The five rules of the investor in startups

After five years of experience at B4i – Bocconi for innovation, I wanted to share some considerations on the investors’ perspective in investing in startups. When dealing with startups, we are talking about very early stage investors with a strong appetite for risk and a specific mindset in assessing opportunities. In general, I would say that these investors are looking, not necessarily in hierarchical order, at the following elements with a highly disciplined attitude: 

I) Market need addressed by the business proposition; II) Quality of the team; III) Scalability of the business proposition; IV) Pragmatic assessment of the financial support required before the next round of equity financing; V) Quality of the shareholder base.
 

1. Market need addressed by the business proposition

The first element of assessment is the size of the potential market whose needs the business proposition is expected to address. The first level of analysis can be limited to the domestic market (e.g. Italy) or a specific product or segment of clients. Ultimately the analysis will evolve to include broader segments of potential clients or an international expansion. Investors naturally devote more time and effort when the proposition has sizeable upside. 
 

2. Quality of the team

The second element of assessment is the quality of the team. The team must have diverse competencies and skills: leadership, vision, tech, finance, operations, execution and marketing. Investors do not like a team too concentrated on one professional (usually the founder). As a result, investors like diverse and highly motivated teams. The most recurrent point of attention is the level of motivation: teams which are not fully dedicated to the enterprise are always a "no go” for investors. Finally, a team with professionals who are flexible and open minded is very appreciated. The road to success requires a lot of flexibility: professionals and entrepreneurs who are too dogmatic or opinionated usually are a concern for investors as the right recipe for the execution of the plan requires a lot of flexibility and ability to adapt to changing market and business conditions.

3. Scalability of the business proposition

Investors spend a lot of time understanding the scalability of the business. Once they are comfortable with the viability and sustainability of the business proposition, investors assess the conditions that allow the team to upscale the business with limited additional headcount and financial investment. Usually, startups with extensive headcount absorption and heavy capital intensity (marketing expenses, Capex etc. etc.) are considered a big question mark for investors.
 

4. Pragmatic assessment of the financial support required by the startup before the next round of equity financing

The fourth element is the assessment of the downside scenario. In the early stages of an enterprise, a lot of things can and will actually go wrong: it is the nature of these initiatives. On the one hand, people are naturally inclined to assess the upside of any initiative. On the other, sophisticated investors are very careful at assessing what could be a downside scenario and the likelihood that something could go wrong: less clients than expected, inflation which can affect the cost base, new competitors, regulatory hurdles, etc. etc. When potential investors make their assessment, they also assess the possibility that more capital could be required down the road and the risk of being massively diluted in case the “cash call” exceeds their expected commitment.
 

5. Quality of the shareholder base

Finally, the quality of the shareholder base plays an important role. The presence of professionals with a strong reputation in the industry, the presence of a core investor (even a private investor) which can offer stand-by equity and support in case of financial stress, a simple shareholder base (too many cooks are not appreciated) can reassure investors at the time of the investment. The rate of success for startups is in the single-digit (2-3%) likelihood area. The numbers are strongly suggesting that an important element of luck is also required to hit the investment that turns out to be a unicorn (a one-billion dollar startup).