Investing in startups can be attractive but risky, as around 90 per cent of them fail. However, even those who survive do not achieve outstanding success. The goal of venture capitalists is to find that small number of startups that achieve outcomes, invest in them, and get their x3-x100. In this article, we'll have a closer look at how venture capital investments work and what metrics VCs look for in startups.

What is a startup, and how does it work?

A startup is a young, usually technology-based company that is geared towards rapid global growth and innovation. The difference between a startup and a traditional business is that a focus is on scaling and creating a technology product or service. What are the main stages in the development of a startup?

1. Idea and prototyping (pre-seed). At this stage, a business idea is formed, the target audience is identified and a prototype of the product or service is created;
2. Seed stage. Once the prototype is developed, the startup begins to raise seed funding to complete the product and conduct market research. At this stage, it is important to confirm the demand for the product among potential customers;
3. Growth stage. The startup expands its presence in the market, and increases its customer base and revenues;
4. Scaling. The business enters new markets, expands its product or service offering and scales the business;
5. Exit. At this stage, founders and investors can make a return on their investment through a sale, merger, or IPO.

Let's break down how investors work with startups.

Step One: Scouting. Finding startups to invest in

Scouting is the first step in investing in startups. It involves actively searching for promising projects that can generate high returns in the future. There are several approaches to this process.

• Attend professional events. Conferences, exhibitions, accelerators, and hackathons are great places to meet entrepreneurs. This is an opportunity to see startups in action, listen to their presentations and ask questions in person;
• Monitor online platforms. There are many resources for finding promising startups, such as AngelList, Crunchbase, Product Hunt and LinkedIn. These provide information about teams, funding, and the industry;
• Networking and personal contacts. Networking with other investors, entrepreneurs and market experts gives you access to closed deals;
• Work with accelerators and incubators. These organisations select the most promising startups through their own channels and help them grow. Investors often work with such programmes to gain access to quality projects at an early stage;
• Market and trend analysis. It is important to track trends in fast-growing industries such as artificial intelligence, biotechnology, and the like.

Finding startups is as much about analysis as it is about intuition. It is essential not only to evaluate the financials but also to understand the team's vision and their ability to execute the idea in the real world.

Step Two: Due Diligence

Once a promising startup has been identified, a thorough screening procedure should be carried out. This process is called due diligence. It helps to assess the risks and prospects of the investment. Due diligence includes the following aspects.

• Analysis of the business model. Does the startup have an understanding of how it will generate revenue?
• Reviewing financial performance. Does the startup have a stable cash flow or is it dependent on external funding? Analyse expenses, forecast revenues and check for debt;
• Team and management. Do the founders have business and industry experience?
• Market assessment. How big is the potential market, and what are the growth prospects? Analysis of competitors, barriers to entry, demand for the product or service;
• Legal review. Patents, copyrights, regulations, and legislation; assessment of risks and major threats that may affect the success of the startup.

Professional due diligence helps avoid investing in dubious projects and increases the chances of success. It is a critical stage before the final decision to invest money is made.

Step Three: deal and documents

Once the startup has been successfully vetted, the final step is to close the deal. There are several documents involved in this process.

1. Term Sheet — a preliminary agreement that sets out the key terms of the investment, but is not binding;
2. Investment Agreement — a formal document that sets out the amount and terms of the investment;
3. Shareholders' Agreement — defines the rights and obligations of the investors and the founders of the company.

It is worth noting that to invest, startup founders must incorporate a company in an appropriate jurisdiction. This is most often the state of Delaware in the USA.

Step Four: Funds transfer and collaboration launch

Once all the necessary documents have been signed, it is time to transfer the funds.

1. Financial transfer. The investment may be made in one or more tranches after certain indicators or milestones in the development have been reached;
2. Establishment of a financial structure. Once the money has been received, the startup must allocate the budget properly. This includes the cost of product development, marketing, team salaries and other operating expenses;
3. Cooperation between the investor and the startup. As well as providing money, the investor can help with the strategic development of the business. This can take the form of mentoring, access to useful contacts, help with market entry or attracting new partners;
4. Monitoring and reporting. A startup should report regularly to investors on progress, key metrics and financial health. This can take the form of quarterly or monthly reports, meetings or presentations;
5. Scaling the business. With the investment received, the startup can begin to expand: attracting new customers, entering international markets or improving the product. Investors are interested in seeing the business grow rapidly, as this increases its value and profit prospects.

