Deciding whether to invest in a new venture is often challenging due to the many unknowns.  In the following article, our CEO, Bruce Roberts, expands on the subject, drawing upon his decades of experience working with early stage enterprises.

Defining Venture Stage Deals

Venture-stage enterprises, according to Roberts, refer to operating businesses that are not consistently generating positive cash flow.  These will require additional investment to reach a self-sustaining level.  Unlike private equity deals, with companies which are generating positive cash flow (EDITDA) or can be valued based on multiples of cash flow, venture deals require more subjectivity and involve a range of  unknowns.  So, how do you evaluate the chances of success in such deals?

Nine Leaps of Faith

Roberts returns to the concept of the “nine leaps of faith” (you might have read a version of this before – 9 Leaps of Faith – that investors need to consider when evaluating venture opportunities.  These are questions an investor should ask, all dealing with the risks of early stage companies.  Once addressed, these should help investors get to the heart of the venture analysis process, break it into digestible pieces, and determine whether it’s worth “continuing the meal.” As with any type of investment, we recommend you conduct extensive due diligence (read Due Diligence and Investments: What do I really need to know? here).

Has the Entrepreneur Launched a Start-up Before?

If an entrepreneur has never started a company, let alone worked in the industry before, an investor might consider tapping the brakes.  Building a company requires personal traits that cannot be taught in a classroom.  And working in a large corporation even if the same industry, doesn’t mean that the entrepreneur has the persistence, creativity and flexibility to succeed.  So, to begin, a more experienced founder may pose a safer bet, even if they have experienced failure in the past.

Furthermore, the assembled team’s experience, background and previous ventures are critical to the venture’s success.  Remember, the team is the one that will guide the company.

Is the Product or Service an Improvement or a Truly Disruptive One

The second leap of faith is whether the product offers a disruptive innovation or merely an incremental improvement to an existing product or service.  Disruptive technologies – representing a paradigm shift – can generate greater upside potential, while sustaining technologies may offer lower returns but are generally safer investments.

Disruptive products face resistance from a basic human instinct, a customer’s “happy place” where they feel secure using their current product and will be difficult to convince them to change.  Developing a supply new chain, capturing repeat customers, and a myriad of other challenges make this a higher risk, longer-term venture. Those which represent incremental improvements, generally considered safer investments, are likely to generate lower returns but will succeed more often than the former.

Do They Have a Product?

Does the company actually have a tangible or intangible product available on the market?  Is it in beta stage, or already in commercial production?  With the geopolitical instability we’re facing in 2023 and the foreseeable future, clearly a foreign supply chain represents a higher risk.  These factors can significantly impact the venture’s potential for success.

What are the Customers’ Motivations for Buying the Product?

“We are creatures of habit,” says Roberts.  The purchase decision generally falls into two categories: either the customer perceives that the product provides value, or the customer has some urgent need to buy – in Roberts’ view, the more compelling factor.  This includes evaluating any switching costs that customers may encounter when adopting the new product or service.  Startups must find ways to overcome their  potential customers’ inertia.  If not easily swayed to make a switch, it could hinder the venture’s growth potential.

Do They Have Customers?

Simply stated, investors in startups must understand the importance of customers.  Does management have a clear understanding of their target market, their motivations to purchase the product, and how to sell the product to them?  Many ventures fail, not because they cannot create the product or service, but because they cannot attract and retain enough customers to generate revenue.  This, too often in Bruce’s experience, is because a founder is a solution provider – he or she produces a product without fully understanding whether it solves a critical problem for customers at a price point that is compelling.  To be a successful enterprise, management must understand their decision-making process and pain points.  It is crucial for a startup to comprehend what it costs to acquire a customer and to have a strategy in place either for capturing new customers or generating recurring revenue from existing customers.

Are There Distribution Channels and a Sales Pipeline in Place?

“Business is hard,” says Roberts.  In his mind, it’s tough to balance the need to start generating revenues versus ensuring that your product quality is high, the supply chain is complete, and your distribution process is adequate to handle the volume.  On the one hand, the company needs to focus on sales.  But, conversely, you can’t scale too fast if the product, or some aspect, isn’t ready to do so.

Is the Business Ready to Scale, and is the Management Team Complete?

Venture deals often falter due to scaling too early or not being prepared for growth.  Startups must understand their unit economics and have a clear plan in place for scaling their operations when the time is right. This includes ensuring that the management team has the necessary skillsets to transition from a development-stage company to an operating business.  Often as not, a founder may have the drive and vision to start a company, but that same founder (and management team) must recognize that, frequently, his or her skills are not suited to running a multi-million-dollar company.

What is the Competition?

No business can exist without competition, and startups must be prepared to face it head-on.  At the outset, their first challenge is the status quo, no matter whether in a disruptive or sustainable product company. If a sustainable company, the competition is deep and entrenched.  Even if disruptive, beware of those who say it has no competition.  When evaluating a venture deal, it is essential to consider the competition and how the startup plans to differentiate itself in the market.

Conclusion

Evaluating venture-stage deals can be challenging due to the many unknowns involved.  By considering factors such as management experience, product development, and customer motivation, investors can better assess the venture’s potential for success.  By asking these questions, you can make more informed decisions and increase your chances of backing a successful venture.

For more information, we encourage you to watch our complementary video from the Direct Private Investments Show here.  And, if you’re considering direct private investments, we encourage you to look here.