If you ask the interwebs for what investors look for when they are evaluating a potential investment in a startup, you will find many different answers, among them: A great product — because of course that will sell itself; the right team DNA — as apparently genetics are key for entrepreneurial success; product / market-fit — whatever that is.
It’s hard to define a silver bullet for the success of a startup, but I can tell you what we at Point Nine Capital pay attention to when we are diving into the process with a company that we find interesting. Please keep in mind that this list won’t hold true for every angel or VC you talk to, but many of these points should apply to other early-stage investors out there. So hopefully it will give some entrepreneurs a better understanding of what awaits them when they are entering a ‘Due Diligence’ process.
Seize the potential √
As there is a lot of risk involved in early stage investing (duh!) and statistically VCs are wrong most of the time, we are looking for break-out potential. This means that in the case an entrepreneur beats all odds and we back a winner, at the time of the exit that investment has to make up for many of the startups that didn’t pan out — and then some, as our ability to raise future funds naturally depends on returning a profit to our own investors.
I originally had this down as the total addressable market or TAM. However, in my view that term isn’t very accurate as it assumes that the the market is clearly defined right from the start, but this is not always the case. In fact, most successful tech companies either enter adjacent markets (think Amazon), significantly move up-market (Zendesk), expand into new categories (eBay) or launch completely new products as they mature (e.g Alibaba Pay). So we don’t have to be able to reach unicorn status with the very first product, but there should be a (realistic, even if hard) way for the company to become a massive business.
Meet the team √
They say the relationship between investor and entrepreneur is like a marriage… just that it usually lasts longer. As it typically takes 7+ years for a startup to a successful liquidation event, there is some truth to it, but fortunately founders won’t have to share the bed with us. ☺
Nevertheless, the right chemistry and especially trust is crucial to us. As we are going to work with each other for many years, we want to make sure that our values are aligned and can work well together. Of course that goes for both sides, that’s why we always offer reference calls with our portfolio founders so that future members of the P9Family can get a feel for what it’s like to work with us.
We also like to meet the rest of the team. It’s not just nice to know the whole team, the first few employees are also a great signal for the ability of the founder(s) to recruit. And if there is any one trait that we have seen in all of our successful founders, it’s the ability to hire great people.
Use the product √
This might be a shock, but there are many investors that never actually sign up for the product they are investing in (and it should be easy for you to find out which ones that are). To me that’s crazy, but probably I’m just more product-focused than other investors.
Of course there are some products that are hard to really try yourself, especially when they require industry specific knowledge or data. It’s hard to be a farmer, lawyer and real estate broker at the same time. Yet, most founders are happy to share a demo log-in with pre-populated data or even offer a personal tour through the product if you ask nicely.
Dig into the metrics √
Hmm, yummy, metrics. As they are a great reflection of user behaviour, we look on all numbers we can get. Here are some exercises that we always do, assuming there is sufficient data:
- Run a cohort analysis for all (paid) accounts to learn about churn / retention and get some customer lifetime value (CLV) estimations
- Benchmark the growth with other companies we have seen and invested in (especially in SaaS our data base is pretty strong now)
- Some health-check on user / customer activity
We like numbers at Point Nine and we like them raw! (That sounded nerdier than I intended…)
Understand customer acquisition √
It’s important for us to learn how customers or users are reached and that the founder(s) have a good understanding of this themselves.
The key is that there is potential for one or multiple scalable distribution channel(s) with reasonable customer acquisition costs (or CACs). Combined with the results of the CLV estimation this is also the best health check for the business itself, i.e does the company make more money with customers over their lifetimes (with the product, not on earth) than it spends on acquiring them. If the answer is yes, congratulations! You found a sustainable business model. ☺
Check out the competition √
There are different types of competition and if we have the time, we check out all of them:
- Direct competition: Players in the same market with a comparable positioning, targeting the same customers. Are we betting on the (future) market leader?
- Indirect competition: Usually outdated solutions or hacky substitutes. In many SaaS cases customers have previously used simple (or very complicated) XLS sheets to get the job done (more or less) for instance.
- A big, hairy incumbent: Are we 10x better and find a way into the market that allows us to grow 10x faster?
- No competition: Really? If so, we are either geniuses or missing something. Probably the latter.
Do reference calls √
The best way to get real insight into the customers’ pain points and understand how they are using the product. We always try to take a number of customer reference calls with (potential) customers and industry experts. It’s really significant how talking to people with real industry knowledge can help to understand the case better.
Ideally, we also have some experts in our network that we can solicit input from. Important to note here that although we always listen, we don’t always follow the advice we get. At the end of the day it’s on us to take all the information we receive and make the best decision possible, which means putting less weight on some of the information / opinions most of the time.
Run the numbers √
As we know that they often become obsolete soon after they are created, business plans are not the most important data point for us. However, we do want to make sure that the company has enough funding to reach the next level, which usually means the next round of financing for us. Therefore we like to understand the cost base of the company and try to get at least 12 months (better: 18 months) of runway.
Sign a Term Sheet √
At what point in the process a term sheet is signed depends on the structure and timing of the financing round (and sometimes it is skipped completely). We only sign term sheets when we are sure that we want to invest and it’s usually only subject to some formal parts of DD and making sure that there are no skeletons in the closet. It’s no fun (for either side) to have the other party pull out after days or weeks of work.
Legal DD √
Not the most exciting step, but a necessary evil (if you’re a lawyer: No offence!). While what we look at exactly varies case by case, there are a few things that we always check off: Reviewing the cap table, making sure the IP lies in the company and that all employment agreements check out.
Note that large parts of this are happening after we have signed the term sheet and we are very thankful for having a great lawyer that takes care of this on our behalf (thanks, Tilman!).
So do we always check all 10 boxes? Nope, not at all. I can’t remember a single deal that we wouldn’t have liked to spend more time on or that was ‘perfect’ on every level. And that leads to one of my biggest learnings: At the end of the day it’s about focusing on the right reason to do a deal and not about eliminating all reasons against it. There are always many unknowns and risks with Seed investments, but I believe the great investors out there know when to ignore these doubts and go for it nevertheless.
PS: As I’m merely three years into VC, I’m sure my thinking on this will evolve over time. If you want to contribute to my learning or feel like I missed something substantial, feel free to comment on this post or send me a note. Thanks! ☺