Autopsy of a Startup Investors Mindset
I have been involved with the startup space for a while now, and even though I can wholeheartedly attest to the dazzling brilliance of the ecosystem, I have to admit that it is absolutely not for the faint of heart. Instead, it is dark and full of terrors, with founders and their teams struggling to answer a thousand different questions at once.
The select few who survive this rough yet rewarding journey, get to stand in the light, shining at the end of a long, winding tunnel. The way to that is exciting and intense, but perhaps also a little lonely. It is not the easiest task for founders to figure out every aspect of their business so soon, and find their feet in the startup space. So they fall back on the internet for advice. And the internet does not disappoint, at least at first. Hundreds of articles jostle for the attention of startup founders, all of them trying to explain the perfect way to get funding for their passion project. This can sometimes have quite the opposite effect than they intend to. Instead of helping the founders and their teams, these articles can end up convincing them of the absolute, pressing need to get funded. That is something I am strongly opposed to, and I would much rather prefer startups that choose bootstrapping or friends and family funding. But it would be myopic of me to assume that every aspiring startup founder out there can manage either of these financing options. Sometimes they simply lack access to these sources, and sometimes their startup ideas are far too large-scale to be funded by such small rounds. For them, I wouldn't exactly recommend any of the dummies' guides to bagging investors available online. Instead, my advice would be to understand the mindset of the startup investors and put themselves in their shoes.Instead of focusing solely on pitch decks, and grabbing VC contacts, it makes much more sense to focus on what drives the startup investors, so that you can give them exactly what they want. If you manage to do that well, they are likely to give you exactly what you want: funding!
This autopsy of a startup investor's mindset can potentially help in figuring out what they really want.
The Basic Investment Strategy
For startup investors, the mantra is fairly simple, and similar to most other investors. They are all trying to make money work, to make more money. The whole thing is a bit of a calculated gamble, as investors try to bet their money on enterprises that they think will be most successful in the long run. Success in this case can be measured by two key metrics, the ability of the firm to generate high revenues and great profits, and its ability to get higher valuations in the equity market. Investors typically earn a share of the profits, called the dividend. But a vast majority of them tend to focus on how much they can earn by potentially selling their stake.
In the private equity and venture capital markets at least, most investors are looking to bag a few investments that will hit it out of the park. These are the star kids of an investor's portfolio, responsible for making up for most of the losses other stakes generate, and bringing in the greatest returns. Naturally, all investors are perpetually on the lookout for these stellar investments that can grow fast, but sustainably. Usually, a good multiple that investors set their sights on is a 3X return on the original valuation. While some investors are definitely interested in being a part of a startup's growth story, most of them prefer to think long term, and look at a startup's exit projections. You may think it sounds a little too cold to be interested in nothing less than the exit numbers, but it is perhaps the only practical way to look at it. After all, startup investors typically have their attention divided amongst several businesses, and they can barely afford to develop strong attachments to portfolio businesses. Your investors may be great mentors, and really committed to your vision, but they will never be as enthusiastic about your project as you are. If they were, they would still be founding startups! This is why startup founders tend to focus on the final value they can get out of an investment, and try to get the most bang for their buck.
Investors focus on exit prospects and are excited when their investments fetch good money in subsequent rounds. When other investors come in at higher valuations, it means that the existing investors are already in a position to sell off their stake for a profit. For this reason, investors tend to be constantly on the lookout for fast growing startups. However, this is not to say that every investor is taking a leaf out of SoftBank's book, and hoping to have their investment values unduly skyrocket. After all, most investors, at least apart from Masayoshi Son, seem to have gotten the memo that rising valuation alone does not equal growth. So they tend to focus on investing in businesses they think can find takers, both among consumers and fellow investors.
