What Investors Consider Before Investing in Startups: Part 2
In Part 1 of this series, What Investors Consider Before Investing in Startups Part 1, we looked at seven key factors to investing in startups that investors consider before writing a check.
In particular, we took a look at the vital components, key factors, and metrics of your business’ pitch, like your one-pager and your pitch deck. These documents are at the core of what investors consider before investing in startups. Without those seven things, investors are not likely to write you a check.
However, that previous list was by no means exhaustive! There are seven more key factors to investing in startups that smart investors will want to see before providing you with any funding. Without further ado, let’s learn more about what investors consider before investing in startups!
Table of Contents:
- Correct Corporate Documents
- Current on Taxes
- Professional Bookkeeping
- The Company’s Relationship with the Bank
- Pending Litigation (or Lack Thereof)
All investors will want to ensure that the company in which they invest is in good standing with the law and has accurate records.
For companies, that means they have the necessary licenses in order to invest in startups. Most states require a statewide business license, and some cities need one as well. Even if your startup only has a few people working remotely, you still need all the necessary business licenses.
Similarly, investors will want to know that your company is in good standing with the state. Usually, this means that you have paid the necessary annual fees and filed the required annual reports.
C corporations are supposed to have annual meetings for all shareholders. Even if your corporation only has one shareholder or one person on the board of directors, if it’s a C corporation, then it needs to have an annual meeting and keep proper notes. Not having that meeting can, in theory, be a reason why a court might consider piercing the corporate veil. If that were to happen, shareholders or directors could be liable for corporate debts, which could have very negative implications for investors.
Similarly, if you have an LLC, S, or C corporation and don’t set up proper books, bank accounts, receipt tracking, and so forth, that could also spell trouble in the future.
Bottom line: investors will want to make sure that your business is operating as an actual business, complete with all legal, financial, licensing, and tax paperwork. That way, neither you nor investors will have any unforeseen issues down the road.
Tax debts are a huge red flag for investors. If a company cannot make enough money to pay its tax obligations, that doesn’t bode well. The IRS is not known for tremendous amounts of leniency, and the penalty interest rates and other fees can sometimes be punishingly high. Therefore, investing in a company that isn’t current on their taxes presents a substantial risk that most people aren’t willing to take.
However, being current on taxes is more than being up to date on income tax. There are numerous taxes that businesses must pay. When you make a sale to a customer, you’re supposed to collect sales tax. Some jurisdictions, like the State of Washington, even require you to pay a fee on all revenue you earn. Washington calls this the “Business and Occupancy Tax.” Other states have similar concepts, even if they’re not the same.
Failing to collect and remit these types of taxes properly can also make investors flee the deal. As a quick example, suppose your business did $100,000 worth of sales each year in California for five years. In California, the state sales tax rate is 7.25%. Failing to collect that money would mean the company owed $36,250 for those five years. Of course, the state would add on penalties and interest. If the business failed to collect and remit sales tax properly, there could be a substantial liability for the company.
When making sure you answer all the questions for what investors consider before investing in startups, make sure your tax liabilities are current and have no issues. You probably don’t want the IRS after you, and neither will your investors!
Businesses sometimes try and get by with minimal external bookkeeping, especially during the very early days. The founders may know enough about accounting that they can handle some of the transactions, which will assist in investing in startups. Profit/loss statements and balance sheets certainly aren’t super complex to prepare – especially with some of the advanced accounting software so readily available online. Most of these sites make it seem very easy to run your business’ books, yourself.
While this works for small businesses, remember that risk is one of the first things of what investors consider before investing in startups. Being your company’s accountant might be okay. Maybe you know the law entirely and are genuine. However, there are undoubtedly some unscrupulous people who “cook the books.” Others undoubtedly make mistakes that result in the books looking better or worse than they are.
Once you start getting to the level where you’re soliciting investors, you’re going to want to have professionals handle your accounting and prepare your taxes. For starters, having professionals handle this for you ensures that it is right. It frees up your time to worry less about the books and more about the business. Furthermore, it provides objectivity to your company. The fact that a third-party is handling your finances means that it is more likely to be accurate.
Think about it this way: would you trust Facebook’s numbers more if they came from Mark Zuckerberg or Ernst & Young? Zuckerberg may have all the knowledge necessary to prepare Facebook’s financials (or he may not, nobody knows). The problem is that he’s also got a significant incentive to make them look as good as possible. Ernst & Young, though, has a reputation of honesty to protect. They have the motivation to make things as accurate as possible.
If you haven’t already, start having your bookkeeping done professionally. Prospective investors will have more confidence in your business if trained professionals do the accounting.
Similarly to the first point, investors want to ensure that their money is safe. Financially, one of the best ways to do that is to ensure that your company is in good standing with the bank.
By good standing, we mean that your business has not had issues with the bank. There are no debts they’re trying to collect, you haven’t tried to avoid paying any charges, and that all your company’s corporate accounts have the right names, information, and signatories.
