Investing in early-stage startups is an inherently high-risk high-reward business. Unlike growth or later stage investments, we come in before a company has delivered on their promises.
But we do not invest out of gut-feels or first impressions; intense due diligence and analyses takes place in order to mitigate as much risk as possible. Many early entrepreneurs in search of funding are not yet well-versed on how the investment process works and what VCs are looking for, hindering their ability to come fully prepared to that pitch meeting.
In this piece, I will run through five vital aspects a VC will analyze before deciding whether or not to invest in an early-stage startup.
The first is founding team- complementary individuals where at least one is very strong technically who can build the product, and one very strong commercially who can sell the product. The classic example here is Steve Jobs and Steve Wozniak. Steve Jobs could sell anything, and Steve Wozniak could build anything, together they created the most valuable company on earth.
F2 Operating Partner and Startup Psychologist, Noa Matz, expounds,
“While products pivot, go-to-market strategies evolve, and customers come and go, the founders are often the most consistent factor in the startup journey and are consequently a crucial parameter in the due diligence equation.”
The second is market. One of the most common obstacles for VC-backed startups is a lack of a solid market for their product. As Maor Fridman. a Principal at F2, explains,
“We need to make sure that we have an opportunity to create a billion-dollar company. Therefore, it is crucial that a startup has defined their target audience and has ensured that there is a big enough market and an urgent enough demand for their product at the earliest stage possible.”
A great example of a ripe market is insurtech- insurance is a huge market, yet customers typically hate their experience. This untapped market has allowed companies like Lemonade, Hippo, Next Insurance or our portfolio companies Parametrix and Five Sigma, to flourish. Using innovation on either customer experience or business modes, these insurtech companies deliver a delightful experience for their customers, and consequently become very successful very quickly.
Coming at third is value proposition, including intellectual property. The questions asked of startups here include: is there something deep and defensible under the hood? What is their competitive advantage? Is the value measured by the company’s abilities to charge high prices or build at lower cost?
Barak Rabinowitz, a Managing Partner at F2 gives us an example of just how important a good value proposition can be,
“Back when I was running my gaming company, we came across Onavo, a startup from Israel that was later acquired by Facebook. Onavo was offering unique insights to their customers, like which ads your competition were running and estimates on their click rates. For me, these insights were invaluable as I could see exactly which ads ran best before I created or ran my own. For this killer value proposition, I was willing to pay $5k a month despite being a young startup ourselves with a very tight budget.”
Fourth is the business model: How does a company intend to make their money? A startup can have an innovative idea and a huge market, but without developing a scalable business model that will lead to profitability, the rest does not matter. As Jonathan Saacks, a Managing Partner at F2, explains,
“I look to invest in companies who have a business model that can generate exponential growth. Eventually that exponential growth will need to be translated into revenues and profits.”
Understanding a company’s business model can and will save you a whole lot of time. Barak Rabinowitz recalls an experience in which the business model was a make or break:
“A couple of weeks ago I had someone pitch me a sports related venture, but when I asked how they intend to make money, they informed me of their plan- to be an affiliate and send customers to other sites. Ultimately, we want companies who can build and retain customers, not send them elsewhere. Even though they didn’t present their business model, by homing in and asking that question I could rule them out, saving time and resources before we went into deeper due diligence.”
Terms of Investment and Cap Table
And finally, terms of investment and cap table. In venture capital, it is vital to achieve meaningful ownership of a company; that is what drives our model. We are looking for fund makers and the way we calculate that is: size of fund divided by percentage ownership you achieve in a company. The higher the percentage of your ownership, the lower a company’s valuation needs to be in order for an investment to return the entire fund.
If a company that is raising money comes to you and is only willing to give up 10% ownership, you would need that company to achieve a billion-dollar valuation (which is VERY rare) to get a substantial return. Under those conditions one ought to say thank you, but let’s not waste our time.
Equally if you look at the cap table you can see explicitly who owns what percentage. This allows you to determine very quickly if the opportunity will be relevant before investing too much time and resources. For example- take a company in which a corporate entity owns 70% of the startup, in this case, there is no way we could achieve meaningful ownership.
These are not the only factors to look at before deciding on an investment. But they are vital points on the roadmap that allow us to get a feel on whether or not starting the funding journey is worth the high risk.
Likewise, these factors are essential knowledge to founders, and should be used to self-reflect and come fully prepared when starting to look for funding.