Less than one percent of businesses receive venture capital funding.
It is often difficult to understand the criteria used to set the bar for these new companies, so I decided to put together a summary of some high-level methods myself and other investors use to vet new companies. Below is a guide to help as well as a free notion template that I often use when diligencing new startups. Whether you're an associate looking to add more structure to your diligence process or a founder looking to get insight into “grading rubrics” you can access it for free below.
Every startup is unique, but when evaluating deals you can generally sum up an opportunity into a handful of topics. The most important topics to address being the company overview, customer, product, market, traction, team, and fundraising details. All of these details are taken into account and may be weighted differently when determining which deals to move forward with.
Whether you’re an associate reviewing a deal or a founder creating your pitch, one of the best things you can ask yourself in order to set yourself up for success is “How succinctly can I describe what the company is doing?” One of the best formulas to use here is COMPANY solves PROBLEM by SOLUTION. A company description that is easily explainable will travel much further than convoluted explanations filled with jargon that makes your eyes glaze over. Regardless of how technical a solution may be, it is important to do your best to explain it like you’re talking to a 5th grader. A succinct explanation helps both investors and future customers understand the value proposition of your company. The simpler the message the farther it will travel.
Customer & Product
“Build it and they will come!”
This advice often leads founders to create solutions for problems that don't exist. To avoid this you want to ask certain questions to evaluate the opportunity. What is the problem and how does the team know? Is this the right timing for the solution? Is there a demand for it? If so, how much? Can the team maintain a competitive advantage or MOAT? How will the solution generate revenue? These questions lead toward an understanding of whether the company has real legs. Having a defined core product without a best-case alternative is a home run here. Great founders will often remove features from their product roadmap to eliminate distractions and hone in on the core value prop.
One of the main obligations VC’s have is returning capital to their limited partners. This leads to most startups undergoing scrutiny based on their market size. You may hear investors say that the opportunity does not look like it can provide venture-style returns. Does it mean it's a bad business?
In short, no. Several great opportunities are passed on simply because the math does not work for the risk profile of most VC's. VCs are looking for home runs that can 100x or even 1000x in value. In order to do this, a startup must be tackling a problem in a large enough market where they can hit revenue targets by acquiring a fraction of the total addressable market. Whether it's a defined or emerging market. In short, investors are looking for a large TAM (total addressable market) in the billions that is growing healthily with a double-digit CAGR (compound annual growth rate).
Relevant traction will vary based on where the company is in its life cycle. Generally, if you are in the earliest stages of your company, you want to focus on proving there is a sustainable market for the solution you’re building aka proving product-market fit. Once you have PMF you should focus on creating a repeatable sales cycle that allows you to scale. Subsequent rounds will continue to fuel this growth. The nomenclature for “seed” vs “Series A” tends to shift based on location, but below is an example of general metrics for a Series A Enterprise SaaS company.
The Founders / Team
Finding product-market fit in your startup is pretty ubiquitously understood. Less so is founder-market fit. This is where storytelling plays an important role during your pitch. Investors will ask themselves.. How passionate is the team about the problem? Are they prepared to see it through to the end? What’s their personality like? Would you want to work for them aka can they recruit an outstanding team? Do they have enough relevant experience in the space to foster unique insights? The amount of experience needed varies between a founder building consumer gene-editing tools vs a direct-to-consumer candle company. The effect of founder market fit on disruption doesn't.
This is generally straightforward. VC’s are looking to understand the dynamics of the round. Founders often don't realize investors are comparing these terms to other deals in their pipeline to determine the best opportunity to deploy capital. The economics of the deal is what's used here (valuations, vehicle used to raise, prior investments, commitments, any caps or discounts, terms etc).
One thing I often see missed here in pitch decks is the use of funds. Often times founders include the breakdown of where the funding will go, but not the outcomes they are hoping to achieve. It is great to see the KPIs the founder is looking to hit in order to be an attractive deal for the next stage of investment. These targets can be revenue goals, user targets, product development goals, etc. This helps the investor understand your goals.
As an investor few things make me happier than seeing an organized data room. Having all the relevant documents in one place drastically speeds up the diligence process and speaks to the organization of the founder. You want a data room populated with relevant documents (deck, exec summary, pro forma financials, cap table, etc) Depending on your stage you may have some, none, or all of the following documents. Having the appropriate documents on hand and ready to go makes the diligence process smoother should an investor decide they want to dig deeper.
At the very least you want to provide the following
- Pitch Deck
- Historical & Pro-forma Financials
- Cap table
Hopefully, this gives you a great high-level overview of how deals are generally reviewed. You’ve earned a free gift for making it this far so here is my Free Notion Template. Use the duplicate button at the top right to save.