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While investing in technology startups can be lucrative, it is also risky. There are several cases of well-funded companies breaking into a market only to experience significant losses. How can you evaluate your investment opportunities to determine their feasibility?
The Problem With Investing in Tech Startups
Tech companies are often disruptive or inventive — and are in constant supply — meaning the sector is ripe with investment opportunities. However, not every opportunity is equal. In fact, one conservative estimate claims that approximately 75% of venture-backed startups fail by not providing liquidity to investors.
While pinpointing an exact figure is challenging — some estimates are much higher — many startups fail to sell, merge, get acquired or go public. Even more of them fall short of their optimistic projections, providing a much lower return on investment (ROI) than investors expected. The only way to combat this uncertainty is to objectively evaluate investments.
6 Key Indicators to Assess Tech Startups
You should use these seven indicators to evaluate investment opportunities in tech startups.
1. Cohort Analysis Data
While your first instinct may be to use customer lifetime value to calculate future profitability, this metric is inapplicable to startups because early-stage churn rates are often too unstable. Instead, consider using a cohort analysis to plot the customer acquisition cost payback period.
2. Short-Term Credit Rating
Short-term credit ratings are strong ROI indicators since they objectively measure risk. Anything below K3 — which demonstrates an adequate ability to meet short-term obligations — from a Nationally Recognized Statistical Ratings Organization is a questionable investment.
3. Founding Team’s Strength
Dedicated founders are fundamental to early-stage success. You can quantify the founding team’s strength by analyzing their experience, skillset and history of success. Subjective metrics like commitment and collaboration can supplement your findings.
4. Competitive Landscape
Does the tech startup have established competition? Can you convert competitors’ customer bases? The competitive landscape determines how easy capturing a large market share would be. Consider the cloud computing industry, where just three companies hold 72% of the global market share — breaking into such a well-guarded market would be all but impossible.
5. Market Potential
Is the target market growing exponentially? Does the startup have the potential to become a disruptor in a stagnating industry? This metric is critical because it determines the ease of scalability and long-term success.
6. Business Model
Whether the company has a software-as-a-service, freemium, commission, advertisement or subscription business model determines its customer retention rate and profitability, making it a critical indicator during evaluation.
Why an Objective Evaluation Is Advantageous
An objective valuation is crucial because it provides you, stakeholders and founders with critical information to inform decision-making. Considering an estimated 75% of venture-backed startups fail to provide liquidity to investors, a thorough assessment may save you from significant financial losses.
Overvaluation is not uncommon. Consider Uber, which was once one of the world’s most valuable startups. Investors valued it at approximately $120 billion in 2019, just before its highly anticipated initial public offering. Then, on May 9, 2019, it broke records for the wrong reason — by experiencing the largest first-day dollar loss in U.S. history.
Uber remained unprofitable for years until it went from losing over $9.1 billion in 2022 to making a net income of $1.9 billion in 2023. It had subjective indicators of success — it seemed to be a disruptor, was mobile-friendly and had an aggressive expansion strategy — but it still amassed tens of billions of dollars in losses. For reasons like this one, an in-depth assessment is crucial.
Evaluating investment opportunities is becoming more important since funding is increasingly expensive. According to the Silicon Valley Bank, venture capitalists have been scaling back as costs rise. In 2022, pre-seed valuations grew by 18.8%, seed-stage grew by 43.7%, series A grew by 21.3% and series B grew by 9.7% year over year.
Do Your Due Diligence to Understand the Investment
The company’s product development stage, intellectual property rights and technological innovations are strong predictors of its long-term viability and success. Your due diligence doesn’t end at evaluating key indicators — you must thoroughly review scalability and profitability drivers to accurately assess your investment opportunity.
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