The transfer of funds and the start of cooperation is not the end, but only the beginning of a long development process. The success of a startup depends on the right use of investment, effective teamwork and investor relations.

Conditions for investing in different rounds

Investing in startups takes place in several stages, called investment rounds. Each round has its characteristics, conditions, and risks.

Pre-Seed Round

This is the initial stage when the startup is just being born. At this point, there is usually an idea, a founding team and a minimal product prototype.

Investors can be founders investing their own money, friends and family, angel investors, accelerators, and incubators.

Investment amounts at this stage are typically small: from a few thousand to tens of thousands of dollars. Investors put money in knowing that the risks are very high and the chance of failure is significant.

Seed

At this stage, the startup has a working product prototype, early users and some understanding of the market. The main objective is to validate the business model, attract more customers and prepare to scale.

Investors at this stage can be venture capital funds specialising in early-stage investments, more experienced angel investors and crowdfunding platforms.

The amount of investment is around $150-250k.

Series A

Round A is the first major stage of raising investment. The startup already has a product, users, and revenue growth and needs funding to scale.

Investors in this round are venture capital funds (VCs), corporate investors (large companies interested in the startup's technology), and strategic partners.

Investment amounts range from $500,000.

Series B

At this stage, the startup has become visible, shows stable growth and is entering new markets. Funds are raised for team expansion, marketing and further scaling.

Investors can be mid-market venture capital funds, private investors, or corporations.

Investments range from $10 million to $50 million.

Series C and beyond

Rounds C, D, E and beyond are for startups that have become large companies. Investments are aimed at dominating their niche, acquiring competitors or preparing for an IPO.

Investors can be large venture capital funds, private investors, corporations, hedge funds and investment banks.

Investment amount: $50 million or more. Company valuation can exceed a billion dollars.

How does a startup know if it needs investment now?

The question of attracting investment is one of the key issues for any startup. On the one hand, funding can help accelerate development, but on the other hand, it can lead to a loss of control over the company and the assumption of additional obligations. Therefore, before seeking investment, it is worth analysing whether you require it.

Start by assessing your stage. If the startup is at the idea or prototype stage, it is advisable to use your own funds or turn to grant programmes, accelerators, and support from friends and family.

If there is a first version of the product and first users, the investment will be larger and the investors will come from VCs. These funds should help refine the product, grow the team and start marketing activities.

At the scale-up stage, when the product has a stable customer base and is showing growth, funding becomes a key factor in entering new markets.

A startup's business model is also a key factor in deciding whether to attract investment. Investors look at how the company makes money, its cost structure and its ability to achieve profitability. If the startup cannot clearly answer these questions, it is worth focusing on business model development and internal development first.

The willingness to give up equity is another important consideration. Investors usually get a share of ownership and decision-making influence when they invest. If the founders are not prepared to make such a compromise, it is worth considering alternative sources of funding.

A clear strategy for the use of the funds raised is a prerequisite for investment. A startup needs to understand how the money will be spent, what results need to be achieved and how quickly the investment will pay off. The absence of such a plan can lead to inefficient use of resources.

How should a startup prepare to attract investment?

Attracting investment is a complex and responsible process that requires careful preparation. A startup must be prepared not only to negotiate with investors but also to use the funds raised effectively to grow the business. It is significant to demonstrate to potential partners that the business has prospects, a solid business plan and a clear vision for the future.

The first step in preparing to attract investment is to thoroughly analyse the current situation of the startup. Founders should assess the stage of development of the business, understand its strengths and weaknesses, and identify potential risks and ways to minimise them. If the startup is in its early stages, it is important to build a proof of concept for the idea: market research, competitive analysis, early prototypes or MVPs.

The next step is to create a detailed business plan. This should include a clearly defined business model, monetisation strategy, projected financial performance and development plan. Investors pay particular attention to the prospects for financial stability and scalability, so it is critical to prepare realistic financial projections and explain how exactly the funds raised will help achieve new goals.

