Five Fundamentals: what we look for when assessing new investments
Previously in our Navigating VC Series, my colleague Peter Duffy discussed the key steps in our deal process at Smedvig Capital.
In this post, I will lift the hood and talk about what we look for when assessing new opportunities. We are constantly evolving our thinking, so would love to hear from you if you have any challenges or suggestions.
Above all we are investing in you and your team. This is about building a relationship and a shared excitement for your vision and mission. No scoring framework can capture this. But we use frameworks to provide structure to our discussions and to highlight strengths, weaknesses, and trade-offs.
Evaluating teams is such an important and nuanced topic that we will write a a separate post on it. This post will focus on our overall assessment framework, which considers each businesses against 5 areas:
- Market — is the addressable market large?
- Position — does the product have a strong position in the market, and a vision that is sustainable long term?
- Team — is the founding team capable of scaling the business to take advantage of the market opportunity and vision?
- Economics — can the market position and business model be monetised effectively?
- Traction — is this translating into efficient growth?
1 to 3 are causes which lead to 4 and 5 as symptoms. If you are a strong team, with a differentiated position, in a large market, then the business should have good economics and traction. If your position is defensible, then you can sustain traction into the future.
From first meeting, we structure our questions and thoughts to align against these 5 areas, ultimately working towards an Investment Paper (you can see our standard template here).
We use an indicative 1 - 5 score for each area. This is not an exact science. Scores are imprecise initially but become more considered as we spend more time with a company. Scores force us to be objective and structured, but we do not use the aggregate or comparative scores to make decisions.
I will now explain what we look for in each area, before wrapping up with some key takeaways for founders.
1. Market: How big is the addressable market?
To answer this, you need to clearly understand and articulate:
- Who is your ideal customer and what characteristics make them a good fit for your product?
- How many potential customers exist who fit that profile?
- How much will those potential customers pay you for your product?
You can calculate Total Addressable Market (TAM) as follows:
TAM = # of Potential Customers x Average Annual Revenue Per Customer
We prefer this ‘bottom-up’ analysis, because it is founded on evidence of actual buying behaviour, as supposed to ‘top-down’ analysis which is an abstract assumption of buying behaviour (e.g. “if we capture 1% of technology budget in our sector our market will be y”).
A limitation of bottom-up analysis is that it is constrained by today’s segments, products and pricing, which may be different from the long term potential opportunity. But we like to start from what we know, and build from there. We think about three concentric layers of Total Addressable Market:
Proven Direct TAM: the size of the opportunity in segments where you have demonstrated product market fit with your current product.
Wider Adjacent TAM — New Segments: additional revenue potential from adjacent segments, which logically should be addressable with today’s product, even though you you do not have proof yet.
Wider Adjacent TAM — New Products: additional revenue potential from future product expansion, which will allow you to increase pricing to current segments, access new segments, or both.
The table below summarises how we score different Direct and Adjacent TAM opportunities. We think about TAM in terms of Gross Profit, because this gives a consistent comparison of different business models.
Scores are a rule of thumb, not an exact science.
It is important to consider whether you are competing in an existing market, re-segmenting an existing market, or creating a new market. Existing markets have proven demand and established buying behaviour but are more competitive. New markets present the potential for category leadership and pricing freedom, but have uncertain demand.
Next, let’s discuss how we think about competitive positioning in a market.
2a. Differentiated Position
This is about the strength and uniqueness of product market fit. Who is your customer, how acute is their need for your product, and how well does your product serve those needs vs. alternatives?
Some things we look for:
Strength of Need (Product — Market — Fit)
- How tightly and coherently can you define your user and their pain point?
- How severe is the pain, and therefore how compelling is the need for your product (must have vs. nice to have)?
- Is there a step-change in user experience, or value chain economics?
- Is there a compelling long term vision that customers are excited about?
Suitability and Uniqueness of Solution (Competitive Differentiation)
- From your customers’ perspective, what differentiates you from your competition? How clear is the difference?
- How competitive is the market? Are you the first mover? Are you one of a few, a clear leader? Or are you one of many?
- Are you better and cheaper than alternatives?
We evaluate Position based on the clarity, coherence, and consistency with which you and your team can articulate it.
For ‘proof’ of product market fit, we need to see a consistent group of customers with similar characteristics buying for consistent reasons, ideally exhibiting repeat purchasing, with high Customer Satisfaction.
To reiterate, this all starts from a deep understanding of you target customer segments and their use case for your product. Tom Mohr gives a superb overview of how to develop Vision, Segmentation, Value Proposition and Competitive Positioning in his book Scaling The Revenue Engine.
You can see our scoring framework below.
2b. Defensible Position
To create a valuable business, your market position needs to be defensible long term. What’s to stop competitors old and new from copying your product and eroding your competitive advantage?
There are two sources of sustainable advantage: high barriers to entry, and sticky customers.
High barriers to entry come from:
- Cutting edge technology or detailed process development which is difficult to replicate
- A clear vision and road map of continuous improvement to build on a first mover advantage or market lead
- A product that gets better with more customers or data (network effect)
- A market which requires regulatory approval to participate
- Brand reputation leading to structurally higher prices or lower customer acquisition costs
Sticky customers result from:
- User experience which improves the more an individual uses the product
- A product that becomes embedded in a customers’ life or workflows, with multiple touch points and users
- A ‘mission-critical’ product. E.g. processing a high volume of revenue that would be at risk if it was turned off
- High switching costs resulting from investment in training, set-up and integration processes. In consumer, just think of the admin involved in switching bank or utilities provider!
