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Welcome to the third and final installment of our series on evaluating deals. So far, we’ve covered two of the most essential things VCs and angels look at when vetting a startup: the market and the founding team.
Both are important factors that can make or break a startup in its earliest stages… but having the right foundation built is just half the battle. Venture capitalists want to see that any company they’re investing in has already demonstrated at least some level of success, or traction.
Success is subjective, but there are a few indicators that are pretty much universally considered to be positive. Let’s talk about the top three.
Traction Signal #1: Steady or accelerating revenue growth
Generating revenue is a big step for a small company. It can take months or even years for a new startup to go from the “idea stage” to a real market launch—but once that happens, it becomes an excellent source of data investors can dig into.
A very young company may only have a limited amount of revenue data on hand; in those cases, they may only list “lifetime revenue,” or the total amount they’ve brought in since their inception. Other companies may disclose their revenue on a monthly or yearly basis. The two most common ways to measure revenue growth are:
YoY (year over year): growth from one year to the next–e.g., 2021 vs. 2020
QoQ (quarter over quarter): growth from one quarter to the next–e.g., Q1 2022 vs. Q4 2021 vs. Q3 2021 and so on
It goes without saying that growth is a good thing when it comes to revenue… even better if that revenue is growing at an increasing rate. If a company doubles its revenue its first year in business, and triples it the next… there’s now a demonstrated trend that approaches the “hockey-stick growth” VCs dream about.
Note that in some cases, a company that’s even a few years old may not have any revenue to speak of. This is particularly common in industries that require heavy research and development (R&D) to design a product. In those cases, it may be helpful to look for letters of intent (LOIs)---basically purchase orders—and other commitments that should generate revenue for that company in the future.
Other types of businesses may be pre-revenue but still show demonstrable traction with their customer base. For example, a startup building a new type of social networking platform might not start monetizing their user base until they’re satisfied that they have enough members. In that case, a VC would probably want to see that their user base is growing steadily, and that the platform is “sticky” enough to keep new users engaged over time.
In short: measurable growth is one of the key qualities venture capitalists look for when evaluating a deal—especially if that startup is raising for the first time. Things get a little more interesting if a company already has some backing… especially if those investors are well-known and experienced.
Traction Signal #2: Notable investors or advisors
Venture capital used to be an incredibly exclusive industry; only accredited and institutional investors had access to startup opportunities. That’s no longer the case—anyone can be an angel investor now—yet VC still has a bit of a herd mentality.
Simply put, when a famous investor or firm decides to back a company, we often see a rush of other investors that follow suit. This is part of why startups raising capital typically search for a compelling lead investor. There are two main benefits to having a household name (like Elon Musk, Peter Thiel, Softbank, a16z, etc.) on a startup’s cap table.
First is that phenomenon we just discussed: herd mentality. Getting a famous investor on board—especially one with a proven track record of choosing winners—is like a public statement of validation for a startup. Not only can it generate a lot of publicity for a company’s raise… it can also spark a “feeding frenzy” of investors that want to get into the same deals as the Horowitzs, Conways, and Cubans of the world.
The second benefit is the expert guidance and Rolodex of valuable connections these investors often bring. VCs and angels have an obvious incentive to help their portfolio companies grow in any way they can—and the most well-known of them have the power, influence, and experience to make incredible allies. That help alone can be enough to transform a startup from struggling to successful.
Plus, experienced investors and VCs can help fledgling startups achieve one of their most challenging (and important) business objectives: achieving product-market fit.
Traction Signal #3: Proven product-market fit
Product-market fit basically means that a company’s product or service is successfully meeting the demand of its market or consumer base. At a high level, these questions might help ascertain whether product-market fit has been established:
- Is the company reaching its target audience?
- Is that audience using/engaging with the product/service?
- Is the startup’s customer base growing, without massive increases in marketing spend?
- Are the customers satisfied with the product and brand?
- Does the market show an appetite for the product or service? (E.g., does it solve a problem for a large number of people?)
- Is right now the right time for this product or service? Are consumers “ready” for it (or, on the other hand, tired of this type of product)?
These are all good starting points to get to the heart of a company’s product-market fit (or lack thereof). A company that can successfully demonstrate that fit is attractive to VCs for many reasons—but what it really boils down to is that it proves the founders are “on to something.” It’s one of the earliest indicators that a company is doing the right thing, in the right place, at the right time. When all of those things are true, a startup is likely to have a much smoother ride as it grows. They won’t have to work as hard to convince the market that their product is worth spending money on.
The exciting thing about traction is that progress in one area can be a catalyst for progress in another. A startup that’s found product-market fit might start to see rave reviews of its product appear on social media... Which could get the attention of a prominent angel investor… Who might help that startup optimize its revenue streams and bring in more money.
Likewise, a celebrity investing in a little-known brand can generate massive amounts of hype online and in the media—a great way to get more “eyeballs” on the product and spur customer growth. For example, many of the companies that win investments on Shark Tank also get huge sales spikes—10X or more—from the exposure alone.
It’s important to keep in mind that traction can look different depending on the type of company and how early it is. This seems to be especially true with so-called “moonshots”---projects that are incredibly ambitious and exploratory, and that may show no clear path to profitability or product-market fit in the short term.
For example, a (hypothetical) startup that’s building modular homes optimized to support human life on Mars probably doesn’t have an existing customer base to speak of… let alone revenue. Projects with massive R&D needs may spend years or even decades burning millions (or billions) of dollars in funding before they bring in a single penny. By the time SpaceX had its first successful launch in 2008, the company had spent hundreds of millions of dollars—and Elon Musk was nearly bankrupt. Today, SpaceX is valued at roughly $100 billion.
Still, moonshots are the exception, not the rule. For most companies, an experienced VC will look for proof of traction—including revenue growth, product-market fit, and high-powered backers—before they’ll agree to invest.
Our own diligence team takes non-revenue traction into account; it’s one of the metrics used in their holistic assessment of companies. Traction indicates that a startup has made it past “day one” of their journey; it shows that they’ve already begun to put in the really hard work of executing on their vision.
Over the past three weeks, we’ve done deep dives into three of the most important things top-tier VCs and angel investors consider while vetting opportunities. Now the ball is in your court. You now have the power to create your very own process for conducting due diligence and ultimately deciding whether or not you want to invest in a deal.
Want to put those skills to work? You’re in luck—there are currently 23 opportunities on Republic that are closing their doors on or before May 1, 2022. Check them out below… and, if you want, use them to practice evaluating deals efficiently (and thoroughly).
Lastly, if you want to see more of this type of content, let us know in the comments below! We have a massive pipeline of educational content like this in the works… so drop us a line if there’s anything in particular you’d like to see covered.
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