Startup investing is inherently different from investing in the public markets. There is no 10K or 10Q to review, no analyst commentary, no chatter on Seeking Alpha, there aren’t even discounted cash flows. How does one evaluate such a company?
We discuss in this episode a framework to evaluate startups. We identify eight factors that can be used to evaluate a company: 1) Market risk 2) Competition risk 3) Execution risk (call it team risk) 4) Technology Risk 5) Regulatory risk 6) Financing risk 7) IP risk 8) Exit potential.
You might also want to read: Conducting Diligence on Deep Technology Startups
This is Propel(x) podcast, discussion on investing in all things startups. Startup investing is highly risky. Please listen carefully to the disclosures at the end of this podcast.
Andy Reed: Hey, this is Andy and this is the Propel(x) podcast. We’ve had a few episodes on who should be an angel investor, getting started, and we had a conversation with a seasoned angel. So let’s get into the heavy lifting portion of things. Today, we’re going to talk about how to evaluate a startup for investment. We are going to start this discussion today with our CEO Swati Chaturvedi. Swati is also the Managing Partner of our venture capital fund, the Newton fund. All right Swati, let’s get started understanding the process of evaluation. How would you lay out the process?
Swati Chaturvedi: Thanks, Andy. Hi, everyone. Good to be here. So let’s start with the goal of evaluation. Our goal is to understand if this company that we are looking at can yield us returns in the long run, and it would do that if it were itself profitable. So our goal is to understand if this company is likely to make a profit in the long run. Sometimes that’s so far out because many of these startups are really visionary; they are bringing new technologies to market that it is not as evident as it would be for a public market company, for example.
Andy Reed: Or real estate.
Swati Chaturvedi: Or a real estate firm. Specifically, there are no discounted cash flows, there is no forecast, and so on. So you have to use your imagination a little bit, but there are frameworks. There are frameworks that people use. Different people use their own frameworks. There is no kind of trademark or patent on these. Anyone can use any framework and I can share with our audience, what framework we use internally to evaluate these companies.
Andy Reed: Yeah, that’s going to be helpful.
Swati Chaturvedi: Before I explain our evaluation framework, I want to reiterate that these are high-risk opportunities, and I will continue to reiterate that each time. And while we are going to talk about frameworks, these frameworks are not exact science by any means. They are just frameworks, ways of thinking. People can use different frameworks, but that’s what it is. So, this is one way, like I said, to evaluate these companies.
We use a set of eight factors and I can explain how we think of them, but an eight is a lot for an audio podcast so we’ll write about this as well. But specifically, those eight factors are: What is the market? What is the competition? What is the regulation? And then moving on, these are the external factors. So you can probably divide them into external and internal. External factors are market, competition, regulation. And then moving on, there’s a set of internal factors; technology, whether or not the company has IP, or how it protects its IP, how are they positioned to execute? What are the execution plans? That’s the sixth factor. Seventh is financing risk; so how much capital does this company need? And finally, eighth is exit potential. How much money this company could make for me in the long run.
So it’s kind of a long list, but I’m putting it out there for our listeners: Eight factors: market, competition, regulation, technology, IP execution, financing, risk, and exit potential.
Andy Reed: Yeah. And so there’ll be a write-up of this that goes along with the podcast to walk everyone through that. But I think it’d be helpful to understand the logic behind this.
Swati Chaturvedi: Yes, sure. So the way we think of it is when a company comes along, offering a product or service, there is a buyer for this. In other words, there’s a market for it and that’s what we call the market. So we want to understand how many buyers, how much would they pay, and how much dollar revenue potential would it translate into? So at the highest level, there is the market. Now some of that market gets taken by competitors, right? So if you think of this big kind of universe or big circle, think about it visually as a big circle – that’s our market. Within that, some segment of it or some portion of it gets taken by the competition. So we are left with a smaller portion. Right? So we need to consider what’s the total market? What’s the competition? Then we are left with this smaller portion, which is the revenue potential for our company. Right?
Andy Reed: Can I stop you there?
Swati Chaturvedi: Yes.
Andy Reed: Because most startups don’t have any revenue when they start. So, what’s the time frame that you’re thinking about, is It the ideal state, or if things were fully executed, according to spec and our best belief? How do you gauge what’s left?
