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How Do You Invest in Startups? - Understanding the Market

October 21, 2016

Imagine buying a house for the first time. Instead of doing research, you decide you are just going to go drive around the neighborhoods you want to live in. As you drive up to that first home, your eyes get big and your heart skips a beat. This is it, you’ve found your dream home. You call the agent, put down the full asking price, and stake your claim in the neighborhood you’ve always wanted to be in.

Once moving day comes around, you go to open the front door and notice it seems a bit stuck. No problem, we can fix that later. Week one rolls by, and you start to notice a musty smell in the bathroom. No problem, you crack open the window to hope the smell goes away. Week two, you notice the ball that fell out of your golf bag seems to be picking up speed as it travels through the living room. Week 3, you wake up to the news that the market just crashed. After calling a repairman to make some minor fixes, you realize you’ve got mold in the bathroom, a cracked foundation, and a house that has devalued in under a month.

While this may be an extreme case, it is a scenario that draws parallels to what new investors may face when entering startup investing. This is why understanding the business and marketplace are crucial steps in tackling the question of how to invest in startups online. If you decide to go into an investment blind, you aren’t going to know what to look for when doing your due diligence, which translates to higher risk and higher rate of a failed investment.

While building up your expertise in the areas you desire, take a look at 5 of the market trends to look out for when investing in startups online. Before you start, be aware that the companies mentioned below are used solely to illustrate market principles, and are in no way a recommendation or opinion.

 

Mega Trends

Think of this as supply and demand. Growth in any industry has the ability to fuel opportunity, and market growth is supported by trends that propel a company and its innovations forward. As an investor, you are going to want to find a company that has the foresight to spot the trends in order to be first to market and position themselves as the leaders in the space once it gains mass appeal. While Uber (ride sharing) and Oculus (VR) are great examples of companies being ahead of market trends, you can see how quickly the rest of the market was able to catch on and compete for position within the space.



Fragmentation vs Consolidation

As an investor, you need to understand the level of competition your startup investment will face. A fragmented market means that one company does not have the influence to shift an entire market. Fragmented markets usually consist of a larger amount of medium sized businesses that compete against larger corporations that don’t hold the largest shares in the overall market.  Industries like real estate and computer software are good examples of fragmented markets. On the other end, consolidated markets consist of a small group of companies that control the industry. Oil and automotive are great examples of a consolidated market, where larger manufacturers control the space.  If you know what market your business falls under, you can see more about market concentrations here.


Now that you have an understanding of both sides of the coin, think about which market your potential investment falls under. If it falls under a consolidated market, some would say that the business has a much tougher point of entry because of all the challenges it will face. Any new business trying to enter the space will have to compete against a company that has more money, experience, and consumer trust. Even though a fragmented market may seem like an easier point of entry in comparison to a consolidated market, you have to make sure that any new company entering the market has a clear competitive advantage to even get a chance at seeing success.

 

Economic Moats 

A new way to describe competitive market advantage is by using the phrase economic moat. When a business can achieve an edge in their industry, to the point where any other competitor would find it almost impossible to compete, they have created an economic moat. Intertwined with market structure, a moat signals the difficulty level of competing in any market as a new entrant.

You could say that a large economic moat is something an investor might look for, but be aware that a moat will never automatically translate into success. Something like a sudden market shift could deem a company's economic moat useless overnight. While the company may not always succeed, having an advantage is a clear win win situation for the business and potential investors. Companies that create moats have a strong enough edge in technology, distribution, or customer acquisition that may put them one step ahead of any competitor that comes to market. One indicator of how to find companies that fit this structure is looking to see if their return on capital is higher than their cost of capital. With equity investments this is going to be difficult, as many of these startups are in their infancy, but it’s something to watch out for when looking at the competition of a startup you want to invest in.


While Amazon is a great representative of an economic moat, we could see the longevity and strength of moats dwindling with the improvement on technology. Take both Uber and Oculus as examples of the well drying up. Even though Uber holds a grip on market share, competitors like Lyft along with statewide bans could turn their moat into a puddle. After raising its first round of funding on Kickstarter, Oculus was quickly purchased by Facebook and a flood of other competitors began to hit the market.

 

Market Creation

I like to call this one, “playing God”, because of the difficulty it takes to create an entirely new marketplace. While market creation may seem like creating something from nothing, remember that these business are usually fulfilling an unmet consumer need that no other business has yet to take advantage of.  Twitter and Netflix are great examples of companies that were able to create new markets. Consumers always wanted to watch movies, but Netflix built a platform to scale this idea while keeping the cost of entry low. Their simple DVD rental service turned into a streaming service that now touts 86 million members in over 190 countries.


So, as a new investor, think about these 5 things when looking at your next startup investment opportunity. Make sure that you are comfortable with the position that the business is sitting in, think about where the market is going, and try to predict the company’s path of growth in the next few years. Ask yourself, “ Will this company still exist in 5 years, 3 years, or the next 6 months?”

Did you like this post? If you did, and want to know more about how investing in startups through equity crowdfunding works, you can check out our previous post in our investor series below, or subscribe in the box above. 

 

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