How Do Investors Decide Which Businesses To Invest In?

The Five-Stage Investing Process Unpacked

Author

Steven Williams
May 25, 2023

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In today’s email:

  • How Do Investors Decide Which Businesses To Invest In? The Five-Stage Investing Process Unpacked:

    1. Problem Recognition

    2. Information Search

    3. Evaluation of Alternatives

    4. Investment Decision

    5. Post-Investment Evaluation

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How Do Investors Decide Which Businesses To Invest In? The Five-Stage Investing Process Unpacked

Today, we're exploring the art and science of evaluating investment opportunities, offering insights from an investor’s perspective that could increase your chances of securing investment.

At the crux of our analysis is the Five-Stage Buying Decision Process, a consumer marketing model that we’ve adapted for assessing startup opportunities. The stages include:

  1. Problem Recognition

  2. Information Search

  3. Evaluation of Alternatives

  4. Investment Decision

  5. Post-Investment Evaluation

We’ll unpack each stage, revealing its importance in making informed, strategic investment decisions, and how you can use this to your advantage when pitching for investment.

Stage 1: Problem Recognition

For an investor, the 'problem recognition' stage revolves around identifying opportunities with the potential for substantial returns. As an entrepreneur, it's crucial to understand that the investor's 'problem' is finding an investment opportunity that aligns with their portfolio, has a strong growth trajectory, and promises an attractive return on investment.

In this context, the 'problem' an investor is looking to solve often gets uncovered through an entrepreneur's pitch. During this pitch, the entrepreneur presents a unique problem or market gap that their startup is poised to address. The proposed problem could range from a prevalent inefficiency in a given industry, an unserved or underserved market segment, or an innovative opportunity sparked by technological advancements or evolving consumer behaviours.

At this stage, the challenge for the investor is to evaluate the problem's scope, relevance, and potential market impact. They need to understand the problem's scale and ask: How widespread is this issue? Does it affect a large enough consumer or client base to yield substantial returns? Is this problem pertinent in the current market, or is it a projected future challenge? Is the problem's resolution likely to create significant disruption, and thus, high potential returns?

As an entrepreneur, when you articulate the problem your startup aims to solve, ensure it's clearly defined, significant, and grounded in market realities. Show evidence to back up your claims about the problem's existence and its scale. The more tangible and substantial the problem appears, the more likely it is to resonate with the investor, thus increasing your chances of attracting investment.

Stage 2: Information Search

Just as customers engage in an information search before making a purchasing decision, investors embark on a thorough due diligence process to gather as much information as they can about a startup before deciding to invest. This stage involves a meticulous exploration of the business model, an understanding of the competitive landscape, a thorough examination of the team's qualifications and experiences, and a deep dive into the startup's financial projections and revenue model.

Investors will be scrutinising your startup's scalability, product-market fit, market size, revenue streams, customer acquisition strategies, and overall profitability. They'll also be examining the competitive landscape to understand how your startup differentiates itself from existing solutions. They may conduct SWOT (Strengths, Weaknesses, Opportunities, Threats) analyses to gauge the resilience of your startup in the face of competition and market volatility.

A crucial aspect of this information search is assessing the team's capability. Investors often say that they invest in people, not just ideas. The qualifications, experiences, skills, and dynamics of your team will be under the microscope. Investors want to see a passionate, committed, and knowledgeable team with a proven track record and the ability to execute the business plan effectively.

In addition, investors will delve into your financials - studying your projections, assessing the validity of your assumptions, and checking your figures' accuracy. They'll evaluate your burn rate, your revenue streams, your growth rate, and your plans for managing financial risks.

As founders, you must be prepared for this stage by having comprehensive, clear, and convincing information at the ready. Your pitch deck should be robust, your financial projections are realistic but ambitious, and your team's profiles should highlight relevant experiences and achievements. Be ready to present detailed market research that solidifies your understanding of the market and competition.

Stage 3: Evaluation of Alternatives

Just as a consumer weighs different product options, investors must assess multiple investment opportunities. Given the high risk associated with early-stage investing, angel investors tend to be very selective about where they put their money. They have to weigh the potential risks against the projected returns and determine how well the startup aligns with their personal or fund's investment strategy.

Key considerations at this stage include evaluating the startup's competitive position, risk versus reward analysis, and alignment with the investor's portfolio. Here are some elements that investors pay close attention to:

  1. Competitive Advantage: Investors will be looking for startups that demonstrate a strong competitive advantage. This can come from unique technology, proprietary data, strategic partnerships, first-mover advantage, or any other factors that set your startup apart from the competition. The stronger the competitive advantage, the higher the chances of the startup succeeding in the marketplace.

