How to Evaluate a Startup: Everything You Need to Know
It's important to do your research, know what to look for in a successful business venture and what questions you should ask in the evaluation process.4 min read
Are you wondering how to evaluate a startup before you invest or get involved? It's important to do your research, know what to look for in a successful business venture, and understand what questions you should ask in the evaluation process.
How to Evaluate a Startup
The first step in evaluating a startup is requesting a copy of the full business plan. At a minimum, the owner should be able to provide you with a brief summary of the plan. If the owner doesn't have a plan, consider that to be a red flag that the business isn't ready for an investment and the owner isn't organized enough to move forward with raising capital.
You should always understand the problem, also known as the customer pain point or market need, that the business is addressing. It's also important to know why this problem needs to be solved. For example, when the founders of Uber launched the business, the problem being addressed might have been something like, "getting a car or cab to take you where you need to go can be a challenge. Why isn't there an app to hire a car?"
It's smart for business owners to present the problem to potential investors in a way that makes it more personal, ensuring that it can resonate and really hit home.
Review the Market
Another aspect of evaluating a startup is looking at the market. This review should include an analysis of the size of the market, who the customers are, and the opportunities available. When presenting to an investor, a business owner should offer the segment of the market that will be serviced in comparison with the total overall market, as well as a timeline indicating the plan to enter into and capture that market. If the business owner makes any assumptions about the target audience or market, those should be clearly explained.
In most cases, the overall market should be large enough to make the venture worthwhile, often between $100 million and $1 billion, but shouldn't be unrealistic.
Understanding the Business Plan
When evaluating a startup, you should also understand the business plan. A good business plan should include income statements over as many years as the business has been operating, as well as the plan for raising business capital. When outlining the capital plan, a business owner should indicate how much money they plan to raise, as well as when they need it and how it will be spent. If any part of the plan is based on an assumption, it should be explained and emphasized for the benefit of a potential investor.
Although some business owners present spreadsheets with the financial information, these documents often include more detail than an investor needs to see at the start of any potential transaction. Startup owners should steer clear of any type of steep, miraculous growth curves as these are not credible to investors.
When a business owner is presenting to an investor, they need to provide all the most important details on one to two pages of text and a pitch with up to 20 slides. Going through the process of pitching and raising capital is beneficial for every business owner for three main reasons:
- The experience offers insights into what it takes to transform a startup into a successful business.
- If investors are willing to write a term sheet and give you capital, you can take these actions as a major validation of your business idea.
- At some point, every business owner must answer all the questions that an investor will ask, so it's best to compile the information before starting the business.
Review Marketing Plans
Finally, make sure to review any marketing plans for the business to figure out how the business owner plans to increase awareness and generate demand. This plan should be realistic based on the resources available. For example, if a business owner has a marketing budget of $5,000 but their plan includes advertising on eight highway billboards, this would not be a realistic plan.
Useful Metrics in Evaluating a Startup
One of the most useful metrics when evaluating a startup is the gross margin, which is the company's total revenue minus the total cost of goods sold. This metric offers insight into the potential for profit. When looking at the gross margin, take a closer look at what the startup includes in its cost of goods sold, as this number should include costs associated with support, delivery, and manufacturing. In some industries, the gross margins are higher than others, but when the business scales, that figure should increase to show that it's viable.