A few years ago, I was doing an informational interview with a potential candidate who asked me: “how do you evaluate companies in Venture Capital?” She was coming from the world of investment banking and the other opportunities she was looking at were in the buyout private equity world, where evaluation techniques are generally very methodical. Companies in the venture world often have much less operational data to evaluate, so rigid methodologies often fail to capture the essence business. One explanation I used: In private equity when you’re looking at a company, you have 100 questions to ask and you spend 48 hours straight in a data room and get your 100 answers before making a conclusion. In venture capital, you can’t ask 100 questions because the answer to most of them would be: “it’s too early to tell,” “it’s going well so far, but we’ll have to see,” “we haven’t built up that function yet,” “the market is still developing,” “it works well now but we don’t know how it will scale yet,” and so on. As a result, you have to figure out how to ask only ~10 questions and still get 100 questions-worth of information: you need to cleverly combine sets of questions which individually have no valuable answer but when consolidated properly capture the nuances of the business. The combinations vary for every company, and the art of it is being able to adapt to each specific company and ask the right questions which hit the key points for that specific company in a unique and enlightening way. I also feel that the questions asked during a diligence process should be helpful to the company, not just to the investor, and that truly good questions help founders think through their strategy more deeply. It should feel more like a counseling session than an interrogation.
Coming with a predefined quantitative set of questions can push the most important qualitative factors to the background. For example, the team. In an early stage business, the team is the single most influential piece of the puzzle, and there is no substitute for spending time with them. In addition, when I ask an early stage company about metrics, I am often more interested in hearing how the team thinks about the metrics than I am in the actual metrics. With any luck the metrics will change quickly and the associated analyses will also need to change — if the founder has the correct approach, they will continue to adapt effectively.
But in my quest answer the question and bring some methodology and structure to a world where none can truly fit, I came up with five key categories for evaluation: Team, Market, Technology & Product, Business Model, and Metrics & Traction. These are not particularly novel — an IPO S-1 (or any other formal offering memorandum) will cover all these categories. The novelty comes in the nuance of how to look into each of these categories depending on the specific business.
I’ll provide a couple examples below to illustrate.
For example, let’s look at an early stage mobile-based consumer business — Snapchat — at its Series A (which happened before I entered the investing world). Within each of the above categories, which questions are the right ones to ask? What are the major areas of concern and the keys to understanding the potential of the company and how it can be achieved?
Team: Does the team have previous success? Have they worked together before? Are there any red flags? Is the CEO/CTO a product visionary? Can the management scale? Will they be able to attract and manage talent? What are the hiring needs?
Market: Who are the potential users? How many of them are there? How much spending power do they have? Are their needs met elsewhere? Are there legitimate competing products?
Technology & Product: Is it a great product? Does the backend technology support it? Is it user friendly, sleek, efficient, and unique? Is there more room for the product to develop? Is it viral? How is user feedback? Can it be readily copied by another company and achieve the same purpose for users?
Business Model: At some point, can they monetize the product? Is there precedent in this product category? Are the costs out of control? When can they expect to start making money?
Traction & Metrics: How many users? How engaged are they? MAU? DAU? Mobile DAU? L6/7 Users? Usage hours? Messages sent? App opens? App downloads? The macro question here is whether or not the team is tracking and analyzing metrics in detail and using them to drive business decisions.
If we then look at how to prioritize these categories:
- Team: It’s almost always team first. When I make an investment, especially at the early stage, I am betting on the team’s ability to lead, execute, and adapt.
- Product: The success of a consumer internet company will depend heavily on its ability to get and keep users, which requires a killer product. People have to love it and/or need it.
- Traction & Metrics: Usage metrics will give credence to any qualitative assessments of the product. Understand the derivative metrics and how they are changing.
- Market: Need to understand if the users represent a big enough market to build a big business on top of.
- Business Model: Make sure this is something that could one day generate income, but in the meantime can deliver value to its users.
Where quantitative metrics do not exist, I have to look for qualitative proxies. Where quantitative metrics do exist, I have to map them to qualitative characteristics of the business.
