Investing in startups is a risky game with enormous potential payoffs for the lucky winners. Through sweat equity, entrepreneurs are investors in their ventures but as strategists and operators, they must also persuade capital providers to write checks.

If you are in this position and would like to know the inside story of how an investor decides to cut a check to buy a stake in a startup, read on.

Up until November 2014, I had invested in six startups, three of which went out of business and three of which were sold for a total of more than $2 billion.

In December 2014 I invested in a seventh startup--SoFi (short for Social Finance)--a San Francisco-based peer-to-peer lender that provides student loan refinancing for highly educated not rich yet (HENRY) borrowers.

There are five reasons I invested in SoFi and if your startup can satisfy these tests as well, you have decent odds of raising capital from investors.

1. It is targeting a huge market

Investors are inclined towards startups that seek to generate revenues from huge markets. That's because in the most optimistic scenario, the venture is likely to gain 10% of that market.

And since a rule of thumb is that most startups need at least $100 million in revenue to go public, an investor will be happier if the startup is targeting a market that generates at least $1 billion in revenue.

SoFi started out targeting the $1.2 trillion student loan industry and recently announced an expansion into the $12 trillion mortgage market.

These are huge markets. But most investors are interested in knowing the size of a startup's addressable market--that is, the specific segments from which the company will draw revenues.

SoFi is targeting students at relatively selective schools--such as Stanford and Harvard--and my analysis of the company convinced me that student loan and mortgage demand among such schools' alumni would constitute a big market opportunity.

2. Its management team has excellent industry knowledge

Investors seek great management teams to deal with the uncertainty involved in turning a decision to target a big market into substantial revenue.

Ideally, a CEO would be someone who knows an industry well based on previous experience, is highly intelligent and motivated and can build a team of strong executives.

When I considered SoFi, I was pleased that its CEO, Mike Cagney, had extensive industry experience--having worked as a head trader at Wells Fargo and was smart--holding a graduate degree from Stanford Business School. Moreover, he had attracted top talent--SoFi's Chief Operating Officer was previously CEO of KKR Financial and Treasurer of Wells Fargo.

3. It knows what ails stakeholders and provides a remedy

A startup must deliver a solution to problems that other companies are not solving. To accomplish this, an entrepreneur must know all of a venture's stakeholders--groups of people such as customers, employees, suppliers, and investors--what is ailing them, and how the venture can relieve that pain.

SoFi seems to have pinpointed a pain point for students who borrow money--the loan rates are too high. And it saves money for the borrowers. Of the 15,500 borrowers who have taken out about $1.3 billion worth of loans, SoFi estimates that it has saved the average borrower $11,783.

Given its rapid growth and October 2014 announced intention to raise at least $200 million in an initial public offering in 2015, it is clear that SoFi also understands how it can meet the needs of investors for higher yields--SoFi is beginning to offer mortgages that average around $1 million--and Cagney described investor appetite for these loans as "voracious."

4. Its customer value proposition is hard to copy

An investor seeks to understand how a venture can get an advantage over rivals that might try to replicate the venture's successful strategy.

That special sauce could come from delivering customers a lower price for a high quality product that makes those customers happy to recommend the venture to people they know.

Investors look for evidence that the startup is creating large numbers of customers who will recommend its services to others. And if the startup's marketing expenses as a percentage of revenue go down as it grows, there is reason to believe that satisfied customers are helping the venture grow--a resource that will be hard to copy.

SoFi also seems to be doing well here. By streamlining the loan application process, offering borrowers lower rates, and providing services to help borrowers find jobs or start companies, SoFi helps HENRYs to succeed in their careers--thus removing speed bumps that might impede loan repayment.

5. It could reach $100 million in revenue

Passing the first four tests is very promising for investors. However, a venture is not likely to sell its shares to the public unless it is growing rapidly and reaches at least $100 million in revenues.

I would not be surprised to see SoFi reach this magic number in 2015.

There are plenty of risks that concern me--Can SoFi achieve its ambitious targets? Will SoFi require additional financing and how much would that dilute my investment? Will the market conditions that yielded a successful December 2014 IPO for rival, LendingClub, persist until SoFi is ready to try the IPO waters?

In the meantime, SoFi is offering quarterly dividends hinged on how well its borrowers do at repaying their loans.

Nothing is certain in the startup world, but if you can do as well as SoFi did at passing these five tests, you may have a shot at raising capital for your venture.

Published on: Jan 1, 2015