Rating for start-ups: founders should know these knock-out criteria

When people talk about ratings, terms and buzzwords such as “Moody’s”, “AAA”, “corporations” and perhaps also “blind fish” and “no good” come to mind. Few people think of start-ups or SMEs, and I don’t think that’s the case in our industry either. Systematic rating of start-ups is not particularly widespread, at least in Germany, because there are far too few hard facts about the company being assessed.

It goes without saying that every venture capitalist rates their potential and existing investments, even if it is sometimes just a gut feeling. ‘Does it work‘ or ‘doesn’t work’ is also partly an assessment that lies in the eye of the beholder. The employee from the controlling department and the CMO may have a different view of some KPIs or assess their relevance differently.

A rating is normally understood to be the classification of the creditworthiness of an economic entity or financial instrument. In the case of a start-up, the creditworthiness of the company or the reliability of the financial instruments is certainly not the focus of interest. The rating of start-ups therefore differs substantially from the credit rating of established companies.

Ratings form the basis of risk management. They also influence the level of risk-weighted assets and therefore also risk controlling. Ratings are indispensable for larger companies for various reasons. A change in a rating has an impact on loans and their conditions, credit insurance, bond and share prices, etc. In the case of bank ratings and the external ratings offered by the agencies, mathematical-statistical procedures are used to calculate default probabilities based on default characteristics and classify them into rating levels, which are abbreviated as rating codes.

The ESG rating is a relatively new addition to our toolbox. Environmental, Social and Corporate Governance (ESG for short) are criteria and framework conditions for the consideration of environmental, sustainability and social issues within start-ups. As the following section deals with the rating of companies in the early phase, this rating is relatively unimportant, as the focus is more on product development and traction in the company development phase.
Nevertheless, the “S”, the relationship between the start-up and its employees, customers, suppliers and other relevant stakeholders, is also important in this phase. Issues such as working conditions, health and safety in the workplace are important so as not to hinder the company’s development.

The rating of start-ups has nothing in common with the quantitative factors that banks and rating agencies use for their assessment. When it comes to qualitative factors, the differences between a start-up and a DAX-listed company are no longer so significant.
We have developed a rating grid for our portfolio companies that can be used regardless of the company’s phase. However, the weightings change over time, as some criteria that are important at the beginning of a company’s development are no longer as important later on and vice versa. The following section deals with the rating of start-ups in the seed or pre-seed phase.

34% Management

I am not betraying a secret when I clearly state that management is the most important factor in the overall rating. A good management team knows how to recognize problems early on, set a new course if necessary and react to requirements. Most of our investments also fail to meet the original business plan after our haircut. The negative record after > 250 investments is -99%. However, with investor backing, the management team was able to successfully develop the company through to IPO at the second attempt. It is doubtful whether the investors would have gone along with this if the rating or the management’s assessment had only been average.

Knock-out factors in the rating

• Major management gaps in business-critical topics
• Founders’ resistance to advice

Pro-factors:

• Experience and previous successes of the team
• Professional and entrepreneurial competence
• Ability to scale and lead

22% Technology / product / demand / market

More than the sheer size of the (potential) market is relevant to the market penetration of products. The necessity of a high quality of the offer or product together with the technical feasibility is often underestimated. No customer wants to be the beta tester without being asked. The rating is based on whether the technical implementation seems feasible within the planned time and cost frame and whether the necessary resources are available or can be procured. A large part of the rating depends on sales: how significant is the risk that the promising product company will become a living dead company that keeps its head above water with projects? Incidentally, the assessment of industry-standard KPIs is not part of the rating; this step is part of the due diligence.
Other important points of the rating are the expected market position, the possible IP situation (which would be worth a separate article. Just this much: IP belongs in the company) and competitors. Which current or potential competitors are on the market, who could follow as a second mover or copycat, how big is the lead? Ultimately, dependencies must also be assessed, both on the customer and supplier side.

Knock-out factors in the rating

• Too high probability of failure in product development
• One-trick-pony
• Market size and growth too low

Pro-factors:

• Sufficient size and growth of the target market (TAM, SAM, SOM)
• Good differentiation from the competition
• High barriers to market entry

12% Financial position and results of operations

In the case of start-ups and seed financing, the financial and earnings situation is of more downstream importance. This rating feature only becomes increasingly important over time. However, what investors consider disadvantageous in all company phases are liabilities that have already been accumulated and are planned to be repaid from the upcoming financing round. Particularly welcome are shareholder loans or accumulated liabilities, e.g. from salary claims of the founders, which are now to be serviced. Another point that deserves its own article is convertible loans from Businessangels and the resulting share of the operating founders after conversion. Gladly in connection with planned further financing rounds in the future.

A second important point is the completeness of the accounting. In many business models, the financing structure and planned losses result in a very special balance sheet picture: “On the left side, nothing is right and on the right side, nothing is left”. Equity is actively involved, so to speak. This is not a problem for very young companies and can also be fixed as part of the financing round, but as the company grows and gets older, the fact that the balance sheet is overindebted can have a very negative impact on the rating.

Knock-out factors in the rating:

• Insolvency application missed
• Accounting incomplete

Pro-factors:

• The cash runway is bigger than a few weeks

14% Company organization

Starting with the distribution of know-how within the company, dependencies on individual people, technologies or suppliers, the list of organizational factors is long. In addition to such elementary things, it is also the impressions from the softer factors that flow into the rating here. A miserable atmosphere in the team, high sickness rates and unusual fluctuation rates are just as important as a conscientious approach to law and order, whereby the business models are important here. Distributors, companies with QM certifications or special regulations such as environmental protection (e.g. BImSchG approval) are to be assessed differently than an agency business.

Knock-out factors in the rating:

• No Freedom-to-Operate
• Complete dependence on external factors
• Disregard of legal regulations

Pro-factors:

• (Hardly) any regulatory risks, all approvals have already been obtained

18% Exit

Finally, the prospective exit is also included in our rating. VCs try to consider which channel, which KPIs and which multiple can be used to terminate the investment even before the investment is received. Of course, the investment contracts also provide for corresponding regulations, but the contractual possibility does not always correspond to the actual feasibility.
In this category, however, not only the founders and their attitude to company development and exit are rated, but also any co-investors, as not all investors always have the same objectives in terms of content and timing. For example, an end-of-life situation in a co-investor’s fund can result in different perspectives.

Knock-out factors in the rating:

• The will to establish a family dynasty

Rating over time

We rate our investments at the end of each quarter in order to monitor the development of the rating over time. The change provides additional information on the investment and may also reflect the success of the company’s own business development, changes in the management team of the investment, the market, the business model, etc. and thus provides a further data basis for evaluation and decision-making in subsequent rounds.