Applying a Comprehensive Framework to Venture Investing

Introduction

Venture capital investing is widely known for its Power Law returns, which, as Peter Thiel describes, is “in venture capital, the best investment in a successful fund equals or outperforms the entire rest of the fund combined.” Investing in early stage businesses encompasses significant risk- achieving product-market fit, scaling effectively, generating significant runway to realize a liquidation event- but contrary to popular belief, these risks are diligenced considerably by investors using tried and true playbooks and deep analysis.

This analysis has previously been somewhat of a black box. Kleiner Perkins, one of the most recognized names in venture responsible for early investments in Google, Amazon, Facebook, and Spotify, highlights their investment philosophy as investing “in founders with bold ideas that span industries and continents, partnering with them from inception to IPO and beyond to maximize the potential of their ideas… and make history.” Sequoia, another hallmark name in the industry, is “seeking exceptional founders with a unique insight focused on a market poised for large growth.”

While this gives a hint into the investment approach of some of the most successful investing entities, there is clearly more under the hood that venture capitalists take into consideration when evaluating a startup. This is particularly evident when taking into consideration that venture firms say no to 90%+ of the investment opportunities in the pipeline, and those in the pipeline are just a fraction of looks that are received through cold calls and conferences.

I have done a considerable amount of primary and secondary research into the venture capital investment process and have created a framework that synthesizes the predominant takeaways in an easy to interpret and implement way that can help quickly identify the attractiveness of an early stage business. This framework breaks the investment down into 13 different dimensions on which a startup is analyzed in four main categories.

The Framework

The above framework categorizes investment diligence into four categories- the company, the industry, the market, and diligence factors- and are mapped to 13 broad questions that a venture capitalist will ask of a nascent business

Company

1. Is there a strong team?
2. Is there a valuable product?
3. Do customers need the product?
4. Is the business model viable?

Industry

1. Is the business differentiated?
2. Is there a defensible moat
3. Are there any limiting factors on profitability?

Market

1. Is the market large enough?
2. Are there opportunities for growth?
3. Is the timing right?

Diligence

1. What are the risks?
2. Can I exit at an attractive rate?
3. What is the unfair advantage?

1. The Company

Team- Is there a strong team?

Venture investors will conduct a significant amount of diligence on the team. Strong founding teams have vision, product specialty, business acumen, experience, and cohesion:

1. Vision- Someone must have a long-term view of the business, be a master of developing an overarching strategy and communicating that strategy with stakeholders, and serve as the company leader
2. Product specialty- commonly referred to as a “hacker,” product specialty is often one person who is a master of product- able to design a product significantly better than anything else on the market and able to incorporate customer feedback rapidly and effectively
3. Business acumen- business acumen is the understanding of everything outside of the product- sales, marketing, branding, fundraising, etc.
4. Experience- experience either as a previously successful founder and/or experience in the relevant industry carry significant weight. This is part of the reason that the average founder is 45 years old
5. Cohesion- ideal teams are ones that can collaborate, delegate, and put out fires efficiently. Proxies for this cohesion are experience working together and extensive backgrounds

Product- Is there a valuable product?

The most important element of the product is product-market fit. Eric Jorgenson’s analysis of Product Market Fit does a great job of describing that the fit arises from harmony across the business model. It is validation of the product, pricing mechanism, and value chain through consistent organic consumption and promotion. It is important to not mistake growth for fit, for, as Steve Blank and Eric Ries state:

“If the dogs don’t want to eat the dog food then what good is attracting a lot of dogs?”

A second valuable components to a product is the presence of proprietary technology that is difficult to replicate or patents. Zoom video is an example of a technological product that was substantially better than other videoconferencing offerings given product specialist Eric Yuan at the helm that it is set to IPO at a considerable premium to its last $1bn funding round.

