Pitfalls to Avoid When Choosing Startups to Invest in

In the past years, movies and glam articles have portrayed unicorn discovery as a piece of cake endeavor. The same goes for other high-return investments. Consequently, honest materials about what drives VC decisions and about choosing startups to invest in are rare. 

Of course, we’d love to say that any investment decision you make as a VC should rely on data. The reality is that when it comes to the early stage of investing, data is hard to come by. Most startups only have qualitative research, if they have any. Most of them haven’t even really gone to market. This makes it hard to evaluate them properly. Another market reality is that startups have trouble collecting and reporting data. This is something we have discovered while researching our Disciplined Accelerators Series.  

Without enough financial and conversion metrics there isn’t a certain way to model the business and figure out possible returns. Simply said choosing startups to invest in is a hard job. As a consequence, VCs have developed their own ways of evaluating startups, based on founders, product, and market.

Why it’s important to avoid failure

We found some interesting information regarding failure rates of scale-ups. Statistics coming from Venture Capital funds are mostly concerned with real, innovative, scalable startups. However, venture funds invest mostly in growth-stage startups, AKA scale-ups. They are true startups, but most of them have gotten past one of the biggest risks for startups: the search for product-market fit. They have tangible proof that people want what they are offering (this proof is how they attract venture capital).

This means that their failure rates would be lower than the failure rate of early-stage startups. Harvard Business School lecturer Shikhar Ghosh says in a WSJ article that 75% of venture-backed companies never return cash to investors and in 30-40% of the cases investors lose their whole initial investment (he works with a dataset of 2000 venture-backed startups).

That said, only 0.05% of startups get VC funding (Source: Fundable), so this statistic is not applicable for the vast majority of new businesses, especially if they are in the early idea stage.

1. Investing based on personal experience

While we cannot argue that experienced VCs have developed a way of intuitively working out which startup would make a good investment, this model is not replicable or scalable. For someone looking to grow their firm, there is a great need for replicable systems. This way, the juniors that come in have a proven way of choosing well and bringing returns. When choosing startups to invest in, a VC firm must have something more than the experience of veteran investors.

2. The spray-and-pray approach

This approach can work for big VC firms with unlimited resources. But in the long run, even they have issues. Think about recession periods and an unforeseen crisis. Sure, if they’re not involved in any post-investment work (like angels and accelerators) spray-and-pray makes sense. Since all efforts go into sourcing, scouting, and closing with no further work, it’s a good strategy. 

However, for smaller firms spray-and-pray is costly. It may be a “diversified” strategy for choosing startups to invest in. But each deal takes about the same amount of work no matter how much you invest. Hoping that if you place bets on enough companies, you’ll eventually strike one with a very large return should not be the philosophy you apply. Especially if you really want to be successful. 

3. Sticking to traditional discovery methods 

Any investor out there would love to beat the market. In fact, many pride themselves with ways to do this, from special gut feelings or being smarter than the rest, to simply outworking the other person. Think about it. An investor comes to a simple, obvious conclusion based on the market and their own experience. Chances are, someone else is coming to the same conclusion as they have access to the same information. To make sensible investments, VCs need to upgrade their game. They need to dig deeper, get complex, and try to get more data. Even if the data at hand is scarce. There are many tools out there to use. In fact, many VC firms are already developing their own software and tools to identify the right investments. 

Discovering the new hot startups to invest in today moves beyond traditional methods, and is enhanced by better tools, automations and processes. After all, VCs are driving the new tech advancements across the board, and surely they need to also join the tech revolution themselves.

4. Waiting for startups to gain business traction

Early stage startups will not be revenue positive. This is simply the truth. But there are signs that can let VCs know whether the startups are a good investment or not. 

Choosing startups to invest in begins with a good idea. The startup has to be about a good idea. But it goes so much further than this. We all know they are a dime a dozen. However, if the ideas are not backed up by data and the right founders, the startups cannot grow into a business worth investing in. Promising startups also have good business planning. Part of this is setting up processes and not skipping important steps. From market analysis to growth plans and marketing strategy, they can all offer you relevant data. To know if a startup has processes in place it’s enough to look at their website, Social Media channels, blog and the profiles of the founders, and to ask for some data. Gather all this data in one place and work out if the startup’s way of doing things is about chaos or processes. 

5. Receding investments in a recession 

Tough times breed great business ideas and some of the most persevering founders. If a business thrives during tough times, it will surely fly during good times. Even if the economy is uncertain, don’t recede your investments. In the end, you’re not investing on a few months horizon. Your returns will show years from when you invest and years after the crisis has passed. Keep this in mind during turbulent times.

6. Not being hands on

Apart from funding, startups need access to investors’ networks. And especially to their knowledge. Simply investing in a startup is not enough to ensure returns. Many founders aren’t experienced. Many founders have invested all their time into planning and developing their startup, not into growing a network. Supporting a startup with more than finance increases its chance of success. Obviously, it increases your returns too. When choosing startups to invest in, make a plan regarding what else you are willing to invest. Think of mentors, courses, bootcamps, and software to support the startup’s growth beyond immediate revenue. 

7. Relying on associates for manual tasks

Great VC firms have associates to spare. And they rely on them for most of the work. This means many aspects of the work are highly manual. But imagine what would happen if associates were upgraded from manual work to high value work. This can be done by automating most manual tasks and getting associates to work with input from those automations. As we’ve said in a previous article, automation can lead to a highly effective deal flow and due diligence platform.

These are just the first steps. Once you have them in place, you can move on to automating many other parts of your firm that will simplify the process of choosing startups to invest in. 

8. Don’t make finding a unicorn your VC investing strategy

If a startup’s financial goal is to “make a billion dollars”, walk away. Rather than hunting for a unicorn, hunt for the startup’s data. Look at whatever metrics you can find and understand how the startup approaches data. This will tell you everything you need to know about the startup’s future success or lack thereof.

No matter what your experience is, no matter who the associates or the partners in your firm are, nothing beats data. Even superstar VCs have a slim chance to discover a unicorn. A startup has a 0.00006% chance of becoming a unicorn. That means three out of every five million companies. In conclusion, when choosing startups to invest in don’t make finding a unicorn your goal. 

Venture Capital has been and will be an important source of financing for startups. They solve a very important challenge in market economies: connecting founders with good ideas to investors with good funds. However, Venture Capital firms need to have solid returns. This makes choosing startups to invest in a high stakes step that should be done with good processes in place. Many VCs have come to this conclusion and have developed software that takes human bias out of investing. This way, there is hard data to look at and on which to base decisions.