Criteria to Use for Evaluating Startups
Factors to consider when determining an investment opportunity
Investors have many challenges when managing a venture capital fund. Still, one of the hardest things they must do is determine whether a company will be a winner that provides them with outsized returns. Many factors go into evaluating a company, and sometimes decisions are made more on gut feeling than hard data. This tendency is especially prevalent regarding early-stage companies who may not have a product in the market or much traction to evaluate performance. Below, I highlight some things to look for in a company when deciding to make a venture investment.
Founding Team
The first and most important factor in evaluating startups is to consider the team building the company. Creating an innovative company from scratch is one of the most challenging endeavors in business and life. How can we determine if the founders are up for it? It's essential to try and get to know the team on a personal level to understand their motivations and temperament. Some of the questions you should be asking yourself are:
Why has this team chosen to tackle this problem?
Does this individual honestly believe in their solution to the problem? Will they be able to persist through challenges?
Many things change when building a company. Can this team pivot and focus on something new in the face of change?
The fact of the matter is, 80% of startups fail. You want to be sure you are investing in an individual or team who believes so much in their product that nothing will stop them.
Product
Next up is the product itself. The goal here is to determine Product-Market Fit. Is there is a need for this product in the market? How is the product addressing that need? Does the company have an MVP (minimum viable product) or prototype that you can use? What competitive advantage does this product have over another company? It's important to note that products will continue to evolve as companies receive customer feedback. Whatever product you are viewing in a pitch meeting likely will not be recognizable when the startup reaches scale. It's essential to put yourself in the target customer's shoes and ask yourself, "If I had the problem that this company is trying to solve, would I use this product?" A useful tool is the NPS (Net Promoter Score), which ranks products on customer experience.
Market/Go-To-Market Strategy
When considering the market, an investor has to consider the market's size and how the venture plans to penetrate that market. We've talked about market sizing already, which you can read about in my post here. The point of configuring TAM (Total Addressable Market) is to understand just how big the opportunity is. Remember, as an investor; you are looking to create outsized returns. If there isn't a big enough market for the company to go after, the venture won't reach a large enough scale to have a meaningful exit at a massive valuation.
A go-to-market strategy must show how the founding team plans to get its product into its customers' hands. Different products/verticals require different approaches. Gauge how the team is thinking about their particular market and its strategy for growing share. Hubspot has a great post on how to approach this strategy here.
Traction
Traction shows a company's performance over time. When evaluating traction, the cliche is "up and to the right," referring to the trends investors want to see. There are many metrics startups use to determine performance, and we will dive into those in further detail in a future post. At it's most basic, we want to see steady growth in customers, revenue, and margins at a high level. Important things to avoid are "vanity metrics," which are metrics that look good on paper but don't add any meaningful value to business performance. Don't be fooled by these metrics and focus on the KPIs that show how the startup performs.
It's important to know that these metrics, particularly the financial ones, will be used to help determine a startup's valuation. A valuation will likely be the most negotiated point when dealing with a term sheet, and there are many nuances around this topic. Similar to KPIs, we will be diving into valuations in future posts.
Exit Opportunity
Lastly, we need to consider a realistic future liquidity event for the company. There are usually three exit scenarios a company has. First, when an investment fails, you end up with a company's winddown that returns some or none of the invested capital to investors. These are always challenging situations, but as mentioned before, 80% of startups fail. The other two scenarios involved the company going public or getting acquired by another one. The traditional way a company goes public is through an IPO (Initial Public Offering), but SPACs and Direct Listings have become popular choices in the past few years. As an investor, you should determine what the founder thinks is the likely exit strategy for their venture and the route to achieving that milestone.
One trend we’ve seen on startup exits during the last decade is the amount of time it takes for a company to go public. As capital has moved from the public market into the later stage private market, companies have had incentives to stay private longer. This year has marked a boom for startup IPOs, with many companies taking advantage of the market rally. This trend, along with the increased popularity of SPACs and Direct Listings, has provided these private companies with a unique exit opportunity.
Final Thoughts
These are just some things to consider when investing in a company. Often, much of this information won't even be available at a too early-stage. Later-stage investors have some advantages by having more data to determine a company's performance, but the returns in a later-stage investment are typically smaller. Using this roadmap and diversifying among many investments can help a fund reach successful returns. If you’d like another resource for this material straight from Sutton Capital, we recently did a live talk with Leo Capital, where we touched on the topic. You can find the video here.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.