Venture Capitalists.
Series A round is the name usually given to a company’s first significant round of venture capital financing. After that, there may be other rounds in succession, named as Series B, Series C, and Series D and so on, depending on the need and justification for expansion. Every series funding is critical, and the start-up needs to prove itself at every hurdle.
The investors at every round of series of financing are serious about the traction achieved by the start-ups, considering future estimates and projections. Investors will only be convinced of the money they have to invest once they are shown tangible traction and metrics that can be tracked in the form of data, etc.
“Wait until companies have an initial prototype, have shown that they have the potential to be profitable and have the ability to scale. That’s the best time to invest.”- Dave McClure, Founder 500 StartUps
While pitching for any series funding, entrepreneurs need to tell a story about their business journey and support it with meaningful metrics. At every round of series funding, the investors are always concerned with the metrics that will prove the past success of the venture with the future growth estimates.
While we have already covered some of the broad indicators that affect investors’ decision to invest or not; there are certain key, more specific metrics investors look for in a start-up pitching for any round of series fund. Let’s look at some of these business and financial metrics:
1. Gross Merchandise Value (GMV) – This is one of the most commonly used metric for online marketplaces. GMV is the total value of goods traded in a marketplace within a specified period. It should not be mixed up with revenue. The cost of creating the product will need to be deducted from the GMV before arriving at the revenue figure. It indicates the quantum of business the venture is doing, to the investor.
2. Revenue Growth – Revenue is the money dependent on the amount of sales an organisation generates, in a year. Again, this should not be jumbled with bookings. Let’s take an example of a firm that may have received a booking from a customer for 12 months at Rs. 100 a month which makes the booking value to be Rs. 1200. Suppose, this booking gets cancelled after four months then the revenue to be considered will only be Rs. 400 and not Rs. 1200.
3. Gross Profits – Another important metric after revenue is the gross profit. It is essentially a figure that one gets after deducting the direct expenses from the revenue. The direct expenses usually include the manufacturing cost, logistics cost, etc. This metric helps the investor understand the profitability aspect of any startup.
4. Customer Acquisition Cost (CAC) – CAC is the cost involved in acquiring a new customer. It can be easily derived by dividing the total money spent on sales and marketing, in a year, by the number of customers acquired in the same year. This metric may be high because of heavy marketing spends during initial years.
5. Life Time Value (LTV) – LTV essentially means the amount of money a customer gives, over the period of the relationship with the organisation. The LTV should always be more than the CAC to be a sustainable business. Naturally, an investor would not be interested in funding a start-up whose CAC is more that the LTV.
6. Burn Rate – It is the amount of cash a start-up is spending in running the business on a monthly/yearly basis. This metric provides an estimate of the time till a start-up can sustain itself before the next round of funding, based on the available cash with them.
Apart from business and financial metrics, investors also put emphasis on product and engagement metrics.
Keep ‘em tuned in
1. Active Users – They are the number of users engaging with the venture’s product or service actively. Investors are usually interested in knowing the figures for daily/ weekly/monthly active users. An increasing number of active users is a positive sign for investors.
2. Churn Rate – It is an indication of the rate at which the business is losing customers, monthly. Investors usually have a fair idea about the churn in many industries, and an entrepreneur should know how to defend the churn rate for his venture. The larger churn your business experiences, the more challenging it is to achieve revenue growth.
3. Downloads/Page views – In the case of an online company, the unique page views or the number of downloads are important metrics to track the engagement level of consumers. This kind of traffic metric will help investors evaluate the scale of the venture.
Also Read: UpGrad’s Entrepreneurship Impact Story
As you can probably decipher from this long list of prerequisites and conditions for funding – one of the most key steps to get your start-up on the road – impressing investors and getting everything right is a gargantuan task for most entrepreneurs. However, with our informative, go-to guide on what investors may be looking for, we hope that you feel a little more ready to take on this challenge and set off on a fascinating journey.
Planning to startup? Gain clarity for your entrepreneurial journey through structured frameworks and insights from India’s leading entrepreneurs and industry experts. Explore real life case studies, group assignments and opportunities for networking and collaboration with UpGrad’s online entrepreneurship program – Entrepreneurship Program
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Himanshu is a Content Strategist for the Entrepreneurship Program at UpGrad. He has 7 years of experience in the education sector. He has worked with various universities & B-schools and has also authored a book on Cost Accounting. Himanshu has written 30+ research papers and blogs. He is currently pursuing his PhD in Management while working at UpGrad.