Donald W. Reynolds National Center For Business Journalism

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Experts’ tips for evaluating startups

February 17, 2022

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Covering startups can be exciting and frustrating all at the same time. The newest billion-dollar startup can become the hottest topic in the business and tech media overnight, and its founder the newest celebrity sensation. But most of the information journalists use to evaluate the health of companies, such as several years of audited financial statements, isn’t readily available for startups – and for every successful unicorn, there are dozens of duds.

Despite the risks, money continues to flow into startups: in 2021, U.S.- based venture capitalists and angel investors poured $329.6 billion into startups, including early and late-stage ventures. That’s almost double the $166 billion raised in 2020.

What can journalists learn from these investors who are staking so much on backing the next Google? What do they look for in the absence of reliable financial data?

Early-stage ventures might have little more to offer investors than sales projections. While these numbers can be helpful, savvy venture capitalists treat them warily. 

Marc Bouchet, an analyst with TDK Ventures said he views sales projections as an assessment of how a founder wants to grow the company – and takes them with a grain or two of salt. Though venture capitalists like TDK Ventures, are usually in search of high-growth companies, a balance needs to be struck between high growth and outlandish projections.

“The best way to evaluate that is you look at the market size, and you try to understand what percentage of the market they say they’re going to capture in five years,” said Bouchet. “An easy example is if a startup says their market size for a certain medical device is $1 billion in the U.S., and in five years they’re going to be generating $500 million in revenue, does it really make sense as one startup that they’re going to capture 50 percent of the market in five years? Probably not.”

Ask questions, lots of them

In order to properly evaluate a company, Bouchet also looks at non-numerical factors. 

Some of the questions Bouchet asks are: Is what they’re offering unique? Do they have a patent? Are there any other variations of the product or idea? What is the competitive landscape? What does the sales process look like? Whatever the founder’s answers are, research and verify. Don’t just take their word for it. 

Most startups will experience losses at the beginning because they are concentrating on investing in their business for growth, so it’s not an automatic red flag to see negative numbers for net income. However, you would need to dig deeper into the numbers to determine if it’s due to something concerning. 

For startups in the early stage, some other key indicators venture capitalists look at are burn rate, gross profit margin, and customer acquisition costs.

Burn rate

One of the main reasons for startup failure is a lack of money. It’s not necessarily due to not having funding, sometimes it’s because they are burning through cash fast.

This burn rate is calculated by dividing a starting cash balance by the ending cash balance and dividing by the number of months during that period. A good burn rate is generally when a company has enough cash to last them for at least 12 months. If a startup is not using its cash efficiently and effectively and is asking for more funding, investors are going to hesitate to provide more unless the company has a very good reason. 

“In general, red flags come in on high marketing spend if not rationalized for a future growth acceleration, headcount coming in faster than a company can absorb people, or putting a large upfront down payment on a lease versus spreading it out,” said Shernaz Daver, operating partner and chief marketing officer at Khosla Ventures.

Gross profit margin

This is the amount of revenue left over after a company factors in their cost of goods, which helps determine the profitability of a business. In general, the higher the percentage the better, but a good profit margin depends on the industry and sector. A grocery store averages a gross profit margin of about 25%, while an internet software company averages one of 61%. New York University’s Stern School of Business maintains a page of margins of various U.S. sectors. 

Customer acquisition costs 

This is the amount a company spends to acquire new customers, including advertising and marketing expenses. This return on investment measurement is calculated by dividing the amount spent by the number of customers acquired. The higher the ratio the better, and the general rule for a good customer acquisition cost is 3-to-1 – meaning for every $1 spent, $3 of value is added.

These are just a few examples of the many financial metrics that are used, and there are different ones based on the type of business or business model. You can find these metrics online, such as on Finmark and TechCrunch.

Deciphering inflated numbers vs. actual metrics

Keep in mind that some startups create their own, non-standard financial metrics that paint an overly optimistic picture of their business. 

One of the most famous examples is WeWork’s creative “community-adjusted EBITDA.”  

WeWork’s innovation was to exclude “community-related” expenses such as rent paid on office space and upkeep – which just happened to be among its largest costs of doing business. This adjustment made WeWork’s earnings appear far bigger than in reality. 

Both venture capitalists and journalists who cover startups caution against being too reliant on a founder for information. Khosla Ventures’ Daver advises speaking with the financial backers of the company, as they generally spend a lot of time performing due diligence on their investments. 

Alex Konrad, a senior editor at Forbes who covers venture capital and startups, asks: “Can they introduce me to their customers? Will they be upset if I contact some of my own? This is important to see whether people are using their product and can give feedback, and for how much they’re trying to control the story.”  If a company tries to restrict or shape the narrative and who you call, it could mean that they’re hiding something. 

Reaching out to a startup’s potential customer base is important as another big reason a startup fails is no market need. Quibi, the mobile short-form video streaming service shuttered in six months because it didn’t appeal to consumers and it had high competition. Even $1.7 billion in private funding and a slew of celebrities for its programming couldn’t save it.

Also, contacting a startup’s competitors can help you analyze the company’s potential to be successful in the market.

“With my Snowflake cover story in January 2021, I immediately spoke to executives from other cloud technologies companies such as Databricks and Hashicorps to vet Snowflake’s claims about its product,” said Konrad. 

Don’t forget to take your time

This all seems like a lot, especially when you’re working with a deadline. Erin Griffth, a reporter at New York Times covering venture capital and startups, acknowledged that having the time and resources to properly evaluate companies is an issue. 

“When I was a tech blogger writing multiple posts a day, I didn’t have that,” she said. “I had to basically just trust the companies weren’t lying and take them at their word. Now that I have more time to dig in deeper, I try to have conversations with as many people involved as I can and dig up any filings or documents I can to support the company’s claim and present a balanced look at the business.”

It’s exciting to be the first journalist to break a story, or to profile a company that could be the next game-changer or behemoth, but we also have a responsibility to the public. Providing an accurate and balanced picture of a business is paramount in preventing consumers and investors from being misled, and preventing fraud and financial scandals.

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