Funding a tech startup that generates a positive return on investment can be challenging and involve significant risk. It’s sometimes hard to know where to begin since your investment isn’t guaranteed to pay off long term.
Identifying an innovative business idea often isn't enough. Some investors have personal savings, but if you’re just getting started, you may not have that cushion to fall back on.
If you want to invest in tech startups, here's an overview of the challenges you might face and seven tips to succeed.
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DOWNLOAD NOWTop Challenges of Investing in Tech Startups
Investing in tech startups comes with challenges. For one, few become unicorns—privately held companies valued at over one billion dollars.
Approximately 90 percent of startups don't succeed, with 10 percent failing within the first year. The tech industry, specifically, has a 63 percent failure rate. In addition, only 20 tech startups reach $100 million in revenue annually.
Beyond being exposed to financial risk, you could invest in a corrupt company and damage your reputation. For example, artificial intelligence and data privacy are impactful topics for tech investors. Consider political consulting firm Cambridge Analytica, which unethically accessed Facebook users’ data during the 2016 U.S. presidential election. Despite news of the scandal breaking in 2018, Facebook—and its stakeholders—still feel its impact.
While it's beneficial to mitigate as much liability as possible in business, some risk is inevitable. Here are seven tips for investing in the right tech startup and maximizing your returns.
Investing in a Tech Startup: 7 Tips
1. Determine Whether There’s Product-Market Fit
Successful startups require more than just good ideas. Their products must resonate with their target customers. This requires finding product-market fit.
“Product-market fit is creating a compelling product that properly satisfies the target market,” says Harvard Business School Senior Lecturer Jeffrey Bussgang in the online course Launching Tech Ventures.
Approximately 34 percent of startups fail because they don't find product-market fit. As an investor, it's crucial to ensure that any startup you consider accounts for product-market fit in its business plan. This requires market testing and positive, measurable results showing potential customers’ interest and value.
If a startup doesn't have a scalable product-market fit, it's best to avoid investing in it.
2. Evaluate Team Quality
Whether you're an angel investor or part of a venture capital (VC) firm, it's critical to research a startup’s product and its team.
According to Launching Tech Ventures, team quality is one of the main factors VC firms consider when making investment decisions.
Team quality includes factors such as:
- Experience: While years of experience aren't always paramount, longer industry history can be worth considering—especially since the average age of a tech startup founder is 45.
- Mission and value proposition: A company's mission statement and value proposition often guide team members’ strategic initiatives.
- Commitment to sustainability: If you want to invest in a sustainable business, gauge its commitment to the triple bottom line.
- Ethical practices: Many red flags can signify fraud or corruption, such as employees giving unrealistic guarantees regarding business growth or failing to register products.
Don’t just invest in an idea. Even if a startup achieves product-market fit, an ineffective team can put your investment at risk.
3. Research the Market
According to Launching Tech Ventures, VC firms must consider market size and dynamics before investing.
“It’s important to consider the individual startup within the larger ecosystem of startupland,” Bussgang explains in Launching Tech Ventures. “Are there opportunities within the ecosystem that will support the growth and success of this startup?”
Regardless of volatility, ensure the company has a solid go-to-market strategy—a thorough plan to reach customers effectively and efficiently.
Run customer acquisition experiments across channels to ensure you firmly understand the market.
“At this stage, the founder may bring on board additional sales and marketing resources to help them scale customer acquisition,” Bussgang says in Launching Tech Ventures, “ideally in the form of a growth team or expeditionary sales leader who’s accustomed to uncertainty and a lack of structure.”
4. Analyze the Business Model
Before providing funding, confirm the company has a good business model and revenue generation strategy.
The most common tech company business modelsinclude:
- Freemium: The business provides a free tier of its product or service and charges for a full or upgraded version.
- Employee benefit: Another organization purchases the company’s product to offer as a free benefit to employees.
- Intermediation: The business acts as a bridge between products or services and consumers.
- Disintermediation: The company streamlines product delivery by removing a step in the supply chain process.
“Not all business models are created equal,” Bussgang says in Launching Tech Ventures. “Certain business models tend to lead to more valuable companies.”
5. Examine the Pricing Model
It's crucial to know how the startup will make money before investing. According to Launching Tech Ventures, three typical pricing models are:
- Advertising-based: It makes money by charging advertisers for ad space.
- Transaction-based: It provides a platform for transactions and receives a cut of each.
- Subscription-based: It continuously earns money rather than a one-time payment in exchange for its product or service’s use.
“Your selection of your business model—and the profit formula underlying it—is a critical aspect of the startup journey and can make or break your startup idea,” Bussgang says in Launching Tech Ventures.
6. Read the Term Sheet
Another step to take is understanding your investment’s terms. This requires a term sheet—a document that outlines the deal’s provisions. While helpful for entrepreneurs, it also protects you if something goes wrong.
“If everything goes well, most control terms don’t come into play,” Bussgang says in Launching Tech Ventures. “But when things go poorly, and there are disagreements, the documents determine who’s in the driver’s seat and has the power to make major decisions.”
A term sheet is just the first take of your proposed agreement’s terms and conditions. If something doesn’t align with your interests, don’t get deterred. Instead, take an active role in the negotiation process.
7. Consider the Company's Scalability
Does the company have a plan for scaling after it’s found product-market fit? According to Launching Tech Ventures, it needs a formalized process to produce sustainable growth.
It can take two approaches:
- Aggressive: Trying to grow quickly despite a possible lack of confidence
- Incremental: Scaling slower to learn along the way
Regardless of the approach, the primary question is whether the company is scalable in the first place.
According to the online course Entrepreneurship Essentials, founders should focus on six areas to boost scalability:
- High-quality staff
- A culture of shared values
- A sustainable business structure
- The ability to move quickly
- Innovation
- Financing flexibility
Scalability indicates whether the company can effectively respond to market changes and competition. Therefore, investing could put you at a competitive disadvantage if the industry experiences a monumental shift.
Begin Your Investment Journey
If you're ready to invest in a promising startup, becoming familiar with what it takes to be a successful entrepreneur is essential. Learning how startups succeed and fail can enable you to identify opportunities and risks when evaluating potential investments.
By taking an online course, such as Launching Tech Ventures, you can gain the tools and frameworks to start investing. Through engaging with real-world business examples, you can learn how to navigate the tech industry’s dynamic landscape and make strategic investment decisions for long-term success.
Are you ready to fund a successful tech startup? Enroll in Launching Tech Ventures—one of our online entrepreneurship and innovation courses—and download our free entrepreneurship e-book.