The third component of a highly valuable product is the degree to which the product is required for business continuity. If the removal of a product / service from a user will cause disruption or even business failure, it is considered mission critical. While not a necessity for attractive products, mission critical products typically have strong retention rates and pricing power. Examples include access management company Okta, ERP providers like Oracle, and niche use cases like fleet management software providers (Switchboard).

The Customers- Do customers need the product?

Value Proposition

Anthony Ulwick’s Jobs to Be Done Theory

The first and most important element of customer analysis is an understanding of the customer’s need. Peter Thiel refers to creating products that are 10x better than any alternative in the market. To understand what needs to be 10x better, investors adopt a Jobs to Be Done framework, identifying both the main job to be done and the related jobs to be done as well as their associated functional and emotional aspects. 10x in any of these categories can lead to considerable success.

AllBirds was at a point of parity with competitors on the main job of a shoe, but the emotional aspects on the personal side of comfort and the social dimension of a statement about the culture of living a relaxed life are 10x better than comparable products in the market. Today, the company is worth $1.4bn.

Don’t make a 10x better product, solve a need 10x better

Price Sensitivity

Price sensitivity is also critical, as price insensitive consumers commoditize product offerings and competition is done on price. One example is AdTech, which has seen a precipitous fall in investment as consumers decide on price. A simple way to test for pricing power is to ask consumers if they would pay twice as much for the product.

CLV / CAC, Retention / Churn, and Promotion

Adoption and recurrence are part of an overall benchmarking for customer lifetime value and customer acquisition cost comparison. See here for more information about CLV and CAC calculations. While this metric typically applies for software companies, it is increasingly pertinent to industries with repeat purchases like direct-to-consumer retail and cosmetics.

For many growth business, customers are the value of the company, and metrics showing strong, sustainable growth attract investment. Y Combinator targets 5–7% weekly growth with a 10% weekly growth goal. For reference, that’s 3,300% annual growth at 7% and 14,200% growth at 10% growth. At scale, astronomical growth numbers such as these come from a consistent recurring user base and growth of new users. As will be shown below, the type of growth is also important for business quality.

Finally, a highly engaged consumer base that organically promotes the product/service (primarily for consumer businesses) leads to earned media and helps to both grow the user base and indicates to investors the positive consumer experience.

At later stages of a company (ARR of $5mm to $15mm), 10–15% monthly growth is typically first-class, implying ~3–5x growth year-over year.

The Business Model- Is the business model viable?

Unit Economics

Unit Economics of Warby Parker

While the level of detail depends on the stage of the investment, all investors will be looking at the business model and using numbers to validate it. Unit economics consists of breaking down the revenues and costs associated with the smallest possible unit of a business. Warby Parker was able to prove its business model with one pair of glasses, cutting out the margin on licensing from brands and retail margins to deliver a high-quality product at a low price of $95 and still make a healthy profit.

Scalability

Scalability is also a critical question. We will later look at market size and why it matters to venture investors, but capital and labor intensive businesses attract significantly less venture investment than asset-light businesses like software. The reason is due to a concept called operating leverage- the proportion of total costs that are fixed. If the proportion is high, then marginal units are sold with little to no costs (Microsoft Office, for instance) and can scale rapidly.

Value Chain

Michael Porter’s Value Chain

Fundamentally, the value chain can be thought of as the internal processes by which a company adds value to an input and generates a margin at sale. The key is to understand that these activities are done in between suppliers and consumers, and the activities that are within vs. outside of the perimeter make an appreciable difference.

One such example is in the PC universe, wherein OEMs manufactured and sold commoditized components to systems integrators who then sold D2C or through retail channels. Because Intel and Microsoft had effective monopolies on processor and OS, respectively, they generated outsized profits at the expense of their suppliers and customers.

Ben Thompson articulates this well when discussing the conservation of attractive profits, stating that “profit in a value chain flows to whatever company is able to successfully integrate different component pieces of that value chain; the other parts of the value chain then modularize and are driven into commodity competition.”

