Your first investment is always the most agonising.
Without the armour of prior experience, you’re likely to be more hesitant, more emotionally led, and unpracticed in completing due diligence. You’ll also feel the sting more intensely if it ends in a loss. In the words of Sheryl Crow, the first cut is the deepest.
So if you’re brand new to the game, how do you take the leap from interested party to investor?
Before you start with complicated analyses of past performance and future predictions, there’s one simple line of enquiry you need to follow. It’ll save you time and money, help you remove bias and emotion, and bring home the reality of the company’s true purpose.
The first question is: what problem is the company solving?
Whether you’re looking at investing in a startup, crowdfunding campaign, or an established stock, the question remains the same.
It should be followed up with two more: is anyone else already solving it? And if so, why is this solution better than others? This line of questioning gives you an uncomplicated grounding for assessing the potential success and ROI of a company.
Every problem a company tries to solve fits into one of four categories. Let’s explore them below to help you develop a framework for assessing a company’s problem-solving factor.
Big common problems
People spend lots of money solving big problems. They’ll happily part with cash for major life-enhancers and must-haves.
But our quality of life has evolved to a point where many big problems have already been solved (thanks, capitalism). We live comfortably, eat well, and have powerful technology at our fingertips. This means companies who are able to solve big common problems are very rare to find. They’re usually disruptors, like Uber (solving problems presented by the old taxi model) or Netflix (solving the problem of “nothing on TV”).
It might be easy to name big common problems (for example, getting stuck in traffic). But the reason they haven’t been solved is usually not lack of trying, but technical limitations. We haven’t figured out how to make flying cars yet, so traffic remains a big, common problem.
If a company manages to identify and solve a big problem that lots of people have, they’ll inevitably make money, and are likely to deliver an extremely good ROI if the idea is executed and the business is managed correctly.
Big rare problems
Big problems that few people experience are easier to find. But they also have smaller target markets than big common problems, and smaller potential returns as a result.
SaaS companies often target big rare problems, or problems only experienced within niches. They use new technology in very specific ways to solve unique problems a business (or industry) might experience. Companies that solve big rare problems are likely to deliver stable - if not astronomical - returns.
Small common problems
People will also pay for solutions to smaller problems. But the money they’ll spend will be proportionate.
Most of us pay for sunglasses to keep the sun out of our eyes and umbrellas to keep us dry. We love home gadgets that save us precious minutes of cooking or cleaning time. Companies that can solve small problems for lots of people can be very profitable. Whether they’ll be a good investment will depend on whether their small solution is a fad (Pringles holders, anyone?) or a lifelong friend to the consumer (Tupperware is a 2 billion dollar brand).
Small rare problems
This is the group you’re probably not going to want to invest in. For small, cheap-and-cheerful, handy solutions that improve peoples’ lives on a minuscule scale, lots of people have to buy them for a company to be profitable. A company solving a small problem for a small group of people may find a niche, but is unlikely to deliver a champagne-popping ROI.
That being said, Gary Dahl made millions by selling Pet Rocks. Go figure.
There's also a secret fifth category. It’s a category that often no one sees coming. That category is non-problems.
One of the most surprising revelations can be that a company’s product or service isn’t solving a problem at all.
A great example of a startup solving a ‘non-problem’ was the Juicero fiasco. A Silicon Valley startup created a $400 machine that squeezed juice packets to make a smoothie. Bloomberg unhelpfully commented that people could squeeze the packets with their hands faster than the juicer. Investors could’ve saved themselves a lot of lost capital by asking the simple question: does Juicero solve a problem?
Another dystopian example is Soylent - the chalky, nutritious replacement to actual food that nobody ever asked for.
In the next article we’ll look at analysing the solutions a company is offering.
But let’s go back to the term ‘due diligence’ for a moment. If you’ve ascertained that a product or service does offer a valuable and welcome solution, and fits with your investing goals, due diligence is the more formal and data-driven next step.
It incorporates analysis of a company’s market cap, competitors, leadership, and valuation metrics such as profit margins and P/E ratio.
If it sounds complex, that’s because it is. Getting your head around the metrics and figures can be difficult, and learning how to analyse them takes practice. But it’s an exercise that can’t be skipped. Completing proper and effective due diligence will often be the line between a successful investing career and… well, a short one.