It is also essential to evaluate your team. Investors invest not only in the product or idea but also in the people who make it happen. A strong team with experience in the relevant industry will increase your chances of securing funding. It is worth preparing short biographies of the founders and key team members, highlighting their skills and achievements.

Another important aspect is the preparation of legal documentation. A startup needs to organise all legal issues, such as ownership structure, patents, and contracts with partners and employees.

Prepare a quality pitch deck to briefly and convincingly explain why this particular startup deserves investment. The presentation should include key data: the problem the product solves, the market, competition, financials, business model, team, and development plans. The presentation needs to be visually appealing and easy to understand.

Network and build a base of potential investors. Attracting funding relies heavily on personal contacts, reputation, and referrals. Attending startup events, accelerators, venture programmes and industry conferences can help.

Finally, determine the amount you want to raise and explain exactly what the funds will be used for. Investors will be looking to see how efficiently the business plans to spend the money and whether it will be able to achieve its goals within the stated budget.

How to calculate the amount of investment in a startup?

Determining the right amount will help avoid both over-funding, which can dilute the founders' share, and under-funding, which can jeopardise the development of the business. To make the right calculation, there are several important factors to consider.

The first step is to assess the needs of the business. The startup should have a clear understanding of the purposes for which the funds raised will be used. This may include spending on product development, marketing, expanding the team, operating costs and entering new markets. To do this, it is necessary to draw up a detailed financial plan, setting out all the main expenditure items for a given period.

The second step is to determine the financial horizon. Investment is usually attracted for a certain period, 12–24 months. The startup needs to calculate how much money it will need to achieve its main objectives during this period, taking into account possible unforeseen expenses.

The third step is to analyse cash flow and break-even. You need to understand when the business will be self-sufficient. If the startup is already generating income, it is worth forecasting how it will grow and whether it will be possible to cover some of its costs from its income.

The fourth step is to assess the value of the business. Investors typically look at investing through the prism of what the business is valued at and the shares they receive. Various valuation methods are used: benchmarking against similar companies, valuation based on future cash flows or valuation at cost.

The fifth step is to calculate the amount of the raise based on the investment round. Different stages of a startup's development are characterised by different amounts of funding.

The sixth step is to analyse alternative sources of funding. If the startup can obtain grants, loans or accelerator support, this may help to reduce the amount of venture capital investment raised and retain a larger share of the company's ownership.

What metrics are used to evaluate startups?

The evaluation of startups is based on various metrics that help determine their efficiency, prospects and financial stability. Let's have a look at the main ones.

CAC (Customer Acquisition Cost). It determines how much money a startup spends to acquire a new customer. It is calculated as the sum of marketing and sales costs divided by the number of new customers for a given period. Furthermore, it is crucial to keep this ratio as low as possible, as it indicates the effectiveness of marketing strategies.

LTV (customer lifetime value). It shows the average amount of revenue that a customer brings in over the entire time they use a product or service. If the LTV is significantly higher than the CAC, it means that the business model is sustainable. A high LTV indicates high customer loyalty and service efficiency. An LTV to CAC ratio of 3:1 is considered optimal.

MRR (Monthly Recurring Revenue). Used in subscription-based business models (e.g. SaaS). Calculated as the sum of all recurring payments for the month. The more stable and higher the MRR, the better the financial prospects of the startup.

ARR (Annual Recurring Revenue). This is the sum of all regular payments for the year. It is used to predict the long-term financial stability of a startup.

Churn rate. It shows how many customers stop using a product or service in a given period. A high churn rate can indicate problems with the product, service, or competitiveness of the company.

Burn rate. The rate at which funds are 'burned'. This is a metric that reflects how much money a startup spends on operations each month. A high burn rate can be dangerous if the company doesn't have enough revenue or investment to cover its expenses.

Runway. Determines how many months a startup can operate at current costs before it needs additional investment.

Market size and growth potential. Estimated as the total number of potential customers and available revenue in a particular niche. A large market with a high growth rate is attractive to investors as it gives the startup more opportunities to scale.