In the past couple months, I have been looking for an all-encompassing framework or list of checkpoints to cover when evaluating seed-stage startups.
Beyond the standard market/product/team framework, I couldn’t find any. Instead I had found that a lot of the decision making processes I had taken advice from — and more importantly the rationale behind them— had been from small tidbits here and there and wasn’t centralized anywhere (see VC Twitter, Fred Wilson’s newsletter, Andrew Chen’s essays, Mark Suster’s blog, Paul Graham’s essays). So I decided to compile my notes and create a framework as a reference for VC’s (and founders) who are starting out to evaluate seed-level companies.
One of the main challenges I have faced while completing due diligence is to find a consistent and structured way of analyzing companies. My main goal in this post is to develop a minimally viable analysis for a first pass of a company that can also serve as a structured starting point for deeper analysis if need be.
Below are 8 main topics of focus and for each area, I have added several questions you should ask companies and my thought process behind the questions and relevant articles, blog posts, and essays.
1. The first area of focus is fairly obvious: What is the problem the company is trying to solve and what is the company’s solution?
- Does the problem actually exist and do customers want it?
— Look at market studies, surveys, and research the company did to actually determine that there is a problem in the space.
— Are the founders uniquely placed or qualified to come up with the answer to the problem?
- Does the company’s solution actually solve the problem?
- Nice to have or is it a must have?
- Are there metrics that show customers value the solution to the problem?
- Can the solution scale globally?
- Is it better, cheaper, easier, or faster than current solutions?
- Is the target market extremely large and can the company realistically target a portion, of the market?
— This article talks about the TAM of several successful startups
— Note when calculating potential market size, TAM, SAM, or any of these metrics, its important to understand the placement of the product that is proposed to be injected into the market. Bill Gurley, a Series A investor and board member of Uber, wrote a post detailing the common mistakes people make while trying to determine a seed company’s potential market size. He says that often people make an implicit assumption that the future will look like the past, or in other words, the arrival of a product/service like Uber will not have an impact on the overall market size of the transportation market. This assumption is obviously incorrect as more often that not, the future offering is different than the past and therefore the past can be a poor guide for the future.
- Can it scale globally?
- Why is there a need for the product or a need for the market to shift right now?
- Is there a shift in consumer behavior (or a rise in “new” consumers like millennials)?
- What is the Go-To-Market strategy?
- Has the company built a community of users who are driving the engagement (ex. Facebook at Colleges)
3. Proposed business model:
- Any network effects or possible moats?
— Great Ben Thompson article that links network effects, moats, and nice-to-have/must-haves together.
- Are the assumptions made in the business model realistic?
- It is important to understand the scope of certain metrics and how it may skew the representation of the company
— For example a popular metric to valuate companies is their DAU/MAU. In many cases this is a quick and easy way to determine user engagement but there are numerous times where the metric is misused. Andrew Chen, GP at Andreessen and former head of growth at Uber, talks about this in his post. -From the diagram its pretty clear that very few applications have both high-frequency and high-retention (in fact only Communication does). Uber for example, has its most profitable ride to airports and typically riders don’t go to the airport every day; Airbnb is typically used a few times a year as the average user travels about 2x a year. However both these companies are multi-billion dollar companies.
— Many times a company’s DAU/MAU isn’t very high but they may have a huge dedicated userbase or the size of their network (or potential network) is extremely large.
— Also statistics like LTV/CAC are often misleading for seed stage companies. Mark Suster talks about this in his post and makes a great point in that the payback period may be long even if the LTV/CAC ratio is large so if you can’t raise capital or get funding during this period, the company is done for. LTV/CAC is an important ratio but in terms of seed companies (i.e. in the short term), LTV is based on highly optimistic future assumptions and payback periods on CAC are way more important in the short term.
- Is the proposed timeline realistic and can it be executed in a reasonable timeframe?