Swati Chaturvedi: We have to think of the ideal stage. In that ideal stage, how much money would this company be making and how much would it be acquired for? Because that’s when we will get our return and to that somewhere, we’ll play the time frame. But for now, we should be thinking of; what is the potential market? What do we think this company could earn? And then within that, from those revenues, some amount has to be subtracted for execution purposes. That’s when you’re left with the profits, ultimately in the public markets, it’s all discounted cashflow of profits, right? But since that doesn’t exist in the private markets, you do have to qualitatively gauge all these factors.
So we discussed what the total addressable market is. That’s the market. Some portion of it gets taken up by competition. And then the remaining of what revenues come to our company, the remaining is expended. There are some costs that are expended to earn a profit, and those costs could be in addressing regulatory barriers, developing your technology, executing, just getting suppliers, getting manufacturing in distribution, all that kind of thing. So that’s where we come to technology IP execution risks. And then there is this idea that especially in our business, we focus on deep tech and there’s this idea that some companies need more money than others to succeed. Let me give you the example of a drug company.
On average, if you’re going to come out with a blockbuster drug, (blockbusters are those that are earning a billion dollars or more every year in revenues. To develop a blockbuster drug, tens of millions go into it. Why did they go into that process? You have to do clinical trials, you have to cross the regulatory barriers, and you have to establish specific types of manufacturing processes, and so on. So there’s a long time to revenue. But when the revenue comes, it’s very big. So this company needs a lot of financing to get to exit. That is the financing risk. A lot of companies fall by the wayside, especially the capital-intensive ones because they’re not able to line up the financing to get to exit, and this is an all-or-nothing game in some of these companies. So, that’s where financing risk comes in. You have to estimate that.
And then finally is the exit potential. By exit potential; typically when companies have an exit, I mean, what are the types of exits you could have? You could have an acquisition, you could have a company that goes IPO in the best of cases, or you could have a company that chugs along and gives you dividends. That’s a public market scenario. So when you think of the exit, because the whole purpose of evaluation is for you to figure out how much money you would make. So it’s important to understand what kind of exit you would have. In our case, which is mostly deep tech companies, we want to understand how much would this company be bought for…
Andy Reed: Mergers and acquisitions.
Swati Chaturvedi: Mergers and acquisitions. Those are typically in multiples of revenues, but when it is a technology buyout, it’s much harder to predict. So you want to understand what are the comparable transactions that have happened in this space? How much were these companies bought for, over what time line, where did they have to get to? And so on. So it’s a complicated framework, but it is more or less comprehensive. I’m not saying this is a hundred percent exhaustive. I’m sure there’ll be factors which we haven’t considered. But internally that is how we think of evaluating these companies.
Andy Reed: If I were to summarize what you were saying, i will put it in the highest level. You said there are external and internal factors.
Swati Chaturvedi: Yes.
Andy Reed: And so it was; what is the potential in the world for this company to create value and then what is the specific potential of this team, company, entity, and corporation to execute on that value that has the potential to be created? And then within each of those, there’s different caveats that help you understand those. And then once you’re going to have a sense of—okay, here’s the big opportunity, here’s the kind of..probability of success. What I hear you ultimately saying is that that goes into the world that, you know, we live in or we’ll live in 10 years from now. And then there is certain kind of financial and economic indicators around that and market that will then determine the valuation range. And that’s a really idealized kind of way of thinking about it, but you’re saying, let’s take the big picture. Let’s look at the specific parts of this. And then let’s figure out where this is going to go in the world. And so it’s putting all those pieces together that’s hard, but fun and interesting work. I think that’s why a lot of people do this—it is because you’re pattern matching and thinking about where the trends are headed, things like that, and then putting your money where your mouth is.
Swati Chaturvedi: I mean at the highest level, at one time I pitched my company. How big do you think this is going to be? Essentially he got to the market size right away and how much revenue I intend to make from this and so on. But that’s what they’re looking for.
Andy Reed: Well, I think there’s a lot to get in with each of these things. I think it makes sense for us to wrap up this podcast. And I know that we’re going to get into podcasts in subsequent weeks with each of these topics.
Swati Chaturvedi: Yeah, analyzing each of these.
Andy Reed: So do you want to give a final recap and then we can call it a day?
Swati Chaturvedi: This is something that I already said, but let’s think of eight factors and we can have podcasts on each of these; the market, the competition, regulation, technology, IP or lack there off, execution, financing, and exit. We’ll discuss each of these in detail in coming podcasts.
Andy Reed: That’s awesome. Swati, thanks for your time.
Swati Chaturvedi: Thank you, Andy.
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