How to evaluate deals

By Reji Joseph

Angel Investor, Advisor, Social Worker and Artist

Context Setting

One of the critical aspects of investing in start-up is to have a robust process of evaluating the deals that are showcased to angel investors.

Investing in a start-up has a bigger element of judgement at an early stage and is more driven by numbers at a later stage. A good start-up idea should have a good narrative, backed by relevant data (not just by conviction), which makes evaluation more coherent. Absence of either a good narrative or data can impair ability to evaluate.

An investor has to be careful so as to not fall for narrative fallacy, besides; relying too much on data alone is not a great trait for deal evaluation, ability to take a decision with limited data points available is necessary, as the journey of a start-up is fraught with lot of uncertainties.

An investor should also look to deploy techniques like inverted thinking to get a holistic view of a proposal. For example, instead of thinking how an idea can succeed, investors should understand how a start-up prepares itself by looking for ways to prevent failure.

Unlike secondary market, investing in start-ups is hard, since a proxy valuation in terms of comparative value matrices does not exist, the source of data is limited, the user validation of product offering is not yet tested and sustainability of business is not known.

The robustness of deal evaluation process determines successful outcomes for investors, both in terms of risks and returns. As an investor evaluates more deals, an element of quick judgement gets developed over a period.

Evaluation Journey

“A journey of a thousand miles begins with a single step” – Chinese proverb

Let’s look at the step by step evaluation journey from an investors’ point of view. While these may not be sequential, these are bare minimum steps that an investor looks at.

Problem solving

The ability to convey business ideas starts from a simple premise of solving a user need, this can be either increasing process efficiency or introduction of a product, where demand is unmet and is large enough. A business idea should start from identifying an existing problem, look at whether workable solutions exist and offer them to the user.

Many a times a user may not be aware of problems or the priority of solving a problem may be low. Understanding the unmet demand for either product improvement or increasing process efficiency is the foundation on which the whole deal evaluation process hinges.

Market Opportunity

Once an investor is convinced that the idea indeed solves a problem, the next step is to understand the market opportunity, in terms of total addressable market, total serviceable market and finally total obtainable market. The size of the funnel here is critical for understanding the market runway available for growth. A smaller runway, but with demand for captive, repetitive paying users can also be good market, provided barriers to entry are high and price sensitivity is low.

Understanding, whether a market needs to be created or whether a start-up is eating away market share from existing players is a factor that needs to be considered. The market opportunity can be huge, but if the users do not want to pay, then avenues for revenue monetisation needs to be clear over a long term.

When an investor looks at market opportunity, he also looks for competition, not just direct, but also indirect in the form of substitutes, alternatives, the pricing power of competitors, funding raised by competitors, mortality of existing players etc.

Revenue Monetisation/Unit economics

While validating the execution capability, it is critical to understand revenue monetisation along with the go to market strategy. An ideal revenue monetisation should consider factors such as recurring annuity-based revenues, transactional revenues (one-time), deferring of revenues and sustainability of these.

The basis of business growth strategy – in terms of chasing market or putting processes in place or vice-versa needs to be understood clearly. A detailed plan for a sustainable unit economics over a period of time is an absolute necessity, in case short term unit economics do not work. The burn rate, the cost paid for earning revenues and the marketing economics are the basis on which a deal needs to be evaluated.

The team

Once the above parameters are looked at, the key differentiator in terms of the team needs to be evaluated thoroughly to understand the temperament, passion, relevant experience and vision.

There is no straight forward way to evaluate these traits, but this comes with experience.

A business is as good as the team that is executing it. If all other aspects of a proposal are good, but the team which is running it are bad, then the outcome is pretty much ordained.  The team / leadership  must have the ability to think for the future. They must look at the business not for today but when the product / service will be ready and relevant.

Key Outcomes

In simple words “An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.” – Benjamin Graham

A good evaluation of a deal not only involves good judgement and foresight, but also right valuations. While evaluation of deals results in an investment decision – whether to invest or not to invest, any investment decisions have to be made on the basis of two key parameters:

    • Key Risks and Mitigants
    • Potential Returns

Risk and returns are two important aspects of a balance scale in investing. A right combination of these two aspects is key in successful investing outcomes. While too much of risk aversion may result in loss of opportunity, too little focus on risks can result in an investment strategy which may not be sustainable.

Risks can be from known or unknown sources. While risks from known source needs to be evaluated and sufficient mitigant processes needs to be built in, risks arising out of unknown source or a black swan event, needs to be tackled with alacrity as and when these arise.

Covid-19, for example is an unknown risk which cannot be predicted and may result in demand destruction over a considerably long period of time for business. However, opportunities that rose from this crisis have benefited those who could react quickly.

Easily replicable ideas over a period of time, which can build strong sustainable entry barriers, are ideal candidates for investment. But these can be built only over a period of time and the outcomes are not known in advance.

Product obsolesces or technological obsolesces can neither be predicted nor can be prepared for. Such risks exist and these are real. While avoidance of risk is next to impossible, ability to manage these known risks upfront plays an important role in evaluating deals.

While potential returns cannot be predicted, an investor should know fire exits at the time of making the investment. The investment returns are directly proportionate to the quality of investments made rather than quantity of investments made.

Managing less is managing better; the key is identifying right opportunity with great potential returns.

To Conclude

Evaluating deals is more of an art than a science, it involves lot of judgement – judgement about people, market potential, ability to execute/grow, ability to attract funds and above all, the ability to exit at the right time.

Evaluation is driven by perception and is perfected over a period of time. While a robust evaluation process is a necessity, given the uncertainty due to investments at an embryonic stage, certainty of returns is not guaranteed. A portfolio level approach is the best approach in order to achieve success in this investing journey.

Entrepreneur – Chennai Angels, most reliable investors
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