4. Value of the Business:
- It is important to try and distinguish the product and the actual value of the business. After all the purpose of the business is to try and create/deliver value in a way that will generate profit after cost. This a great article that talks about purpose and importance of value.
- What is the actual value that is being created?
- Is the product defensible or patented?
- How much will the customers pay for the solution so the value captured can compete with existing competitors in the space?
- Is the team intelligent, hard-working, have a unique perspective or edge, driven, and most important: Are they passionate about the company and market?
- Does the team understand their roles?
— Ex. Fred Wilson on CTO vs. VP Engineering
- Does the team complement each other or do they all share the same strengths and weaknesses and have many gaps?
- Is there a technical presence?
— Great article on why its important to have a technical co-founder or early hire.
- Do they understand the market and how their product fits in?
6. Competition and Risks:
- How crowded is the space?
— Red ocean vs. Blue Ocean
— If there is lots of competition in a space you will lose business which in turn increases sales costs and makes it harder to grow rapidly. (Fred Wilson on competition)
— With that being said, almost every market has competition so its important not to worry about the number of competitors but instead on how the company will differentiate itself from the competition? (Ex. Paul Graham’s tweet)
- Are there any barriers to entry? (Examples of companies that faced high barriers)
— Ride-Sharing and now e-scooters face huge amounts of legislative barriers, yet there are companies in both spaces that are projected to be multi-billion dollar companies.
- Any large incumbents in the space?
— Why hasn’t any other company done what is being proposed? (i.e. will the company need to sell more than reasonable amounts to generate the same value as existing businesses?)
- What is the best-case and worst-case scenario of the company? Is the company a possible moonshot?
— Mamoon Hamid, partner at Social Capital and investor in Box and Slack, says “[moonshots are] very defensible because they’re hard to do, build, and take capital. A lot of the companies become very unique and after five years; they’ll be the only ones in the world to do it.”
— Not only that moonshots are the investments that generate a large percentage of the returns for most VC firms.
- Does the company have the ability to touch the lives of a billion people?
- Does it have the potential of generating a $100 billion market cap?
- Will it fulfill a human need?
- What are possible risks of the investment? What are the key risks we’d need to get comfortable with if we were to make this investment.
7. Does it fit the investment thesis and funding requirements?
- Is it a true seed or Series A company?
- Can the firm provide the capital that the company needs?
- How many other prior investors or firms have already invested
- Can we generate a meaningful return for our investors?
8. Future routes:
- If a company is thinking M&A is in it’s future, when (or in what stage) would this occur?
- Does the company have any current relationships with potential acquirers?
- What was the outcome of other companies in the same market?
Of course, seed-stage companies will not have the answers for every question, but going through the framework is an extremely useful way to determine what areas to focus on during the due diligence process.
At the seed level, it’s almost too easy to convince yourself that a company will fail. Almost anyone can poke holes in a company’s vision or plans. For example look at Airbnb, when they were trying to receive funding, they were met with skepticism as investors couldn’t wrap their head around people renting out their own homes for complete strangers to live in. Or David Conway’s infamous pass on eBay, “Stamps? Coins? Comic books? You’ve GOT to be kidding…No-brainer pass”.
It’s also just as easy to convince yourself that a particular startup will be tremendously successful as well (i.e. look at this list of highly touted startups that sputtered out). One of the most difficult aspects of evaluating startups at this early stage is not to let emotional decisions that are baseless cloud the evaluation. This does not mean avoiding all gut feelings or hunches, instead it means focusing on as much of a bias-free valuation as possible and over time, honing these skills to create a framework for yourself.
I hope this article helps. Feel free to discuss, critique, and share.
**Here are all of the great writers referenced in the article (plus a few more!). Check them out, they have a plethora of advice on seed investing:
— Fred Wilson’s newsletter
— Andrew Chen’s essays
— Mark Suster’s blog
— Paul Graham’s essays
— VC twitter
— Francesca Warner’s seed investing framework
— Google Ventures’ process
— Bill Gurley’s newsletter