May 11, 2023
Due Diligence

Five Innovative Ways to Gauge a Startups Potential

Bram Berkowitz

efore investing in a new company, a startup investor is going to do a lot of due diligence. This work will likely include looking at a startup’s growth so far, the size of the market it’s operating in, the burn rate, customer acquisition costs, the founders, and the company’s financials.

But because startups are so new and difficult to judge, even after gathering and analyzing all of this data you’re probably going to want to do more research. This extended research will likely involve techniques you develop over the course of your career and be less traditional than industry-wide practices. However, if done and used correctly it may also give you the reassurances you need to make a more informed confident decision. 

Here are five innovative ways to measure a startup’s potential.

1. Man on the street

During an investor pitch, every startup founder is going to tell you about all of the traction they have and it’s likely going to sound pretty great. After all, startup founders are passionate about their work and are going to be somewhat biased whether they admit it or not. In order to double-check their claims, go out and collect some feedback of your own. 

This can be thought of as the ‘man on the street’ technique when people go and conduct interviews with random people on the street to try and get completely unbiased opinions.

In this case, the people don’t necessarily have to be random but they shouldn’t know too much about the startup you’re evaluating. See what people in your own network think of the product or application if it’s already up and running. 

If it’s a new social media app, ask people you know that are avid social media users. If it’s a business software solution for construction companies, go speak to someone that works at a construction firm and see what they think of the idea.

If you’ve got people in your own network that you can use, great. If not you may need to go do some networking yourself. Obviously, this will be a small sample size so the results should not make or break a decision but it can better inform your views on the company and maybe also shape your research. 

For instance, if you send a startup idea to people that you believe are the company’s target audience and they all don’t like the idea or find it helpful, this may be a red flag. Or perhaps it shows that you may not understand the utility of the company and that more research is needed. 

2. How much engagement can the product or service drum up?

Now that you’ve gone out in your own network and gotten some qualitative feedback, you can try this in a slightly more quantitative method. Perhaps this involves posting the idea or product on social media if the company is up and running, or conducting an online survey to see if people are actually interested in the solutions the company provides. 

Again this isn’t a perfect science but for anyone that has tried to build a social media following you’ve probably realized that it’s hard to know exactly what your audience will engage with the best. This experiment may not end up telling you much but if it generates a lot of organic traffic and engagement that can be a positive indicator.

3. Try to sell it yourself 

You probably won’t want to do this on every idea that comes across your desk because you’ll want to keep some under the radar but it might be productive to see how easily you can sell an idea that you are being pitched to someone else. For this exercise, I’d recommend speaking with more investor-oriented folks in your network.

What is their initial reaction when you pitch them on the idea? Are they excited or skeptical? What are their biggest questions? Do their biggest questions match up with yours? Doing this could present new bearish or bullish perspectives that you may not have previously considered. You’ll need to be very careful when doing this because you shouldn’t pass the idea off as your own and you may not want to give it away to other investors but most investors have people in their networks they can bounce ideas off of.

4. Assess whether the startup actually needs the money

Investors will get a look under the hood of most startups and be able to see what their financials look like. Investors are going to look at the burn rate, revenue, and profitability, and examine how the company can eventually achieve profitability, using certain assumptions. But another good idea is to assess whether or not the company can survive on its own and eventually become a self-sustaining business. 

Investments should jumpstart and accelerate growth but not necessarily serve as a lifeline, although sometimes they might. But if you can find a business that can become a sustainable business on its own that says a lot about the viability of the business and might be an even better reason to invest. Run a range of scenarios including how the business might perform in a recession or in a thriving economy and what would need to happen for them to achieve profitability and under what time frame. This method will depend heavily on your modeling capabilities. 

5. Stacking it up against public comps

While some startups create entirely new markets, many others are innovations within existing markets such as ride-sharing, social media, fintech, and software-as-a-service. If the company does fall into an existing industry, look at some of the most successful publicly-traded companies in that sector and look at all of the financial data that these companies have posted in the past in their registration statements, regulatory filings, and anything you can find in media reports. For instance, if you can determine that the company pitching you now has more users than Uber in its third year of business then that company could very well be onto something.

Investing in startups requires a comprehensive approach that goes beyond traditional due diligence. While analyzing growth, market size, financials, and founders is crucial, additional innovative methods can provide valuable insights. By combining the methods in this article with traditional analysis, you can make more informed and confident decisions when considering startup investments.

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