For venture investing, it is key to understand what activities in the value chain are generating the most value and whether that value is within the company’s perimeter.

Financials & KPIs

The final two components of the business model go hand-in-hand and serve to illustrate the financial health of the company (through the income statement, the balance sheet, and the cash flow statement) as well as performance on Key Performance Indicators (KPIs).

Historical financials can be broken down into four categories:

1. Top-line: The key takeaway from analyzing top-line revenue is growth, which ideally is increasing exponentially
2. Gross Margin: The main point of focus is on gross margin, the amount of revenue retained after expensing direct variable costs associated with producing a marginal unit
3. Contribution Margin: Gross margin - customer acquisition costs (should trend toward gross margin as growth levels and majority of revenue is recurring)
4. Operating Margin: total profit subtracting operating costs (frequently negative in the growth stage due to upfront costs and deferred revenue)

KPIs vary considerably by industry but can be broadly classified into three buckets (with examples):

Margin

1. Average order value
2. Average revenue per user (ARPU)
3. Gross margin

Operations

1. Customer acquisition costs
2. Retention / churn
3. Conversion rate
4. Sales cycle
5. Capital efficiency
6. Quick Ratio (New MRR + Expansion MRR / Downgrade MRR + Churn MRR)

Growth

1. Revenue growth rates
2. Daily active user growth rates

2. The Industry

Competitive Landscape- Is the business differentiated?

Venture capitalists are looking for businesses that are inherently different from other companies in the landscape. Because of the considerable risk profile, VCs are looking to fund future market leaders in large industries. There are broadly three ways to go about accomplishing this level of differentiation:

1. Market Disruption: Casper disrupted the mattress industry through cutting out the substantial retailer margin using a direct-to-consumer channel and passing some of the value to consumers via cost savings (note that multiples tend to compress in the face of less attractive industry economics)
2. Market Expansion: Transferwise, the UK-based money transfer service, grew exponentially while Western Union maintained its consistent, low growth rate due to the introduction of new participants into the market
3. Both: Uber simultaneously expanded the transportation market through making travel more accessible and increasing overall trips while disrupting taxis and public transport

Barriers to Entry- Is there a defensible moat?

Given that venture investments will often times last throughout a fund or even multiple funds with participation in subsequent funding rounds, investors will look to not only whether a substantial amount of value was created in an industry but if that value is likely to be captured by the portfolio company. Capital will continue to fund competitors so long as outsize returns are being generated, so the key to long-term outsize returns are sustainable competitive advantages stemming from barriers to entry.

There are a number of different barriers to entry, 5 of the most popular of which are:

1. Network effects- the value of the offering increases with incremental users (Facebook)
2. Economies of Scale- in industries with a high enough minimum efficient scale that entry into the industry is difficult or unviable (Boeing and Airbus)
3. Proprietary Technology- trade secrets or tech that is difficult or illegal to replicate, often stemming from patented IP (previously, Invisalign)
4. Brand- while debatable if sustainable, strong brands drive pricing power (Louis Vuitton)
5. Customer Captivity- most popularly switching costs (Apple, which reinforce the value of the offering through pairing devices like the iPhone, Apple Watch, and AirPods with seamless compatibility)

Jerry Chen’s Systems of Intelligence

One additional highly nuanced but very valuable moat is what Jerry Chen from Greylock describes as the System of Intelligence — the layer between the systems of record (database and application that writes source data into a database) and the system of engagement (interface that control user engagement) that collects and owns proprietary data and can enhance the value of that data through artificial intelligence and machine learning. If a business can build, connect, and improve data networks then the reinforcement will make in considerably more difficult to supplant.

Porter’s Other Four Forces- Are there any limiting factors on profitability?

Michael Porter used the five forces framework to determine the degree of profit limitation that an industry has from potential for new entrants (reverse of barriers to entry, referred to above), threat of substitutes, buyer power, supplier power, and rivalry.

