Early Stage Investing Checklist
If you get excited about new technologies and enjoy exploring the potentials of new companies, then you’ll likely find a certain charm in early-stage investing. This post isn’t meant to be your investment guru. It’s more like a self-chat, me jotting down my thoughts to better grasp the world of early-stage investments. Just sharing my two cents, not handing out advice.
The fundamental concept of investing is straightforward. When you invest in an asset, your goal is for your money’s value to appreciate over time. This asset could be real estate, a business, a work of art, or any valuable item. When someone wants to invest in a company, they typically consider two types of factors. The first is quantitative, involving an examination of the company’s financials and their comparison against predetermined metrics. The second type is qualitative, encompassing aspects like the management team, customer loyalty, market dominance, and so forth.
Investing in an early-stage(seed or pre-seed included) company is unique due to the limited financial data available, as these companies are primarily focused on customer acquisition and market penetration. Their financial records often consist mostly of expenditures such as salaries, software(compute) expenses, office expenses, and rent. Consequently, as an investor, you are required to evaluate the company based on this minimal financial information, alongside various qualitative factors. As a result, the significance of qualitative aspects, such as market potential and the founding team’s capabilities, becomes more important. In this post, I will explore various elements of a startup that investors should consider when investing in early-stage companies.
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Story: Most successful startups begin with an inspiring story. For Google, it was “organizing the world’s information,” and for Facebook (Meta), “connecting people.” What is the startups’ story? Does it resonate with you? Be cautious with stories that lack a solid foundation in the market. We humans are exellent at creating stories that appear thrilling initially, but upon closer examination, they may lack substance. Is the market conducive to sustaining their narrative? Take the Segway as an example. Initially, it was surrounded by hype, with claims of “revolutionizing personal transportation.” However, we now understand that Segway struggled to gain market traction due to safety issues, regulatory challenges, and high costs.
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Industry: In “Secrets of Sand Hill Road,” Scott Kupor discusses how VCs assess potential investments, focusing on people, product, and market. Here, ‘market’ refers to the potential size of the market the startup aims to enter or create. When hoping for substantial returns from an investment, it’s prudent to choose a company in an industry with high growth potential. While investing in a business that could become a \$10 million venture isn’t inherently flawed, it’s crucial to consider the industry’s upper growth limit. Here’s a quirky stat for you: the average American earns less than \$2 million in their lifetime. Therefore, a $10 million business is quite an impressive accomplishment. Nonetheless, if your investment strategy targets over \$1 billion, careful consideration is prudent.
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Do You Understand the Business?: While this can be true for any type of investment, it’s especially crucial in startups, as startups pose unique challenges that require strong conviction. You should have a fundamental understanding of the business and the industry it operates in. Lacking this, your decisions might be influenced more by popular trends rather than solid facts. Additionally, familiarity of the business means that during challenging times, your conviction in the venture is stronger due to your thorough understanding of the sector.
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Focus on the Long Game: Early stage investing is a long-term game. You are here for the long haul. Offer value and be appreciative of people. People have many other options to include, and why should they include you in a deal? Try to deeply think about your unique value proposition and what you bring to the table.
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Experience the Product: Always test the product if it’s a customer-facing product or have other people test it to get a feel of the product. Don’t simply buy into what the founders say about their product.
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Don’t put all of your eggs in one basket but also don’t put your eggs in too many baskets: This was the long form of saying “Diversify Wisely”. You should not overly commit to a single industry or concept, as the potential losses may outweigh the gains. Conversely, making numerous small investments across too many companies can also limit your upsides. Rather than allocating a \$X investment in company A, consider investing \$2X in this company and forgo less promising opportunities. This is where the importance of understanding the business (point number 3) becomes relevant once more. With a deeper knowledge of the industry, your conviction grows, allowing for larger investments. In summary, invest substantially in outstanding companies and steer clear of poor businesses.
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Invest at Your Own Discretion: While it can be tempting to follow your smart friends and see what they invest in, you will need to conduct your own due diligence and carry out your research. Ultimately, the decision is yours to make. Have confidence in your conclusions. Avoid half-hearted commitments. No one else will make this choice for you. Remain dedicated, make your own decisions, and then proceed to the next opportunity. The worst outcome is making a mistake and learning from it.