  2. Risk/Reward Analysis: Investors understand that high returns often come with high risks, especially in the startup world. They will evaluate the potential risks associated with your startup – including market risks, team risks, regulatory risks, and more – and weigh them against the potential rewards, such as the potential for high ROI if your startup succeeds. Your job as a founder is to show that while risks exist, you've identified them and have plans in place to mitigate them as much as possible.

  3. Alignment with Investment Strategy: Every investor or investment fund has a specific investment strategy. Some might focus on certain industries or geographies, while others might prefer to invest at a particular stage of a company's growth. Investors will assess how well your startup fits into this strategy. Founders should therefore target investors whose strategies align with their startup's industry, stage, and growth potential.

  4. Growth Potential: For investors to realise a return on their investment, the startup needs to grow significantly. Therefore, investors will closely evaluate your startup's growth potential. Founders should be ready to demonstrate a robust growth plan, showing how they intend to scale their operations, user base, and revenues over time.

  5. Exit Strategy: Finally, investors want to know how they will get their money back. Founders should articulate clear potential exit strategies, whether through an acquisition, an IPO, or another route

Stage 4: Investment Decision

Just as a consumer arrives at a purchase decision after considering different options, an investor also reaches the point of making an investment decision after evaluating various startups. In the context of angel investing, the "purchase" is the act of committing capital to the startup.

At this critical stage, the investor makes the final call on whether or not to invest in the startup. Several factors come into play here, including the startup's performance during the pitching process, the quality of the information provided, and how well the startup aligns with the investor's portfolio and risk tolerance.

Here, investors consider:

  1. Investment Worthiness: This is the culmination of all the previous stages, where investors determine if the startup has sufficiently demonstrated its value, competitive advantage, growth potential, and risk mitigation strategies to warrant an investment.

  2. Deal Terms: If an investor decides to proceed, they will then negotiate the terms of the investment. This can include the amount of the investment, the equity stake the investor will receive, the level of involvement they will have in the company, and other conditions. The key to successful negotiations is to aim for a win-win situation where both the investor and the startup are satisfied with the terms.

  3. Legal Due Diligence: Once the terms are agreed upon, a legal due diligence process will follow. This is where investors verify the information provided by the startup, such as confirming the ownership of intellectual property, checking compliance with laws and regulations, and reviewing contracts and agreements the startup has with employees, customers, and partners.

  4. Final Decision: After the due diligence process, if everything checks out, the investor will make the final decision to invest. This is akin to a consumer proceeding to checkout after deciding to buy a product.

To ensure success at this stage, founders should be open to fair negotiations, aiming to strike a balance between gaining the needed funding and maintaining control over their startup. Be prepared to offer potential investors adequate equity to incentivise them, while also showing willingness to receive their input and expertise. After all, angel investors often provide more than just capital - they also bring their experience, network, and mentorship to the table, all of which can significantly contribute to the startup's success.

Stage 5: Post-Investment Evaluation

The final stage of the investment process mirrors the post-purchase evaluation stage of a customer's buying journey. Just as consumers evaluate their satisfaction with a product after purchasing it, investors also need to assess the performance of their investment. This evaluation helps investors to make future decisions about additional funding rounds, exiting the investment, or changing their level of involvement.

During the post-investment evaluation stage, investors look at:

  1. Startup Progress: Investors will monitor the startup's growth, product development, and market traction to determine if it is progressing as expected. They'll watch for any indications that the startup is meeting, exceeding, or falling short of the projections outlined in its business plan.

  2. Market Evolution: Investors keep an eye on the broader market in which the startup operates. Shifts in the industry, emerging trends, regulatory changes, and competitive dynamics can all impact the value and success of the startup. Staying informed about these factors can help investors to anticipate challenges and opportunities.

  3. Return on Investment (ROI): Ultimately, investors are seeking a return on their investment. This could come in the form of dividends, an increased valuation of their equity stake, or a successful exit through a sale or public offering of the startup. Regular financial reports from the startup are crucial to assess the ROI.

  4. Relationship with Founders: A successful post-investment relationship requires clear and consistent communication between the founders and the investors. Founders should provide regular updates on the startup's performance, upcoming milestones, challenges encountered, and any strategic shifts in the business plan. This communication builds trust and enables the investor to provide ongoing advice and support.

For founders, understanding this stage is critical as it underscores the importance of maintaining an open, transparent relationship with your investors. This doesn't just increase the chances of ongoing support from your existing investors, but it also sends positive signals to potential new investors. By demonstrating a track record of success and an ability to manage investor relations effectively, you can enhance your reputation and your startup's appeal to future funding prospects.

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