At a fundamental level, investors will want to make sure that all your business’ bank accounts are genuinely business accounts (not personal ones) that are not commingling personal and business funds. Companies that do that open themselves to suits that can pierce the corporate veil. Similarly, all corporate credit cards should only have business expenses.
These points might all seem relatively rudimentary, but investors see all kinds of entrepreneurs. What investors consider before investing in startups can sometimes be the core fundamentals that any business should have – because they likely have seen at least one or two pitches where those basics weren’t there.
Assuming you’ve been reasonably diligent about your business’ finances, investors will usually be okay with how you’ve handled your corporate bank accounts and credit lines.
Pending litigation can be a substantial turnoff for investors. If your business is worth $1 million and it’s the subject of a $10 million lawsuit, that means an investor could lose everything if it goes against the business. Pending suits can also expose other problems. For example, a pending suit alleging wage theft could signal more significant issues of accounting and transparency.
Most of the time, when investors go to write a check, they don’t want to see any pending litigation. There should be no lawsuits with merit against your company. However, a lawsuit does not preclude you from getting an investor on board. Remember that what investors consider before investing in startups are risks. Pending litigation represents a risk. If you can explain why investors needn’t be worried about the dispute, there’s a chance that they will still write the check anyway (every investor is different!).
Your pitch deck likely addressed your company’s competition to some degree, but it’s still something that investors will consider. They’ll probably take a look at some of the competing products in your market and objectively analyze if what you are offering is better and, therefore, hopefully, receive more usage
Make sure that you highlight why your offering is better. The more objective words you can use, the better. Instead of saying something like “has a more intuitive UI,” saying something like “the UI enables customers to perform the task in 50% of the time” has a higher chance of making an impact in investors’ minds.
Investors will want to consider critical metrics before writing a check. When discussing the investment opportunity with them, ensure that you explain why you are (or are not) hitting the following corporate success measurements:
- MRR: Monthly Recurring Revenue. As the name implies, this is the recurring revenue that your startup experiences. If you’re meeting your forecasted numbers, explain why. Similarly, if you’re not meeting them, explain what plans you have to address and close the gap.
- CAC: Cost of Acquiring Customer. Usually, you have to pay to get paying customers. Whether you’re advertising online or paying employees to sell your products, you’ll have to explain your cost of acquiring each paying customer and how it impacts your company’s financials.
- LTV: Lifetime Value. If the average customer pays $10/month and stays with your service for five years, their lifetime value is $600. Higher LTV numbers are better.
- ARPU: Average Monthly Revenue per Customer. If the average customer spends $10 on your service, then your ARPU is $10. Higher is better for this metric. If you’re not hitting your targets, you should explain why.
- Total Customers in the Sales Funnel. Be prepared to dive into your sales funnel and describe the customers you have at each step of the process.
- Invariably, some people will drop your startup’s subscription each month. A high churn frequently indicates dissatisfaction with the offering. If you have a low churn, make sure you highlight that!
- Cap (Capitalization) Table. This table provides information regarding the percentage of ownership that the founders and investors have. It also shows the equity dilution and value of equity given for each round of investment. Companys with huge cap tables may find it harder to obtain investors because investors will be wary that you’ll excessively dilute their position in the future.
- Liquidation Preferences. Investors will want to see if other people have the right to get paid before they do.
- CAGR: Compound Annual Growth Rate. Investors want to see that your revenue is growing at a respectable rate. This metric lets them measure your growth quantitatively.
- CPA: Cost per Acquisition. This metric is similar to CAC but has a subtle difference. CPA measures how much it costs to acquire a non-paying customer (e.g., someone who signs up for a trial). If you’re spending lots of money to get someone to even sign up for a demo, you should prepare an explanation.
- TAM: Total Addressable Market. You’ll want to address how big the market opportunity is for your startup. Investors typically like to see substantial markets that are ripe for disruption.
Whether or not investors are considering your pitch deck, diving deep into your ARPU numbers, or making sure that your business is in good standing with the state, there’s one theme that binds them together. They want to see that your business is genuine, has potential, and that you, the founder, are someone with whom they want to work.
Investors want to ensure that the businesses they invest in give them the best possible chance at a solid return. They want investments that do not have undue risk, which are fantastic companies run with integrity, passion, and smart business practices. If your business falls into that category, you’re ready to start seeking investors for your company!
About the Author:
Jonathan Hung is One of the most active angel investors in Southern California, his mission is to drive value creation within each portfolio company. In support of this mission, he serves as Co-Managing Partner at – Unicorn Venture Partners.
Jonathan and his team target investments in US companies that have global market potential with a focus on long-term growth expansion to East Asian markets.
Jonathan developed his investing prowess as a Managing Member for his family office fund, J Heart Ventures, which made investments in start-up companies such as Gyft, ChowNow, Miso Robotics, Clover Health, Bitmain, to name a few startups he funded.
Jonathan has various degrees from the University of Southern California, London School of Economics, Massachusetts Institute of Technology, and The Wharton School at the University of Pennsylvania.