Warren Buffet is considered to be one of the most successful investors in the world. He uses a certain investment formula that he swears by and is disciplined in his approach to investing. Buffett is primarily a value investor and evaluates each investment opportunity according to a strict set of criteria. As one of the most successful investors of all time, Buffett is often the standard by which other investors are measured. There have been many who have attempted to emulate his style of investing and use Buffett’s investment philosophy as they evaluate their own portfolios. This is by no means an easy task and it can become even more challenging when evaluating startup investments or stock opportunities.
There is little or no income produced by a startup venture. This makes it difficult to use Buffett’s model to evaluate the value of a company. Start-ups usually don’t have a track record that may be used as a yardstick to measure their success or their potential stability. Investors who are adherents to Buffett’s investing philosophy must often rely on a few of Buffett’s more qualitative criteria when evaluating a company that is just starting.
If you are considering investing in a startup, there are three Buffett criteria that can help you determine if the company is a good risk.
1- It has a great team.
Buffett believes that a great management team can make all the difference in the success of a company. This is one of his core investing principles and he has developed qualitative criteria to help determine the potential for an entrepreneur’s success. In his book, “The Guru Investor”, John P. Reese discusses the method Buffett uses to evaluate start-ups. He believes a company’s 10-year average return on equity or ROE is a good indicator of the effectiveness of the company’s management team. Buffett looks for a ROE of at least 15% over ten years and if the ROE is less, Buffett walks away.
Buffett also likes serial entrepreneurs. He believes this is a good way to identify startups with potential. Harvard Business Review publishes a recent study that determined that experienced entrepreneurs tend to have a much higher success rate than those who are trying their hand at business for the first time.
Buffett’s philosophy is that when he invests in a startup, he is also investing in their management team. He looks for companies with experienced, responsible leaders and so should you.
2- Be Familiar with the Company Model
Buffett invests in companies that are known for their simple business models. Buffett’s investment portfolio includes some of the strongest companies in the world including Walmart, Coca-Cola Co., and Exxon Mobil. These are all companies with easy to understand business models and a track record of proven success.
This is one of the basic tenets of Buffett’s investment strategy and may be applied to start up investing to improve your return on investment or ROI. Angel investing or investing in start-ups has a higher potential for success if the angel invests in a company they know. It helps if the investor has expertise in the industry. This allows the investor to more easily differentiate between an ordinary company and one that is truly remarkable. “Invest in what you know” is a phrase coined by the ex-manager of Fidelity’s Magellan fund and a renowned stock investor, Peter Lynch. He used this phrase to help investors find undervalued stocks by applying their industry expertise.
When you invest in a company with a simple business model, it is much easier to determine if they will make money or not. This is an important strategy when choosing where to invest your money. If you’re not familiar with this then you may as well spend your time trading paper trading stocks – there’s as likely a chance of you doing well.
Choose companies with stable revenue.
Buffett requires that any company he invests in have a record of stable recurring revenue. He also looks for clear earnings predictability. Buffett looks for companies selling a product that is in continual demand from a huge audience. One good example is a razor blade. Berkshire Hathaway, Buffett’s company purchased stocks in Gillette in 1989. They bought $600 million of preferred stock because Buffett believed the demand for razors would grow. In 2005, Proctor & Gamble acquired Gillette for $57 billion making Berkshire Hathaway’s stock worth $4 billion. The key here is to look for startup companies with a solid business plan and a clean earnings potential.