For another example, let’s look at Workday circa 2011. At this point, the company already had meaningful revenue, but was still far from profitable, and would most readily be described as an growth stage application-layer enterprise software company. (This was also before I entered the investing world). Within each category, there are some commonalities to the previous example, but the vast majority of questions have a different emphasis.
Team: Can this team get the company from here to IPO and beyond? Do they work well together? If a change needs to be made, will they be amenable to it? Do they have the experience to prove it? Will the market receive them well? Are there holes in management that still need to be filled?
Market: Is the market opportunity here medium, large, or massive? Are market trends in the industry in the company’s favor? Where does the competition stand? Are the disrupted incumbents going to be a challenge? Are there adjacent market opportunities?
Technology & Product: Do people like using the product? Is the product differentiated? Is the technology behind the product unique, scalable, stable, secure?
Business Model: Is the company operating a tried-and-true model or innovating on a new one? Have they proved consistency in the model? Can the model itself scale to be very large? Is there fundamental stakeholder alignment? Are there any limiting factors?
Traction & Metrics: This would be where I go deep on a company like this. SaaS metrics, predictable revenue growth, ability to hit targets, path to profitability, sales operating metrics, hiring patterns, cost control.
If we then look at how to prioritize these categories:
- Team: Team first, as always. At this stage, it’s important to understand if the CEO can truly lead the team, if they can hire effectively at scale, and if they promote a positive culture. The team also gets credit for what they have built so far.
- Traction & Metrics: In a business with real financial metrics, they are a high priority. They need to be looked at carefully and from the ground up to understand deeply the derivative trends in the business. It’s also important that the company itself is focused here.
- Market: Need to know if they are on the edge of mass market adoption or will stay a niche player. Market size, competitive dynamics, and trends are hugely important at this stage.
- Technology & Product: To a large extent, the proof is in the numbers. Everything from support tickets to usage rates help show if it works. A product people love is still very important.
- Business Model: Here also, the proof is in the numbers. Either the model is working well or it’s not. If the company is still highly unprofitable, need to understand when and how they can control their cash flow.
From these two examples, you can start to see how I approach all businesses. Every business is different, but there is a consistent framework to approach nearly all of them. Each category has a variety of information depth and priority based on the sector and stage of a company. In all cases, every category needs a good look — sometimes the answer is binary and sometimes it requires deep analysis. The things you may want to know are not always available and you can either get creative or look to other areas for validation. Every company and every investment round presents a unique challenge, but patterns definitely emerge within broader sectors and stages.
Below is an illustrative example of how varied the category prioritization can be across sectors and stages. You could readily use this chart to explain why most VC firms focus on certain sectors or stages and why diverse investor teams are incredibly important. For example, it is extremely difficult to understand both the inner workings of deep technology and the nuanced metrics of a consumer internet business. Diverse backgrounds that create varied perspectives alongside diverse skill sets are incredibly powerful when it comes to effectively understanding companies holistically.
A useful analogy is a prism — all businesses have the same number of sides (the categories above), but they vary in size and shape, so you need to look at each one from different angles (and through different lenses) to understand what is at its core. Even a small difference in one of the sides can have a fundamental impact on how it refracts and ultimately projects light.
The deal terms also factor in, although usually as a separate item. I look at price and terms right at the beginning of diligence to make sure that expectations are managed, and then again at the end of the process as I head towards a deal. Some terms can truly be problematic (for either investor, company, or both), but optimizing for terms rarely yields great results. The vast majority of returns in the industry come from great companies and not from great deals into OK companies. As companies raise more money, the specific terms and the price can come into play in a larger way (see my post on this subject). For early stage companies, all parties should be on the same side of the table, working together to determine a healthy price and dollar amount that positions the company for long-term success and mid-term optionality.
I have found that for me, this methodology works well as it forces me to get past biases and initial assessments and into a deeper understanding of the business. By isolating categories within a business for evaluation and then putting the holistic story back together, I am able to develop a deeper understanding of each business.