Simply put, a VC investor will evaluate if any of these are particularly strong so as to limit profitability. One such example is Spotify, which interacts primarily with four concentrated record labels that own ~88% of the market. Because of consolidation on the supplier side, they have considerable bargaining power and enter into revenue share agreements with Spotify that hinder profitability.

3. The Market

Size

There is a considerable emphasis on the size of the investment simply because of the risk profile of investments. An average early stage venture investment will be ~$5mm for 10% of the business, and if 75% of investments don’t meet targets, then to break even on an probability-weighted NPV basis assuming no discount rate, the target exit (before dilution) would need to be $200mm. However, venture funds must target much higher return thresholds than 0% IRR, so for a 5 year fund and a target IRR of 25%, the exit would need to triple, or be worth $600mm. Assuming a 10x revenue multiple, this is still a $60mm target run rate revenue.

This illustrates why VCs target $100mm+ revenue as a margin of safety and markets that are worth $500mm+ because of the market penetration requirement to get to that point. In practice, investors do not wait for the $60mm ARR threshold but rather forecast the usage characteristics (Company’s North Star) and future monetization and then work backwards.

In addition to the current TAM and growth rates, for a given company it is also important to understand market depth, the ability to expand to adjacent markets. Alex Clayton from Spark Capital notes that a company called Service Titan, which offers a suite for HVAC, electricians, and plumbers employees, has a considerable amount of depth in marketing, fleet management payments, call tracking, etc. This depth takes spend away from horizontal spend categories and makes for an attractive exit.

Growth

Growth for a business can largely be divided into three categories:

1. Organic growth- natural growth in the underlying market- the tide that lifts all ships
2. Opportunistic growth- growth through higher prices and new products, customers, geographies, etc. that require investment but generate incremental top-line returns
3. Inorganic growth- growth through acquisition (uncommon for startups to initiate)

Venture capitalists typically target high growth industries with similar growth trajectories in end markets to make the targeted growth rates more feasible.

Andrew Chen, partner at Andreessen Horowitz, notes that for consumer businesses, organic growth is the most valuable form of growth and should be built on acquisition loops (acquiring new customers) and engagement loops (retaining and re-engaging customers) that scale.

Acquisition loops naturally reinforce each other, like 1) user-generated content loops (Yelp), which consist of users looking for content online, producing more content, and then that content being indexed to Google to continually repeat, 2) viral acquisition loops (Slack), which consist of users interfacing with a product and sharing that product with others to organically attract more users, and 3) paid marketing loops (Uber), which consist of paid marketing attracting new users to generate cash to invest in additional marketing.

These loops do experience diminishing marginal returns as markets saturate and ads become more expensive, but diligence regarding the existence of these loops and runway resulting from them is important for projecting growth.

Additionally, Chen notes that a true growth value is netted against churn, so an investor must not only understand the engine driving new users but also the engine driving engagement, which should also be self-reinforcing. Examples of engagement loops that scale organically are 1) social feedback loops (Instagram) as users bring one another in and 2) personalized content loops (Netflix), which draws users in through providing catered recommendations and notifications of value.

Timing

Market timing can be a difficult needle to thread, as early ventures into wearables like Google Glass failed due to limited market adoption and data availability and late investments will both lead to elevated valuations and potentially saturated markets. Investment timing appears to be optimally done when two factors are at play:

1. Inflection Point of Mass Adoption- end markets are exponentially increasing in demand, generally at the periphery of mainstream purchasing behavior
2. Pull Market- consumers are looking for solutions to problems, giving early indication of blue ocean opportunity

4. Diligence

Risk

While there are a considerable number of risks that are nuanced to each individual investment, common forms of risk include:

Regulatory risk

1. Capsule is a clear example of a company that had to navigate regulatory risk in patient medication confidentiality as well as comply with all other HIPAA regulations
2. AirBnB has also run into considerable regulation risk associated with zoning, permits, and housing standards
3. E-scooter companies such as Bird and Lime have also run into regulation headwinds as they have expanded geographically

Execution risk

There are a host of risks that fall under execution but broadly it is the risk that the company won’t execute successfully on its business plan. This can come from a lack of product-market fit, increased competition, internal team failures, inability to scale, etc.

