Deep technology companies are different from your average internet startup. Their risks are different, their development timeline is different, and their cash needs are very different.
We have found that having a structured way to evaluate early stage deep technologies startups is key to helping investors make better investment decisions. I wanted to share the framework we’ve developed at Propel(x) to help as you evaluate potential investment opportunities.
Like any investor, it is obviously our goal to identify companies that could yield high returns for investors: companies that maximize sustained profitability.
We use a model to assess the profit that is left after costs and the potential for sustained profitability. Our objective is to evaluate which risks might impact company profits.
In this post, I will discuss some of the key categories of risks that we evaluate:
1). Market Risk: OR, does demand exist for the product? Often, deep technology companies do not carry a high market risk (e.g. if a new therapy is discovered for cancer, there will likely be a market for it), and often their markets are large.
Interestingly, it is not always important for the market to run in tens of billions of dollars for an investment to make sense. I emphasize this point because it runs contrary to many venture capital investment philosophies – VCs typically invest in very large markets as those can offer outsized returns. But that is not the only way to make returns. Our goal is not to maximize addressable market–it is to maximize sustained profitability.
2). Competitor Risk: Deep technology companies do carry competitor risk – the chance that much of the market will be cornered by competition. The competitive landscape is important to understand – you can do this by talking to customers and experts.
Assuming our diligence suggests a great market potential and limited competition, we are encouraged to start asking questions that help us determine risks related to delivery of the product:
3). Technology Risk: Because deep technology startups are based on breakthrough technologies, they often carry significant technology risk. At Propel(x), our unique diligence capability connects investors with experts who can help evaluate technology risks. Ultimately, our goal is to get 3-5 experts to participate in the discussion, so that investors may get a well-rounded picture of the specific technology risks.
4). Regulatory Risk: This is typically high for companies that are regulated by the FDA. The risk may be evaluated by talking to the management about their regulatory strategy, and also external experts who may have some insight into the FDA process. It is important to do some research here to understand which companies have earlier been approved by the FDA that had similar risk profile.
5). IP risk: A startup’s IP may include its patents as well as trade secrets. For angel investing purposes, it is helpful to understand whether patents are merely filed or also granted. Additionally, read the claims of a patent carefully. Sometimes the claims are so narrow as to be quite useless. Patents usually only offer a temporary advantage. However, that advantage can be significant for life science companies.
6). Execution Risk: Here we are evaluating the team, the plans for technology development/production at scale/sales-marketing-distribution etc. – the potential of the team to achieve great things!
7). Exit Potential: Because this is so hard to gauge, we use a simple technique as a proxy: we try to quickly list at least 5 companies that would acquire our startup. If we can think of 5 companies that would acquire our startup, then it is presumably creating something valuable. If, on the other hand, we cannot think of anybody who would acquire our startup, then it is a much harder sell!
Overall, our framework comes in handy to quickly gauge companies. It also helps us to structure our conversations with experts, customers and the management to ensure we are being systematic and exhaustive.
As private equity investing becomes more mainstream with the passage of Title III of the JOBS Act, thorough and systematic due diligence is a must to protect investors and get them the information they need to make more informed investment decisions.
We have systematized and formalized this process in our due diligence functionality on Propel(x). We will be sharing with you each aspect of our due diligence functionality starting with the cornerstone: asking the right questions.
This is a summary of the Propel(x) primer, Due Diligence: The Key to Angel Investing. You can download the primer here.