In the world of venture capital, the process of evaluating investment opportunities requires a blend of strategic thinking, market understanding, and financial acumen. We’ve had a few investors reach out and ask what to look for when investing in early-stage companies. Below, we will delve into the anatomy of a deal.
The below are some of the items we look for when evaluating opportunities. They are in no particular order and every deal may not have every item on the list and some may have other elements that make the deal attractive.
One common term you’ll hear in startup analysis is Total Addressable Market, or TAM. This term refers to the size of the market (potential customers) for the product or service that a company is building.
Is the market large enough?
A large market size would imply a substantial customer base and potential demand for the product. The larger the market size, the larger the potential for growth and revenue. Investors look for opportunities where the addressable market is sizable enough to support substantial growth and generate returns on their investment.
Large market or niche market?
While a large TAM is important, beware of any company that says “This product is for everyone.” Even major companies like Uber and XYZ started by targeting niche audiences. A niche market is a more specific and targeted market than a large market. It means the company’s services or products will address a more specific market. Many niche markets exist under the umbrella of a larger market.
Example: A product directed towards business owners would be a large market. A niche version of this market would be a product directed towards female business owners. A company may find a large market in making health and beauty products for any type of consumer, while a niche market within healthy and beauty products is the conscious consumer, who would be more interested in only vegan, cruelty-free products.
Investors closely analyze key traction metrics to gain insights into a company's growth trajectory and potential. Here are some key phrases to know:
Monthly Recurring Revenue (MRR) - The predictable recurring income generated from customers on a monthly basis. This reveals revenue stability.
Customer Acquisition Cost (CAC) - The amount of money a company spends to get a new customer. This assesses customer acquisition efficiency.
Churn Rate - The rate at which customers stop doing business with an entity. This reflects customer retention.
Customer Lifetime Value (LTV) - A measure of the average customer's revenue generated over their entire relationship with a company. This gauges revenue potential per customer.
Gross Margin - The measure of a company's gross profit compared to its revenues as a percentage. This indicates profitability.
Net Promoter Score (NPS) - A measure of the loyalty of customers to a company. This measures customer loyalty.
User Engagement Metrics - A measure of how much users are actively participating with a product or service. These showcase product value.
Runway - The number of months a company can operate before it runs out of money. This assesses the company’s financial health.
Conversion Rate - A record of the percentage of users who have completed a desired action. This evaluates sales effectiveness.
Market Share - The percent of total sales in an industry generated by a particular company. This signifies competitiveness.
These metrics collectively offer a snapshot of a company's viability, customer satisfaction, and potential for long-term success. An investor could evaluate a company’s key markers of growth by answering the following questions: What is their LTV:CAC ratio? What is their average MoM or YoY growth?
A strong founding team is another key factor in any successful venture. In between the time when investments are collected and when a company exits, the company will go through challenges and we’re looking for a founder who can weather it all, who shows creative thinking, determination and grit.
Look to see that founders have experience in the industry or a background working in the field. Look to see who else is on the team, including the COO, CFO, and CEO, and what their backgrounds/experience include.
Problem & Solution:
A ‘sticky’ problem is important when looking at a company because it represents a challenging issue that customers consistently encounter. The problem should create a strong need for a solution that fosters customer loyalty, differentiation, and long-term growth potential for the company.
Difficult challenges require innovative solutions. That’s why we look for startups whose solution shifts the paradigm in addressing the problem. Those innovations often open the door to more efficient processes and better outcomes, giving the startup a competitive advantage. This type of innovation can also provide the ability to capture untapped market opportunities, ultimately driving growth and success.
Look to see if the product has a clear problem that it is addressing. How does it address this problem? Is it streamlined, clear, and efficient? Does it address an existing gap or fill a hole in the target market or industry?
Business Model & Growth Strategy:
A company’s business model is a strategic plan or outline of how a company plans to make money. Similarly, a company’s growth strategy is a plan for overcoming current and future challenges to realize its goals for expansion.
Together, a sound business model and growth strategy provide a clear framework for investors to assess a company's viability, scalability, and potential for generating consistent returns. They demonstrate the company's ability to adapt, innovate, and seize opportunities in a competitive market, making them crucial elements in investment evaluation.
Questions to think about include: What is the company looking towards in their future? Do they have a one-year out or five-year out strategy planned? Maybe their growth strategy involves expanding product lines, hiring key personnel, venturing into adjacent problems, or expanding their market. The company's plans should demonstrate their commitment to sustained growth and innovation.
Valuation is the process of determining the worth of a startup company, taking into account the market forces of the industry as well as the particular sector the company is in. Valuation is done for a number of different reasons, some of which include bringing on investors, selling or purchasing the company, or selling off assets or parts of the company. This metric can be helpful for investors to determine whether a company's asking price is reasonable and if it aligns with the potential returns they expect to gain. It aids in making informed investment decisions by evaluating the risk and potential reward associated with the investment.
There are a lot of factors to consider when looking at a company’s valuation. Some of the most important are:
Revenue - If a company is bringing in more money before they fundraise then their valuation is likely going to be higher because of that.
Market - The market conditions themselves often have an influence on the valuation of a company. Consider the timing as well.
Intellectual property - In some cases, intellectual property can have a large impact on the valuation if the company has developed something proprietary.