Capital Efficiency / Dilution

A detailed analysis on the cash burn of the business is required to fully understand what the future dilution will be and how that will impact overall dilution and therefore exit value to the investor, but there are multiple ways to protect an investment from future dilution

1. Right of First Refusal- the first tool used to prevent dilution is the right of first refusal, which will allow for the venture investor to contribute required funds if being raised / acquire the business at the acquisition price before anyone else
2. Ratchet Protections- there are a number of different types of ratchets including full ratchet, narrow-based weighted average ratchet, and broad-based weighted average ratchet, but the fundamental principal of maintaining ownership in future rounds helps to prevent future dilution
3. Liquidation Preference and Investment Security- venture investors may push for a liquidation preference that pays out to the investor their capital first before owners of common equity and can often be multiples (1.5x — 3x) of the invested capital. The security characteristics will also determine exit to investors as participating convertible preferred instruments double dip in the upside beyond the par amount of the security while redeemable convertible preferred instruments allow for common equity to catch up before sharing additional upside

Exit

Typical Football Field Valuation

Venture capitalists target 10x+ return on their initial investments, but there are generally two ways that investors realize a monetization event in their portfolio companies:

1. Sale- this is the most common exit for venture capital investments and is very frequently discussed at the time of investment. Generally, a strategic acquirer (although sometimes a private equity fund) purchases the company and will pay a multiple on revenue / EBITDA depending on the industry, growth, profitability, KPIs, market conditions, and the nature of the acquirer, to name a few. For software-as-a-service (SaaS), exits are typically on an ARR basis because the majority of SaaS companies have 80% gross margins and 30% EBITDA margins at scale, leading to ARR multiples being the industry standard. The standard benchmark exit ARR multiple is 10x.
2. IPO- Simply put, IPOs are priced at (or slightly below) what investors are willing to pay for the business. Companies with significant traction will get a gauge for investor appetite via roadshows with investment banks that run a series of analyses including comparable valuation, precedent transaction valuation and discounted cash flow valuation (excluding 52-week range given primary offering) to triangulate to a value for the business

At the outset, venture capitalists will often run the same analysis to predict the exit value and then works backwards, including dilution, IRR, and additional capital required to get to an investment amount and valuation.

Secret Sauce

The secret sauce is simply something that your team has that no other competitor can replicate. There are a host of examples of this including product mastery, proprietary technology, and a robust network, but a personal favorite example is Alex Blumberg, who was previously a well-known journalist at Planet Money and This American Life before starting a podcast network called Gimlet Media (recently purchased for $230mm by Spotify).

In defining his unfair advantage during the podcast Startup, it came up that his experience and reach having been a prominent NPR journalist were impossible to replace. He had a knowledge of podcasting content and reach in the journalism world that few if anyone else had.

Venture capitalists are looking for startups that defy the odds and will beat out competition / market dynamics to ultimately grow to be disruptive companies, and an unfair advantage helps to solidify the probability of success and generate comfort around the investment.

Key Takeaways

Venture capitalists are highly selective in which companies they make investments into, and each firm has a nuanced investment profile that includes anything from industry focus to cultural fit; however, there is a consistent, formulaic approach to evaluating the viability of a startup.

That approach deals with identifying high quality businesses with the following four characteristics:

1. A company with a strong team, a valuable offering that meets customer needs, and a viable business model
2. Differentiated in an industry with barriers to entry and limited pressure on profitability
3. In a sufficiently large, growing, and penetrable market
4. With an attractive risk / reward profile justified by a unique advantage