Investing in a tech startup that yields high returns can be a challenging but rewarding experience. There are risks involved, but the returns can be astronomically high. Imagine if you had taken a chance on a socially awkward Harvard dropout in 2004.
You get the picture. But where should you start?
You must first identify suitable investment opportunities and assess the risks involved. You could quickly lose your shirt if you don’t do your homework as an investor. You’ll need more than an online savings bank account to fall back on, even if it is high yield.
You can employ strategies to even the odds in your favor. The following tips maximize your chances of achieving your investment goals.
Top Challenges of Investing in Tech Startups
Technology startups are high-risk investments. Many new businesses fail, and most tech startups don’t make it to their fifth birthday. When investing in a tech startup, you’re betting on a company with a tiny chance of success.
There are several reasons why tech startups are so risky. First, the technology sector is highly competitive. New startups are constantly popping up, and many are trying to solve the same problem. It’s hard for any startup to stand out from the crowd.
Second, technology changes quickly. What’s hot today may be obsolete tomorrow. That makes it hard for startups to keep up with the latest trends. They may develop a product that’s no longer in demand by the time it hits the market.
Third, most tech startups are founded by first-time entrepreneurs with no track record. They may have a great idea but lack the experience or skills to make it a successful business.
Fourth, tech startups often require much capital to get off the ground. They may need to invest in expensive research and development, or they may need to build a complex infrastructure. That can make it difficult to raise money from investors.
Finally, many tech startups are based on a single product or service. The startup may have nothing to fall back on if that product fails.
Despite all these risks, plenty of people are still willing to invest in tech startups. That’s because the potential rewards can be huge. A successful tech startup can make its investors a lot of money.
If you’re considering investing in a tech startup, you must know the risks involved. But don’t let the risks scare you off. The rewards can be worth it.
Tips for Investing in a Tech Startup
How do you know if a tech startup will be the big one? Despite doing your due diligence, you cannot guarantee success. However, not doing any research at all almost guarantees failure. So, what do you need to do?
Research the market
Consider the individual startup within the larger ecosystem of startup land. Are there opportunities within the ecosystem that will support the growth and success of this startup? Regardless of volatility, ensure the company has a solid go-to-market strategy—a thorough plan to reach customers effectively and efficiently.
Run customer acquisition experiments across channels to ensure you firmly understand the market. At this stage, the founder may bring additional sales and marketing resources to help them scale customer acquisition. Ideally, they are a growth team or expeditionary sales leader accustomed to uncertainty and lacking structure.
Discern product-market fit
Successful startups go beyond good ideas. Their products must resonate with their target customers. That requires finding product-market fit.
Product-market fit is creating a compelling product that adequately satisfies the target market. Approximately 34 percent of startups fail because they don’t nail the product-market fit. As an investor, it is crucial to ensure that any startup you consider accounts for product-market fit in its business plan.
That requires market testing and positive, measurable results showing potential customers’ interest and value. If a startup doesn’t have a scalable product-market fit, it’s best to avoid investing in it.
Evaluate team quality
Whether you’re an angel investor or part of a venture capital (VC) firm, it’s critical to research a startup’s product and its team. It is one of the main factors VC firms consider when making investment decisions.
Team quality includes factors such as:
- Experience: While years of experience don’t always count, it might be worth considering. The average tech startup founder is 45 years old, which often means domain expertise, an extensive network, and a proven track record.
- Mission and value proposition: A company’s mission statement often guides team members’ strategic initiatives.
- Commitment to sustainability: If you want to invest in a sustainable business, gauge its commitment to the triple bottom line.
- Ethical practices: Many red flags can signify fraud or corruption, such as employees giving unrealistic guarantees regarding business growth or failing to register products.
Don’t just invest in an idea. Even if a startup achieves product-market fit, an ineffective team can put your investment at risk.
Related: The Team Effectiveness and Different Roles in Teams That Win
Analyze the business model
Before providing funding, confirm the company has a good business model and revenue generation strategy. The most common tech company business models include:
- Freemium: The business provides a free tier of its product or service and charges for a full or upgraded version.
- Employee benefit: Another organization purchases the company’s product to offer as a free benefit to employees.
- Intermediation: The business acts as a bridge between products or services and consumers. Good examples of the intermediation model are online booking and crowdfunding platforms.
- Disintermediation: The company eliminates intermediaries in the traditional supply chain process. This business model includes e-commerce platforms, peer-to-peer accommodation (Airbnb), and direct-to-consumer companies.
Not all business models are created equal. The best business model for a tech startup depends on the product or service. When evaluating the investment potential of a startup, you must determine if the business model will likely create value.
Examine the pricing model
Investors favor businesses with the potential for high growth and recurring revenue streams. It’s crucial to know how the startup will make money before investing. Three typical pricing models are:
- Subscription Model: Companies that offer recurring subscriptions for their service or product have a predictable revenue stream and a more loyal customer base. That makes them more scalable and valuable. (Examples: Netflix, Slack)
- Freemium Model: This model attracts a large user base with a free basic version and generates revenue from premium features or in-app purchases. It allows for easy scaling and upselling to paying customers. (Examples: Spotify, Dropbox)
- Marketplace Model: By connecting buyers and sellers on a platform, these companies take a commission on each transaction, creating a scalable model with minimal operational burden. (Examples: Airbnb, Etsy)
Read the term sheet
Another step to take is understanding your investment’s terms. That requires a term sheet—a document that outlines the deal’s provisions. While helpful for entrepreneurs, it protects you as an investor if something goes wrong.
If everything goes well, most control terms don’t come into play. But when things go south, and there are disagreements, the documents determine who’s in the driver’s seat and has the power to make major decisions.
A term sheet is the first take of your proposed agreement’s terms and conditions. If something doesn’t align with your interests, don’t get deterred. Instead, take an active role in the negotiation process.
Consider the company’s scalability
Does the company plan to scale after it’s found product-market fit? A successful startup needs a formalized process to produce sustainable growth.
It can take two approaches:
- Aggressive: Trying to grow quickly despite a possible lack of confidence
- Incremental: Scaling slower to learn along the way
Regardless of the approach, the primary question is whether the company is scalable in the first place. Founders should focus on six areas to boost scalability:
- A culture of shared values
- A sustainable business structure
- Financing flexibility
- High-quality staff
- Innovation
- The ability to move quickly
A company’s scalability is crucial for navigating future market disruptions. If the industry undergoes a major shift, a less scalable business model could leave your investment vulnerable compared to more adaptable competitors.
Smart Investing Takes Work
Investing in tech startups can be a rewarding experience, but it requires careful planning and risk assessment. The best tech startups combine a robust business model, a talented team, and a compelling product that addresses a real market need.
This combination truly excites investors and leads to the creation of valuable and successful companies. Understanding the terms of the investment and the company’s potential for scalability are also crucial steps for making informed investment decisions.
