Investing in a new business can generate great rewards further down the line, but while there can be a big pay off, there may also be a pretty big risk involved.
90% of startups fail within the first 5 years, so it’s important to conduct a thorough risk assessment to determine whether or not the possible returns outweigh the initial investment risks. Here are 5 quick tips for assessing startup investment risk:
Determine the value of the startup
Valuing a startup is challenging, but it is an essential part of risk assessment as value works to determine share percentage. It is often best to avoid standard valuation methods for young businesses, as there will typically be very little data that can be used.
Instead, there are a few alternative techniques, such as discounted cash flow analysis (DCF) which predicts future cash flow, the venture capital method which estimates a selling price based on per-share earnings, and the First Chicago method which generates an upside, base, and downside valuation. While not always accurate, these methods can be very useful.
Revenue is a vital consideration in terms of risk assessment, and it is recommended that investors look at startups who are not only able to show where their money is coming from, but that this money is expected to continue month on month.
Monthly recurring revenue (MRR) is typically clearer to analyse with subscription-based businesses and those offering rolling contracts. Statistically, there is less risk with businesses showing solid business models and contingency plans to minimise risk if something goes wrong. This could be anything, including business continuity plans and the use of data backup services.
Evaluate the product
When assessing risk, there are two product/service-related risk factors to take into account. The first is the product itself, and whether it is a reliable and necessary contribution to target audiences. In many cases, products that protect the needs of the user are generally lower risk, so look for aspects such as software escrow agreements.
The second is your own familiarity with the product. According to the Returns to Angel Investors in Groups report by the US-based Ewing Marion Kauffman Foundation, higher investment multiples are statistically more likely when investing in something that is familiar.
Analyse the market
Regardless of whether a startup is offering products/services that you are familiar with, one big question remains: are people going to buy? Take some time to look into a startup’s customer acquisition model (CAM); both the model they are using now, and the model they expect to use in the future.
It is essential that a startup not only knows their CAM, but actually understands their CAM, too. Once again, subscription and software-as-a-service (SaaS) based businesses with provable MRR may pose less risk, but consider churn rate; how many new customers are coming in versus how many are going out.
Take a close look at the team
Warren Buffett is famous for his ‘15% ROE’ rule. According to Buffett, investors should only consider businesses with a 10 year average return on equity totalling 15 per cent at the very least.
While this can’t be applied to startups and young businesses, the reasoning behind this rule is an important consideration.
Allegedly, a 15% ROE equates to a capable management team. It’s also important to consider the background of the involved team, with experienced entrepreneurs more likely to succeed, according to the Performance Persistence in Entrepreneurship article published in the Journal of Financial Economics.