Follow the Green, Not the Dream: How to Pick Winning Startups

Follow the Green, Not the Dream: How to Pick Winning Startups

Awesome product? Check. Driven founder? Double check. Growing customer base? Triple check. For that reason, I’m in.

Sep 30, 2021

Follow the Green, Not the Dream: How to Pick Winning Startups
Startups

Startups

Entrepreneurship

Entrepreneurship

Business

Business

It’s 8 PM on a Friday night. But you’re not out getting wasted with your friends. Instead, you’re glued to the TV, watching Shark Tank entrepreneurs pitch like hell for a chance to become instant millionaires.

Every now and then, the five sharks even team up to secure a deal. Of course, Barbara isn’t there to say “I’m out” for whatever reason. 

As they're shaking hands and congratulating the founders, you can’t help but wonder: Why was this deal a no-brainer for the sharks? How exactly do they pick their winners?

​​Best practices for investing in startups

Before you dive into a sea of high-risk startup investing, let’s explore how successful investors manage to keep their heads above water.

To niche or not to niche?

Too often, newbies assume that they have to jump on all the hottest trends—like Cannabis, Machine Learning, No-Code and the DeFi—to hit a home run. But you could choose to specialize in one sector, like Blockchain Capital.

The benefits of niching down:

  • Develop a feel for the valuable problems in your sector and a keen BS detector that is able to separate the wheat from the chaff.
  • Spot small, promising startups before they pop up on most investors’ radars.
  • Make your life easier because you don’t have to start from scratch when learning about a new startup. 

 

The cons of niching down:

  • Betting your entire career on the belief that your investment will go mainstream is risky.
  • Might require 10+ years of experience to become an industry expert.
  • You’ll miss out on billion-dollar opportunities in newly developed industries.

Due diligence will do you good

Since you’re headed into uncharted territory, you’ll want to make sure the treasure actually exists and is worth your while. So leave no stone unturned: from the product, customers and competitors to the finances, regulations and founders.

Have a finger in many pies

For reference, VCs expect 20% to 30% of their investments to go belly up (and they’re trained experts). That’s reason enough to diversify your investments across two or more startups. You might even want to diversify by industry and startup age (e.g. early-stage, mid-stage, late-stage).

(Optional) Teach a man to fish

Startup investing doesn’t have to be a passive investment strategy either. Beyond money, you can invest your time in mentoring startups helping them establish new business relations.

How to pick a startup to invest in

You might be tempted to listen to your gut when picking startups to invest in, but that’s probably just the gas talking. When it comes to pre-IPO startup investing, it's all about due diligence.

With over 100 million startups launched every year, you need a set of criteria to zero in on the best candidates.

What’s the big idea?

Forget about holding hands and singing kumbaya with startups promising to “change the world”. At the end of the day, great startup ideas are simply about solving problems that are:

  • Urgent: Painful enough that the customer can’t live or work without a solution, also referred to as painkillers in the startup scene.
  • Underserved: Lacking in competition, either because the solution is new or difficult to replicate.
  • (Optional) Unavoidable: Triggered by events outside a customer’s control, like regulatory changes, natural disasters, financial crises and pandemics.

But how big is it, really?

We answer this by evaluating our Total Addressable Market (TAM):

  • Size: You’d ideally invest in a startup that captures a tiny slice of a huge market, or one that dominates a new, potentially huge market.
  • Growth: Make sure the product isn’t part of a dying industry, like newspapers, but one that’s poised for growth.
  • Competition: I know your Econ professor taught you that competition is good for capitalism, but PayPal founder Peter Thiel says competition is for losers. So I’m siding with the billionaire. On the one hand, a lack of competition could be a red flag that the idea isn’t a moneymaker.  But sometimes a lack of competition is just due to complacency. Take Lemonade Insurance for instance. Customers love them because, unlike the old guard, they don’t try to screw you out of your claims.

It pays to be different

If people are willing to pay for a product, then you can bet that it will eventually be copied. So invest in startups with sustainable competitive advantages like:

  • Switching costs: When users rely on a product or trust it too much to switch to another provider. E.g. your personalized Netflix recommendations.
  • Network effects: A product whose utility relies on having more users than competitors. E.g. hosts and guests on Airbnb. 
  • Cost advantages: Building more efficient economies of scale to offer lower prices. E.g. Tesla’s $25,000 Model 3 (California only)
  • Intellectual property: Intangibles that other companies are legally prohibited from copying. E.g. Coca-Cola’s secret recipe.
  • Top-of-mind awareness: When a brand becomes synonymous with a certain category of products. E.g. Gillette and safety razors.

Money in the bank

Even though Silicon Valley likes to glamorize this idea of running companies at a loss to reinvest into growth, you’ll probably sleep easier at night knowing that your startup is profitable. 

But making losses in the first few years isn’t always a red flag, particularly in capital-intensive industries. Just make sure that the startup has high margins (50% plus), so you could at least foresee a path to profitability.

Who’s running the show?

VCs often say that they invest in people, not products.

But don’t just go looking for young, quirky geniuses in hoodies and flip-flops. Too much young blood isn’t always B-compatible (see what I did there?) with a well-run startup. Ideally, a startup should have experienced executives and investors on board.

But what makes a star founder?

  • Passion: Are they willing to work grueling hours with no vacation or salary for five to ten years? Only someone with an emotional connection to the startup’s mission would be up for that.
  • Track record: They’ve led successful projects in the past. Extra points if they’ve exited a startup before.
  • Agility: “Everyone has a plan until they get punched in the mouth”. Is the founder able to get things done and adapt quickly when something isn’t working?
  • Skin in the game: Talk is cheap. Has the founder demonstrated their commitment by e.g. quitting their job to pursue this full-time, investing their own money into the business?

 

And if you’re dealing with two or three co-founders, you’ll also want to pick up on their:

  • Commitment: Are they all equally passionate and dedicated to the mission?
  • Cooperation: Do they try to upstage one another, or do they complement each other’s skillsets?

Keep more control or sell your soul?

Say one Shark offers to pay $600,000 for a 50% stake in your company, while another offers $1M for 100% of the company. Which would you do? Take the smaller offer to keep more control at a higher valuation, or take the money and run?

Keep more control or sell your soul?

10-​​point startup investment checklist

The ideal startup investment checks these boxes:

  1. Solves a painful problem.
  2. Has a large addressable market.
  3. Few competitors.
  4. Sustainable competitive advantages.
  5. Part of a growing sector.
  6. Already profitable.
  7. Scalable product.
  8. High margins.
  9. Strong management.
  10. Low risk of legal troubles.

Where to find promising startups

You can find startups in need of funding by either: manually sourcing deals or leveraging a crowdfunding platform.

Assuming that you qualify as an accredited investor, you can source your own deals by: 

  • Keeping up with startup news to discover funding rounds.
  • Building your business network by e.g. attending startup pitching events and getting in touch with organizations (banks, accountancies, incubators, accelerators) that service early-stage startups.
  • Becoming a member of a syndicated angel list, where angel investors pool their funds to invest in private startups.

 

But why get bogged down in deal sourcing and due diligence when crowdfunding platforms do a lot of the heavy lifting for you?

Republic

Republic lets you invest in vetted startups across industries like consumer goods, energy, gaming and transportation for as little as $100. Less than 3% of applicants pass their due diligence process, which covers everything from the founders and product to the market and financials.

republic

Republic

5.0

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Wefunder

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wefunder

Wefunder

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Startups

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