9 min read
Selecting Startups to Invest In
The 5 Step Startup Selection Process
It’s always exciting to hear startups pitch and envision the “disruptive” future the founders paint. It’s all fun and games until it’s time to make a financial decision and put your money where your mouth is.
Regina Zurutuza, Partner at 500 Global has evaluated over 900 startups in her 3.5 years at 500 and has done over 120 deals in LATAM.
With a background in engineering Regina always thinks about the process of choosing startups to invest in as a stage process. Her focus is to understand the inputs and outputs of each stage by breaking down the process for selecting startup into 5 steps:
5 Step Selection Process
Define Your Investment Thesis
From an investment point of view, it is extremely important to define your investment thesis. If you’re a VC firm, you’ve probably spent a lot of time thinking about this. If you’re an angel investor, or if you’re part of the investment team at a firm, take time to define exactly what you’re looking for and have a clear understanding of your investment thesis. This will allow you to have a strong point of comparison when it comes time to speak to founders and analyze companies.
Break Down Each Component
The 500 LATAM team invests in early stage tech companies in Spanish speaking LATAM. If we break this into components, we focus on:
- Industry: Early Stage Tech
- Region: LATAM
Tech encompasses a big market and is a bit vague but we are very specific about the region. When analyzing tech companies, it can be challenging to understand what we are looking for with tech. Define what ‘tech’ fits into your thesis.
We are constantly asking ourselves questions like: ‘How do we define a tech company?’, ‘Does tech enabled fall into our thesis’, etc.
Go back to your thesis to answer these questions with more clarity.
Know What You are Looking For
The second thing to consider when defining your thesis is understanding what your expected outcome is from these investments. This will likely vary between a VC firm and an angel investor.
For example, an angel investor might be more interested in the commercial relationships of that investment. A VC firm may be more focused on building a certain brand and returning capital to your investors. The results of that investment and potential outcome really helps you narrow down the startups you are considering.
Once you’ve determined your thesis, then you can figure out where those founders are and how to connect with them.
To become better investors and better at selecting startups, become aware of your active channels. Track where your best companies are coming from so that you can double down on those channels.
A common mistake is that we lack focus and we try to do everything at once. While you do need to have a lot of channels open, your focus should be on those channels that are bringing you the most qualified leads for your investment process. Hone in on the sourcing channels that deliver your best companies.
Why is it so crucial to have a triage process? If you do not have a thoughtful triage, not only can you make a bad investment decision, but you can miss out on a company that could have been a great investment.
Investing in the wrong company is one of the best case scenarios, because you’ll learn something from that decision. The opportunity cost of missing a great investment is much bigger.
This process of triaging is going to vary by firm and type of investor- so take what works for you.
Start by creating standard interview guidelines for clarity when you meet with companies . You may not have a standard interview with founders, because of time restraints, etc. However, having those strong guidelines will help ensure your team touches on each important point during the triage call.
The topics we touch on with founders on these triage calls are: team, product, market, metrics, business model and fundraising. There is a lot of depth to each of these six aspects but try to at least touch on each one to get a general understanding of what the company is doing.
Asking the Right Questions
The questions you ask founders will tell you how the company plans to execute their goals and will help you understand how they are thinking about their goals.
In general, follow your curiosity and make sure that you ask for clarification on any answers you don’t understand. Dig in to what the founder is telling you. If you are curious but not fully understanding, there is a lot of important information that can be missed.
6 things to look for when you’re talking to a company or to a founder:
- Is the founder being clear and transparent about what they are building?
- Be prepared before a call (review the deck, website, etc.) to at least understand some context.
- Potential & Vision:
- Have a solid understanding of the company’s potential and vision and then determine if it is aligned with what you are trying to build and invest in.
- Do they have the right expertise and team in place to execute on this vision?
- Do they have a competitive edge? You don’t need to fully evaluate competition, but understand what makes them a winner in their circle.
- Has the team been founders of other companies before to help with execution expertise?
- Do employees at the company have previous experience at similar companies?
- What have founders and team members learned from past experiences? These questions can be hard to understand in a first call but spend the time to go a bit more in depth to help assess their execution skills.
- Founder-VC fit:
- Determine if this founder or company is a fit for you as an investor.
- Does it fit your thesis and your way of working?
- Does it fit what you’re looking for in a founder and do you fit what they’re looking for as an investor?
- Determine if this founder or company is a fit for you as an investor.
Triage calls are an opportunity to learn so much about the company. In some cases, you may even be able to make a decision from that call.
Analysis is the stage of the process where you consider key questions for each company. It is impossible to ask every question or know every detail of the company. You are not going to be able to mitigate every risk and understand every decision the company is making. Especially in early stage investing where there are a lot of unknowns. By knowing your key questions, you will ensure you cover the most important aspects.
Try to understand the key drivers and key questions that can make or break a company. For example:
- If you’re looking at a Fintech company that has a strong regulatory limitation, a key question would be “how are you tackling the regulation around their business model? Do you have a team with prior experience with this?”.
Pause and consider the key pillars that move that particular company. Those pillars might be similar between early stage companies, but determine the most important question you want to have answered and focus your analysis on that.
You still need to do the work and due diligence. Really question yourself and the company in a strategic way by focusing on the 80-20 of what might be a deal breaker. Continuously go back to your investment thesis to determine what is right for you.
The most important question to ask yourself before moving to this stage is “Do we have the necessary information to make this decision?” If you are missing information, go find it before moving to the decision stage. A few things to consider when you are in the decision stage:
- Know who the decision makers are at your firm. Sometimes, there is not a lot of clarity on who those decision makers are, so try to pinpoint those people so you can understand what drives each one of them.
- Be aware of your unconscious bias when selecting which startups to invest in. This is where you are your own worst enemy. If you are falling into any biases, you are more likely to make a bad decision. Question yourself often.
- Train your gut, especially in early stage investments. Follow your intuition, but you need to train your brain to think about the right aspects, ask the right questions and know when something is unclear. Continue to follow your curiosity- if something is not sounding right to you, take the time to dig deeper. Don’t ignore yellow or orange flags.
- Post mortems are your best tool for reflection learning and iteration, you will have to make sure that every so often you have the space to do post mortems on right and wrong decisions or investment decisions.
When evaluating different founders from different backgrounds, consider what the team has accomplished with the resources they’ve had available. It is hard to compare a founder that lives in a remote village in Peru with limited access to capital to an Ivy League graduate with a lot of access to capital. What the founder has been able to do with the resources they have tells you a lot about the potential of the company and the team. You can miss out on some great companies if you don’t consider that delta on good resources.
Selecting startups to invest in is both a science and an art. By breaking down the process into these 5 steps, you are able to create guidelines to analyze companies quickly and accurately.
Always evaluate the quality of your decisions, not necessarily the result. A well made decision doesn’t always have the best results- and that’s ok if you were diligent about how you made that decision.
Watch the full session with Regina including live Q & A here.
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