Need to Minimise Risks
Like nearly every person on the face of earth, investors too want to minimise risks and maximise returns. The only difference between a layman and startup investors is that the latter tend to be more technical in their analysis. In order to assess how much risk exposure a particular investment can open one up to, a startup investor typically looks at some important key performance indicators (KPIs). They try to evaluate how experienced the startup team is, and what their collective track record looks like. If the startup has some experience of operating in the product market, then they look for specific metrics like the number of active users, revenue generation so far, break even projections and so on. These can give investors some idea about how a certain investment can turn out for them. Even if the investment does not earn them any profits, investors like to know that they would not lose any of their hard earned money on it. Assessing the KPIs may not be sufficient to determine future risk, but it's usually a decent indicator of a startup's potential risk prospects.
Focus on Large Stakes
Although this is not entirely universal among startup investors, it can be more or less surmised from the current crop of investors around that most of them go for larger equity stakes. The more you can offer of your business, the higher is the likelihood of the investor developing clear interest in the funding opportunity. To put it simply, investors want more skin in the game. For starters, having a large slice of the equity means that their stakes are less likely to be diluted when more investors come in during the subsequent rounds of funding. Having a greater stake will make sure that the investor has a significant voice in the startup's decision making process, and also give him more reason to take interest in what goes on with the firm
Besides, having a larger stake is always helpful when an investment turns out to be a smashing success. Considering that investors only put their money in firms that they feel are capable of bringing in high returns, having a significant equity share is extremely important. If the investor's calculated faith in the startup's potential turns out to be accurate, any investor would much rather have upward of at least 15% of that profitable business. Of course, having a small part of a stellar venture is better than not investing at all, so if a startup is able to convincingly justify excellent growth prospects, investors may be ready to settle for smaller stakes. But by and large, they prefer to go for bigger stakes.
Fear Of Missing Out
FOMO may be millennial lingo coined only in the recent years, but the phenomenon it represents has been around for years. In fact, FOMO seems to thrive in the hearts and minds of startup investors, who are constantly weighing the odds to figure out which startup will propel their own investment fund to the pinnacles of success. The key here is to appeal to this FOMO and demonstrate to investors why you are a catch. Having an extremely innovative value proposition, a keen conception of competitive position and excellent understanding of financial outlook are key to generating FOMO in investors.
When startup founders come up with stellar products, matched by their own confidence, investors are bound to be attracted. It is imperative to make sure that the ones pitching the startup exude confidence and can successfully show that they know what they are doing. Of course, the facts and figures may not always be accurate to the T, but dishing out absolutely inaccurate information to investors is a terrible idea. An experienced startup investor knows exactly how the market works and will call you out on it if you try to give them the wrong facts. Exaggerating the importance of the Total Available Market in a pitch is also a bad move, because startup investors know perfectly well that it is Serviceable Available Market that matters more. SAM is a more realistic measure, and justifying your projections about it will allow investors to trust you far more easily.
In the end, understanding startup investors comes down to common sense and a clear idea about the specific investor you are pitching to. While the mindset of a typical startup investor consists of everything I have discussed above, it also comes down to a lot of individual variations. For example, while a Masayoshi Son would be all for pouring truckloads of money into promising startups, I would personally prefer a more sustainable approach. Similarly, startup investors have their own preferences about the sectors they are ready to dip their toes in, and the stage of startup they would be willing to work with. Developing a thorough knowledge of these aspects is crucial to landing the right deal. Most importantly, founders have to remember that startup investors are as human as the rest of the world. They hate to lose money, bear undue risks or take unnecessary hassles, and thoroughly dislike being proven wrong in the end. So, they prefer to undertake investments that are likely to seem strategically smart in retrospect, even if they don't turn out to be profitable. The key task for founders and startup teams is to convince the investors why they would miss a great deal if they do not come aboard. At the same time, it can be useful to assure the investor that they would not be deemed a fool if they went ahead and invested their money in the startup. Proving the clear viability of their idea is probably the best thing founders can do to win over potential investors.
Clearly, startup investors are not much different from the rest of the people and it is fairly easy to decode their motivations. That is why my advice would be to focus on the investors' mindset instead of relentlessly trying to crack the funding code. After all, as one of my favourite characters once said: don't play the odds, play the man!