By Guest Blogger Rebekah Wu, Founder at Right-Hand Partners
In my ten years of experience working with the venture capital (VC) community here in the Silicon Valley, I’ve learned that VCs evaluate four criteria: team, market, intellectual property (IP) and business model. Of course, they always look for exit potential; that is a given.
The team is what many VCs consider before anything else. Their priority is valid. If the team is made up of B- and C-players, what good will a huge market opportunity or defensible IP or disruptive business model do without a team that can execute?
Different VCs look for different DNA. For example, there are VCs that like to bet on young founders in their 20’s who have the passion, hunger to succeed with a disruptive idea. Other VCs look for teams with seasoned executives with previous startup experience and success. What is absolute is the current management team’s ability to attract and hire *A* players to join their company. Another absolute is the current CEO’s willingness to hire a new CEO better than himself and take another position in the company if that is the right thing to do for the company.
Heads-up #1: During the due diligence process, the VCs will do both “front-door” and “back-door” reference checks on the management team. I’ve heard VCs say that LinkedIn and Facebook are their favorite tools they use for reference checks.
Though VCs never invest in advisory board members alone, they feel that key advisors can propel the company to scale quickly by opening doors at the decision maker level. Such advisors can add credibility to your company. For example, if Bill Gates wants to spend time advising you, there must be something credible there that you are doing. I typically advise my clients to put their advisory board slide in their appendix unless you have an “A-List” advisory board.
Board of Directors at the pre-Series A is not necessary. In fact, it can complicate matters as you are raising venture capital. The VCs that lead or co-lead are going to be on your board. If you already have three outside board members, someone or some people are going to be negotiated off the board at the term sheet.
Market opportunity is what many VCs consider before anything else. Their priority is also valid. If there is no market, what can a strong team or defensible IP or disruptive business model do without any customers?
Market opportunity is not just about the size or CAGR, it’s also about disruptiveness. Has Forrester already published a report on your market or is Gartner “coining” a new 3 letter acronym for the market you are creating in their next analyst report?
I often get asked by entrepreneurs about how to come up with a market size when they are creating a new market. Depending on your business, it can be as simple as looking at the number of target customers. How many people or companies can potentially use your product or service? And, how much are you charging for your product or service? Multiply those two numbers. Then think about what portion of that total addressable market (TAM) is your serviceable addressable market (SAM) today. This can be as simple as focusing on a specific vertical market or a demographic, such as the number of college students inFinland.
Heads-up #2: One trick of the trade is to look up your competitor or so-called competitor’s website and see what they quote as their market size and their source, and then figure it out from there.
Market validation is also part of the market opportunity evaluation. The VCs will take a close look at your referenceable customers and your competitive landscape. It can be helpful to investors if you can offer exit details about your competitors that have had recent activity in your space.
Heads-up #3: Customers and partners you mention in your investor presentation package can be called upon by VCs if they are seriously interested in your deal without you knowing.
Defensible IP is what many VCs consider before anything else. Their priority is again valid. If the IP is not defensible, what can a strong team or huge market opportunity or disruptive business model do if there is no barrier to entry and it’s only a hop, skip and a jump for any competitor to over take you at any moment?
Registered patents can be defensible for core technology and sometimes disruptive processes, but if you are software or a services company, patents may not be particularly worth filing. However, I’ve heard VCs mention other defensible competitive advantages such as:
- A founding team of known top three domain experts in a particular market that have worked successfully together in the past
- Exclusivity agreements with key partners or channels
- Marquee referenceable customers that are leaders in their industry – this is because followers in their industry will follow their lead to purchase the same system
- A CEO that has made a lot of money for investors in his/her last two startups
- Your working Rolodex
I’ve produced many events where the question of what is considered defensible IP was asked, and often the VCs themselves can’t always articulate their criteria for software and services companies. It seems to me that it is one of those unclear “they know it when they feel it” evaluation criteria.
I think it’s worth mentioning here that some VCs in the first meeting will assume that your technology works and focus more on your “bleeding artery” problem and how your solution solves that problem. It may not be until the technology due diligence process that you will be drilled on your technology and its defensibility.
Business model is what many VCs consider before anything else. Their priority is again valid. If the business model produces low margins, what can a strong team or huge market opportunity or defensible IP do if the business isn’t VC fundable?
Business model is about how you make money. This encompasses the disruptiveness of your idea, customer value proposition, go-to-market strategy and revenue model.
I’ve often heard VCs say that your gross margin speaks to your business model. VCs are always looking for high margin deals. In general, they want to see software deals with potential of 70% or more, SaaS with 80% or more, systems (hybrid s/w and h/w) with 60% or more, hardware with 50% or more in gross margin.
Heads-up #4: Investopedia defines gross margin as: Gross Margin = (Revenue – Cost of Goods Sold) / Revenue x 100%. Make sure that you have this percentage in your financial projection slide in your deck. It’s also important to know that VCs DO look at your financial projections carefully. They want to know how far you drilled down in your long term plan and how much you’ve thought through your business model. I coach my entrepreneurs raising their Series A to have detailed financials available for VC in their first meeting that show quarterly numbers over the first 2 years. The spend numbers are key here.
Lastly, I hope you noticed that each criteria mentioned in this blog is a priority for different investors. This means it is beneficial to do your homework and find out which one criterion is most important to your target investor(s) and customize your investor presentation content accordingly.
About Right-Hand Partners (RHP): RHP is a VC Relations company and a trusted conduit to reach the venture capital community. RHP has relationships with hundreds of venture capitalists representing over 150 VC firms. 34 companies that RHP coached have raised over $167M since September 2001; 8 have been acquired. www.rhpartners.com
RWu (at) rhpartners.com