I’ve reached the conclusion that investing in startups is half science and half art. While we could argue that Private Equities have by now developed enough tools, statistic samples and experience to base their investment choices on quantitative frameworks and be pretty reliable in what to expect, Venture Capitals still sail onto uncharted seas. And that is exactly the way we like it!
Even when we try to frame typical behaviors in recurring patterns, we end up making exeptions and correcting results with deal-specific factors, to take into account industry trends or even first-mover effects. It’s a heuristic approach. That became very clear during course Entrepreneurial Management at IE Business School, by professor Matthias Tietz.
Especially when analyzing business ideas and preseed/seed startups, some sanity checks will open your path to deeper questions to the founders and even find some fatal flaws. We can therefore divide our initial questions in two categories:
The Lean Startup, by Eric Ries, clarifies how to spot the basic assumptions a business is counting on. Understanding those assumptions is the key to perform a sanity check of the story behind a business.
For example, lately someone presented to me the idea of a platform (you already know what I think of platforms) to connect local food producers with foodies and food tourists through an auction system. I must say that the idea seems attractive. However, what are the basic assumptions to be checked? Are local producer tech-savvy enough to use the platform? Are tourists willing to buy online instead of on site? Why an auction at all?
Said that most of sanity checks we can perform are context-specific, the same applies to numbers, as one ratio could provide distorted views on different ventures (think of very low margin results of Tesla, for example, still today!).
However, some metrics are worth being checked in any case:
GM, Gross Margin, and its ratios, to check whether the business is healthy and sustainable. Especially interesting to check are figures per SKU, Stock Keeping Union, or per customer.
CLTV, Customer Life Time Value, and CAC, Customer Acquisition Cost. Their ratio is what investors expect to see in the pitch presentation and that should be above 3. But also loose CLTV and CAC calculations need to be done quickly and question how they are calculated and compare them with industry or similar concepts.
WTP, Willingness To Pay, for basic price needs to be checked and for premium price too, when applicable.