How do VCs evaluate early stage startups?
Investing in businesses at the very early stage when the founding team has just been formed and the startup team is figuring out their product. A lot of the evaluation is qualitative as there is a lack of financial as well as user data to analyze and understand where the startup is headed.
So, how do VCs evaluate early-stage startups?
Investing in early-stage companies is more about applying qualitative heuristics and patterns which are used to evaluate the prospects of an investment. And they generally fall into three categories: team, product, and market.
Founder and the team
Many VCs focus on the team as the core determinant for deciding to invest. This is especially true in case it’s just a couple of cofounders with an idea. VCs will look into the background of the founders and see if the team has the capability to build a world-class product and sell their products to customers.
The quality of founders is more important than the startup idea. Most investors will prefer investing in quality teams with a B quality idea rather than B quality teams with an A quality idea. The problem with good ideas is that, if they are visibly good, other entrepreneurs are also trying to build something in the same space. So the question VCs ask is,
‘Is this team the best to execute this particular idea?’
Because if they invest in the startup, then they usually will not back another team with the same idea. The reason being that a VC’s decision to invest in a company is effectively an endorsement of the company as the de facto winner in the space. A VC’s decision to invest in company X means that they cannot invest in a different team that may come along and ultimately is better positioned to build a better company in that space.
The biggest challenge for VCs is getting both the category/space and the company right. They usually get the category right, but picking the right horse to back is extremely challenging. An example is choosing Friendster over Facebook.
Unlike late-stage startups where VCs are looking for product-market fit, in early-stage startups, VCs look for founder-market fit. Founder market fit is where the founding team is well-positioned to take the company to unicorn status and earn great returns for the investor.
Founder-market fit usually comes from the founder/team’s deep experience or educational background in the sector they are starting up. Or, the founder had a unique experience or did extensive research that exposed them to the market problem in a way that provided unique insights into the solution for the problem.
The primary question VCs are trying to answer is:
“Why back this founder against this problem set versus waiting to see who else may come along with a better organic understanding of the problem? Can I think of a team better equipped to address the market needs that might walk through our doors tomorrow?”
If the answer is no, then this is probably the right team to partner with.
Another important area where the VC focuses on is the founder’s leadership abilities. In particular, VCs are trying to understand whether this founder will be able to tell a great story around the company mission to hire potential employees and top management executives. In the same light, the founder has to be able to get customers to buy the product, partners to work with building and distributing the product, and, eventually, other investors to fund the business as it grows. Will the founder be able to articulate their vision in a way that causes others to want to join him/her?
Basically, the single question VCs are trying to ask is, can this person build a billion-dollar company over the next 8-10 years?
In terms of product, the key question VCs want to figure out is – has the founding team built a product that is loved by their early set of customers, and will these customers pay money to consume the product? In other words, VCs are looking for a problem-solution fit, and once that is there, it is easier to reach to product-market fit.
If a startup is pre-product, the founders have to work really hard to convince investors using insights and research obtained through potential customer interactions. Pre-product startups need to have either a good founder-market fit I.e. previous experience of building and exiting startups, domain knowledge in the field or, very high-quality insights that put them in a great position to beat their competitors.
VCs are also not interested in marginal products but products that are 10x better than their existing counterparts. 10x products are basically painkillers compared to vitamins i.e. vitamins are nice to have compared to painkillers.
Vitamins offer some potential health benefits but are more forward-looking. Painkillers on the other hand get the job done. If you have a headache, you want a painkiller. Painkillers solve your problem and they are fast-acting. Similarly, products that often have massive advantages over the status quo are painkillers and VCs want to fund them.
Many VCs look at market size. VCs like Sequoia bet on markets. When VCs bet on companies, they expect 9 out of their 10 investments to fail, the 10th bringing in more money than they invested in the 10 companies. In order to get such a winning company, it is necessary that the company is going after a large market.
Many VCs believe that companies can succeed in great markets even with mediocre teams but that great teams will always lose in a bad market.
Understanding market size is a huge challenge. The challenge of investing in big markets is that if it’s already big, there are many players dominating that market. Investing in small markets means that the VC won’t get a big return out of the investment. So VCs try to understand whether a market that is small today can become big tomorrow. Or, a big market, can it become smaller or even bigger than what it is?
A great example is Airbnb. When Airbnb was raising money, the market was considered small because it was assumed that customers would be college students sleeping on other people’s couches. But many VCs missed because they had not considered the bigger opportunity that Airbnb might end up competing with 5-star hotels.
So a lot depends on how VCs understand markets and envision the role of technology in developing these new markets.
To conclude, there is an important principle VCs try to follow. It’s okay for a VC to invest in a company that ultimately fails—as we’ve discussed, that’s par for the course in this business. What’s not okay is to fail to invest in a company that becomes the next Facebook.
If you are an early-stage startup looking to raise funding and don’t know if you are fundable, take our ‘are you fundable’ assessment and find out in 2-minutes if a VC will fund your startup.
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