We debate market position a lot internally, and draw on industry experts and technical advisers where necessary. Below is our scoring framework.
Having a differentiated and defensible product in a large market is a great start. But to realise the opportunity this presents, a business needs to rapidly scale, navigating a changing market landscape along the way. This requires a strong team.
3. Team
Assessing teams is the most important, and hardest part of being a VC. It requires an open mind, discipline to manage bias, and experience. I am only just getting going on this journey, and have a lot to learn still.
We have developed a framework to help us structure our thoughts on teams, and we will write a separate post on this. For context, the 8 areas we focus on are:
- Self Awareness, and Adaptability
- Drive, Energy and Focus
- Customer and Market Led Strategy, Vision and Value Proposition
- Leadership and Culture
- Data Led Decision Making & Execution
- Organisational Structure, Talent Attraction, and Management
- Performance Delivery
- Cash Management
More on this in a future post.
4. Business model
Good unit economics are a manifestation of a strong market position.
If the customer need is strong, then your customers will pay you a high Price for your solution, resulting in a high Gross Margin.
If your product is differentiated, then it will sell well, with a high win rate. If the opportunity is large, then Pipeline and Sales Velocity will be fast.
If the product delivers on it’s promise, and has a defensible position, then you will have low Churn, high Repeat Rate and perhaps rising Average Revenue Per Customer. We spend a lot of time looking at cohort analysis to understand buyer behaviour.
There is a cascade of unit economics which can tell you about the drivers and sub drivers of your business. But ultimately all the detail rolls-up to a handful of top level metrics which tell us in aggregate how things are going.
High Gross Margin and LTV:CAC indicate long term potential profitability.
Low CAC Payback Period implies the potential for capital efficient growth.
I wrote about the importance of these metrics here.
We spend a lot of time digging into the detail and specific metrics relevant to each business. But we always come back to these top level metrics as a consistent barometer of performance.
Early stage metrics are volatile, and they will change as the business evolves. We start from a baseline of what is proven to then discuss the art of the possible from there.
It is unlikely that a business will be strong across the board. For example, B2B SaaS businesses are typically higher Margin and LTV than Consumer businesses, but tend to have much slower CAC Payback Periods.
We focus our early conversations on Market, Position and Unit Economics, as these are the fundamentals which underpin the potential of the opportunity. But at some point, we turn to cold hard traction for evidence that the theoretical fundamentals are translating into commercial value.
5. Traction
As with all investors, at some point in the conversation we will revert to the question:
What is your run rate revenue and how fast are you growing?
Revenue
Revenue is a hygiene factor. You need a minimum critical mass of revenue to be able to demonstrate product market fit for a given segment. The more revenue and customers you have, the more sectors you can prove and thus the larger Direct TAM you can demonstrate.
Growth
It’s difficult to demonstrate unit economics that ‘work’ without a minimum level of growth. The faster you grow, the stronger the proof of product-market and route-to-market fit, all other things being equal.
What counts as ‘high growth’ depends on the stage of business. It’s easier to grow 100% when you are £100k revenue than when you are £100m. The scorecard below is an illustrative example of how we ‘score’ growth.
Capital Efficiency
Absolute growth is a helpful metric, but it’s important to think about how efficiently the company has used capital to generate that growth.
Capital Efficiency = Revenue Increase / Capital Invested
A company that burns £0.5m to grow 50% from £1m to £1.5m has a capital efficiency of 1.0. A company that grows 100% from £1m to £2m but burns £2m to do so, has a capital efficiency of 0.5. Arguably the former (lower growth, higher capital efficiency) is more attractive.
We don’t ‘score’ Capital Efficiency, but we do keep an eye on it to make sure we don’t overvalue Growth that has been ‘bought’ at high cost, or undervalue Growth that has been ‘earned’ at low cost.
The chart below shows the Capital Efficiency of 40 different businesses of different sizes, that we took to Investment Committee. Anything over 0.5 is pretty good.
Size, Growth, and Capital Efficiency are crude measures, which is why we focus on fundamentals first and then look to traction to validate our thesis. We can pick holes in the fundamentals of a business, but if it’s growing fast and efficiently at scale, something is going right. We can be excited about a thesis, but if the growth isn’t there, something must be holding it back.
It is our job to get into the detail and understand what is going on.
Conclusions for founders
We are not looking for Fives across the board. That is impossible. The skill of investing is understanding the strengths and weakness in an opportunity and being clear about the trade-offs and ‘leaps’ we are making.
A large TAM will usually be competed. A complex defensible product, will usually be slow to sell early on.
Consumer businesses typically have lower margins and LTV than SaaS businesses but often play in larger markets and can grow faster, with shorter CAC Payback Periods.
At Series A, we are looking for product-market-fit. At Series B, our focus widens to look at route-to-market-fit and evidence of a larger Direct-TAM.
Above all, we are looking for open and transparent debate and a shared mission to truly understand the market, position, and business drivers.
We are as interested in how you think and discuss these topics, as we are in the “answer”. We expect there to be weakness, we want to understand them with you. We hope that you enjoy the conversation too!
Everything starts from a deep understanding of your customer and their needs.
Do everything you can to truly understand from your customers’ perspective why you win and what makes you stand out. Think through the defensible ‘asset’ you are building, which will ensure you remain the best option for your customers long term.
In our next piece ‘Debunking Investor Myths’ we look at what goes on behind closed doors and the internal decision making processes from 1st meeting, right the through to Investment Committee.
If you found this article helpful, you may also enjoy these videos on how to give the ‘Perfect Pitch’.
