What Makes a Good Investment?

Last week I was asked to look at a potential investment a friend was considering. It was an early-stage SaaS business, an area I know well.

I spend a fair amount of time sitting on the other side of the table, helping those businesses raise investment. I constantly talk to founders about what different investors are looking for, so it was interesting to attack this from the investor side.

I have weighed up a lot of investments, many for friends and family, but have never taken the time to put down on paper the process I go through - it has often been an informal, high-level opinion vs a formal written report that I would produce for paying clients. Still, I was clearly following an evaluation process every time, so here is a glimpse into the questions I ask myself before making an initial decision.

DISCLAIMER: This is a high-level list of questions to get you thinking about whether an investment is right for you. It is certainly not comprehensive; it should be tailored to you individually. It is not investment advice and is absolutely not a substitute for full and proper due diligence before making any investment - Never skip Due Diligence!

I like to keep the initial stages of analysis as simple as possible. I ask myself four high-level questions, each needing digging deeper.

1. Is It A Good Business?

A fairly obvious starting point when you think about it.

What’s The Current Financial Position

One of the starting points for me is to look at the management accounts. What has it done so far in Revenue and Profit, how strong is the balance sheet, and is it cashflow positive or negative?

If it is clear they did not already have management accounts prepared and are scrambling to piece them together after my request, this is a big red flag! As are reports that don’t make sense, are not laid out well or can not be articulately explained.

If the business is early stage (especially pre-revenue), then the information available might not have too much influence on my decision.

Does the Model Work?

I could write a whole post just on this question, but this is a snapshot of the questions I ask myself when looking over their model.

Have they thought about how they will make money (seems obvious, but many early-stage founders miss this bit!)? Can I see a pathway to other revenue streams and, if they are currently loss-making, a pathway to profit?

Does the business scale? What are the bottlenecks as they grow? Can they acquire clients at that rate and cost (flex testing CAC is big)?

What happens to the model if I stress-test certain areas? Does it hold up?

The ultimate question - is this model realistic and achievable?

If I think the model itself works, then there are two other areas here that I spend time looking at:

  1. Is the Total Addressable Market (TAM) big enough? Have they given thought and can clearly explain the market and how they will access it? Does that provide enough scope to scale in line with their plans?

  2. Does their cash flow hold up? Is their burn rate realistic? Will they manage the cash well (which plays into my next point about the team)? Is this enough cash to get them to their next raise or exit?

Do I believe in the team?

The earlier the business is in its journey, the more important this question is. Do I believe in the team to execute this plan?

If the business is early stage, sometimes all you have to go on is the high-level concept and your faith in the team.

Do they have experience? Are they genuinely passionate and committed to this? Do they have the skill set to manage each business function or a plan to plug these gaps? No finance experience (or support for the team) is a big red flag, as is no CTO for a tech biz…

What’s the competition like?

Who else is out there doing something similar, and why are you better than them?

Founders often have a warped view of this question. They either believe they have no real competition or that their product/service is 100x better than what’s on the market. They need to believe in themselves to go all in but remove the rose-tinted glasses and ask some hard questions here.

What’s the moat like? i.e. what protection have you got against others? Is there any IP here?

2. Is It The Right Price?

Ok, so it passed the first test. It’s a good business. Now I need to look at how much they are asking for and their company valuation.

A good starting point is to ask them how they came to their valuation. I certainly wouldn’t rely on this, but it makes for an interesting starting point.

The truth is, there are so many different ways to value businesses. Every business will be worth a different amount to each buyer, and again, for very early-stage companies, you don’t have a lot of facts to back this up.

A business is worth what someone is willing to pay for it.

It sounds oversimplified, but it is true. That means I have to be comfortable myself with the valuation.

Are there other similar examples in the market I can compare this to? Does it support or hinder future raises?

Does this valuation and raise give them enough cash to scale, or will it leave them short?

A large amount of the valuation will be based on the forecasted figures in the model, so I ask myself again how much I believe these are realistic and achievable.

3. Will It Give You A Large Enough Return?

The first two questions are all about the business itself. Is it a good business, and is it priced right? Presuming it passes these two tests, the following two questions are personal to me.

Before I can analyse whether this investment is suitable for me, I have to think about what my Investment strategy is:

  • What timeframe am I happy to invest over?

  • How much risk can I tolerate?

  • What return could I get elsewhere, in something safer?

  • Is this money better spent investing in my own business?

Armed with at least a rough idea of my investment criteria, I can now compare it to this deal.

What is the route to exit? Have the founders shown a clear pathway from here to an exit? Who will we exit to? When will we exit? What price can we achieve at exit?

How I exit will vary depending on the stage and plans of the business. As a very early-stage investor, I could be exiting to a larger Institutional Investor at the next raise. It could be a whole business sale to a competitor, or for the really ballsy, it could be clinging on until an IPO.

There are no guarantees here, but I must ask the question and feel like I have a route out.

Once I have an idea of possible time and valuations on exit, I can apply my massive pinch of salt and stress test it. What happens to my returns if you achieve only 50% of the valuation or it takes 3 years longer, or I am diluted by another 20% before you get to this stage?

Now weigh this potential ROI on exit vs the risk factor of it actually happening. This is where schemes like SEIS & EIS help as they reduce the risk to early-stage investors.

4. Is It Right For You, Right Now?

So this is a good business, the price being asked is sensible, and I am happy with the potential returns. Great, I will dive right in.

At least, this is what many people do. They fail to ask themselves the vital final question!

Is this the right investment for me to make right now?

It could be a great investment opportunity, but do I have the cash to make this investment now without putting a strain on other aspects of my finances?

I will see many good investment opportunities if I look in the right places. Be patient and ensure this is the right time; if not, hold out for the next one - avoid FOMO at all costs!

In addition to this, I am looking at a few more factors that matter to me personally:

  • Does the story/concept of the business excite me?

  • Is it an area I am familiar with? (some people are Ok investing in things they have no idea about)

  • Does the business match my values, social & economic impact?

This post risked turning into a long list of questions, but this is what this process is all about.

Asking the right questions.

Focusing on the four key questions:

  1. Is it a good business?

  2. Is it the right price?

  3. Will it give me a large enough return?

  4. Is it right for me, right now?

Remember the point of this post. To get you thinking high level about how to analyse a business and the investment opportunity it presents. Remember the disclaimer at the start -This is just the beginning of the process. Never skip full Due Diligence!

If you are a founder trying to raise investment, read this and put yourself in the mindset of an investor. How can you best prepare for these questions, especially one & two?

About the author

Luke Desmond

Fractional CFO for Tech, eCommerce & SaaS. CEO @Crisp_Acc provides virtual finance functions. Co-Founder @getvaulta SaaS Startup for accountants.