Is That Startup a Good Investment Opportunity?

More than two-thirds of startups never deliver positive returns to investors. Is it possible to identify the likely losers in advance?  Harvard Business School professor and startup investor Tom Eisenmann surveyed hundreds of business founders and investors to answer that question for his book Why Startups Fail. His conclusion—in addition to being wary of deficiencies in business ideas and company founders, investors should ask the following questions before putting their money into an early-stage startup…

Have you done tests and experiments to prove that there’s a strong unmet customer need and that your solution fills that need? Pouring resources into engineering or product development before conducting significant customer research is the most common error among early-stage startups. Today’s entrepreneurship culture suggests that it is better to try and fail—then try again as many times as necessary—than to devote significant upfront time to analysis. Many entrepreneurs don’t consider failure a disaster—after all, plenty of famous entrepreneurs describe their early failed attempts as necessary steps on the way to success. That might be acceptable to the entrepreneurs, but each business failure likely burned through investors’ cash. It is a positive sign when an entrepreneur has conducted extensive interviews with potential customers as well as user tests of existing solutions to understand those solutions’ strengths and weaknesses.

What are the strengths of your cofounders…outside investors…strategic partners…and the rest of the team? Investors usually evaluate the skills and experience of the person launching a startup, but they often underestimate how much all the other people involved matter—the cofounders and employees, who should fill gaps in the founder’s skills and experience…and the strategic partners and investors, who should be able to offer advice and connections. Ask if there is someone who can provide expertise on every issue the company is likely to confront…and fill every function it will require—including oft-overlooked things such as tech, marketing and operations.

Are the needs of early adopters the same as those of mainstream customers? If they’re different, how do you plan to respond to that difference? The third big danger for early-stage startups is a false-positive—the young business gets a great response from a small number of early adopters…only to discover that those early adopters’ needs and preferences are very different from those of most other potential customers. There’s more than one possible “right answer” to respond to this question. The startup founder might explain how the company’s product will serve the needs of the divergent groups…or that the company is making a separate version of the product to account for the differences…or he/she might reasonably show that the company has done sufficient research to conclude that mainstream customers have similar needs and priorities as early adopters. What’s important is that the founder provides a credible answer to this question that shows he/she understands and has taken steps to address this potential risk.