How to invest in startups: 10 terms to know before backing your first venture
India’s vast startup ecosystem offers many opportunities for investors. But if you are a beginner, how do you ensure you get the most out of your money?
Investing in startups is not for the faint-hearted. Whether you’re a friend or a family member of a startup founder or an eager investor, choosing the best startups to invest in can be tricky. After all, about 90% of startups fail in the first five years. Yet, if you know how to find good startups to invest in, it can be quite the moneymaker. That’s why a lot of investors take a bet on companies that show promise. If the startup does succeed, you can make multifold returns.
A startup goes through multiple stages, each of them offering distinct opportunities and returns for investors. If you’re a new startup investor, understanding startup terms is critical. From valuation and pivot to accelerators and incubators, understanding how these impact your investment is the key to finding good startup investment opportunities. Here are some terms that will help you find the best startups to invest in.
Valuation is the estimated worth of a startup at a specific point in time. When you consider how to become a startup investor, you should learn to understand the valuation of a company. Startup valuations are influenced by various factors, including market conditions, revenue potential, competitive landscape, intellectual property, and the team's expertise.
Pre-money valuation is how much a startup is worth before receiving funding while post-money valuation denotes its worth after funding.
2. Due diligence
Due diligence refers to doing a thorough investigation before making an important decision. Startup due diligence involves examining various aspects of the startup's business, financials, operations, legal matters, intellectual property, market potential, and team capabilities. This will help you assess the startup investment risks and returns. The aim of conducting due diligence is to make an informed investment decision and be aware of the potential risks.
3. Product-market fit
Achieving product-market fit involves finding an alignment between a startup’s offerings and the needs of the target market. In simple terms, it means that the startup has created products or services that people want and are willing to pay for. A startup should ideally undertake market research and collect feedback on its prototype from customers before it launches.
When you’re wondering how to invest in startups, it is always advisable to find a company that has found product-market fit because it paves the way for the success of a company.
A pivot is changing directions when something isn’t working. Say a food startup wants to create an app to rate restaurant service. After some research and trial and error, they find that there’s no product-market fit. Instead of giving up, they pivot to food delivery because of high demand. This change in direction helps them cater to a larger audience and make more money.
For instance, during the pandemic, many companies had to pivot in order to stay relevant. An example is the bike-taxi service Rapido. It pivoted to delivering groceries and essentials during the pandemic to stay relevant.
Startup accelerators are organisations or programs that support, and help with resources and mentorship to early-stage startups. This gives them an environment to grow and flourish in. Accelerators usually work with a cohort of startups for a fixed period, often around three to six months. They offer a structured curriculum and access to a network of mentors, investors, and industry experts.
Accelerators can act as a stamp of validation for startups. You can be assured that startups in reputed accelerators have gone through a rigorous selection process, indicating they have potential and are on their way to success. When you embark on the journey of how to evaluate startup investments, finding one in an accelerator can give you the confidence that you are heading in the right direction.
Startup incubators are similar to accelerators. They provide support to early-stage startups, but they differ in terms of their focus, structure, and duration. Unlike accelerators, which have a fixed duration and follow a structured curriculum, incubators provide a more flexible and longer-term environment for startups to grow at their own pace. Incubators often have a physical space where startups can work, collaborate, and access shared resources.
Incubators often provide startups with access to resources such as office space, equipment, legal support, and networking opportunities. These resources can help reduce costs, accelerate progress, and help startups overcome operational challenges. As an investor, choosing to invest in a startup that’s in an incubator can help you find good startup investments that have the potential to reach their milestones more efficiently.
Traction is a measure of how well a startup is doing. It shows that the startup is not just an idea or a concept, but that it is gaining real-world validation and generating results. A startup that gains traction is becoming popular in its target market and getting adopters.
The best startup investments are in companies that are gaining traction fast because it demonstrates that the startup is on the right track and has the potential for future success.
8. Exit multiple
In startup investing, an exit multiple is a measure used to determine the return on investment (ROI) that you as an investor can expect when you exit your investment. It refers to the ratio between the exit valuation of a startup and the amount of investment made by investors. The exit multiple is calculated by dividing the exit valuation by the total investment amount made. For example, if you invested $1 million in a startup and the startup is later acquired for $10 million, the exit multiple would be 10x.
9. Runway extension
A runway extension is the act of providing additional capital or resources to a startup to extend its runway (the length of time the startup can operate before running out of funds). It involves injecting additional capital into the startup to support its ongoing operations. This extension can take different forms, such as a follow-on investment, bridge financing, or other means of injecting capital into the startup.
When a startup receives a runway extension, it means that investors or stakeholders believe in the startup's potential and are willing to provide the necessary financial support to help it continue its operations and progress towards its goals.
A cap table, short for capitalization table, is a spreadsheet or document that outlines the ownership structure of a company, specifically detailing the ownership stakes and equity distribution among its shareholders. It provides a snapshot of the company's capital structure, including the various classes of shares, the number of shares issued, and the percentage of ownership held by each shareholder.
Additional: Check out YourStory’s premium publication The CapTable for exclusive reportage on the Indian economy.
Taking a bet
When you’re learning how to invest in startups, you need to be confident about how you have evaluated the investment. Understanding startup investment risk and return entails getting into the nitty-gritty of how the startup operates. These terms should get you started on basic startup investing, helping you scope out the best startups to invest in.