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Founding Team: What distinguishes the founding team as uniquely capable of solving these challenges? Operating a startup is tough and demands a resilient and determined mindset. What attributes in the founding team backgrounds demonstrate that they are the ideal team to tackle this difficult task, no matter how small yet meaningful? Identify these indicators in their lives before the founding of the company. Some examples include: adeptness at rapidly assembling prototypes, early interest in sales and business during teenage or even childhood years, strong ability to get along with others, and prior startup experience.
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Founders’ Market Mastery: Although there are instances of founders starting as outsiders, they must still possess a clear grasp of the market. Founders should be knowledgeable about various aspects, including the target audience and its size, recent trends in the relevant market, indicators of market demand, and market research. At times, founders may not exhibit significant interest in the market but are deeply passionate about their product and technology, often with a long history in the field. For instance, Palmer Luckey, the founder of Oculus VR, demonstrated a great passion for electronics, spending years creating various products and prototypes.
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Time-Tested Founder Goals: If two years ago they said they would achieve revenue goal X, how close are they to this goal? If they lag behind the goal, what’s the reason? Is it because of their poor execution, overpromise, or poor market condition?
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Founders’ Technical Acumen: When investing in a technology company, it’s crucial that at least one of the founders has a deep technical background. If the CEO lacks a technical background, they should at least have a deep appreciation and understanding of the technology. While one could argue that Steve Jobs lacked a technical background, Steve Wozniak complemented him in this aspect. Furthermore, Steve Jobs showed an appreciation for technical concepts, as evidenced by his admiration for Object-Oriented Programming(OOP) when he first encountered it at Xerox.
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Founders’ Character: What do other people think of them? How do the founders treat their employees, investors, and partners? Do other people like working with/for them? More importantly, do customers love them?
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Founders’ Commitment: You would want to give your money to someone who is committed to the idea. There are always safer investment alternatives, so why choose this company if the founders aren’t fully devoted? Key indicators of commitment to look for include: a) Founders leaving their jobs or dropping out of college to work on the company full-time, and b) Founders not engaging in other side projects that consume a significant portion of their time and focus.
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Founders’ Salesmanship: Fortunately, nowadays, you can easily find videos of founders delivering speeches about their idea or company. Take the time to watch these. Put in the effort. How inspired do you feel by their presentation? Does their speech excite you? Do you find yourself eager to use their product after listening to them?
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Customer Traction: Founders are not charismatic? Founders didn’t go to Ivy League schools? Who cares if they’ve got customers who love their product. Customers don’t care about which school founders went to. Customers care about how the company can solve their problems. As an early stage startup, they might not have a customer base yet but for the ones that already have a customer base, you would want to check whether customers love their product or are heavily dependent on their product. Would the customers be sad if this company didn’t exist? Talk to their customers and figure out how much they like the company? For example, I genuinely become sad if Trader Joe’s didn’t exist.
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Engage with Founders: Try to briefly meet the founding team and go over the questions that you have for them. Be very friendly, polite, and humble (it’s a small community) but ask your burning questions. It might be hard to get a hold of the founders if you are investing via a syndicate. You can either ask the syndicate lead for an intro or directly email the founders for a quick 15 minutes casual meeting. One side effect of this is that you show the founders how serious you are and you care about their company.
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Long-Term Commitment: What’s your time horizon? Are you comfortable for your money to be tied to this company for 5, 10, or even more years? Given the longer number of years required for companies to go public these days, how comfortable are you for your money to be tied for 5-10 years at this company?
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Bet on People, Not Just Ideas: I added this with the risk of sounding cliché. In early stage investing you are investing in the people and not necessarily the idea. Everyone has great ideas but when it comes to execution, there are very few people in the world that can do the job. Be mindful whether you are investing in the idea or you are attracted to the founders and investing in them.
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Revenue: If they already have revenue, what does the revenue look like? How is the historical revenue growth? Try to go into detail. Is the revenue coming from one customer or do they have enough diversity in their customer’s profile? What percentage of revenue will be one-time payment versus recurring revenue?
Early stage investing can be fun if you enjoy exploring the possibilities of new companies. Yet, it is hard because you are investing in something with less than a 90% chance of success. To make things worse, you are making this decision with a very limited amount of financial data. In this post I tried to put my thoughts into a list that can act as a checklist when I make my investment decisions. It’s possible I’ve overlooked certain aspects or placed undue emphasis on particular items. I would love to hear your thoughts on this.