Thinking Like a VC: How to Assess Your Startup
Funding from a venture capital firm can be a significant milestone for any startup. But how exactly do VCs decide which startups to invest in? VCs use a rigorous process to evaluate startups, looking at factors like team quality, market trends, traction, and more before writing any checks.
Let’s take a deeper look at what VCs look for when assessing startups for investment potential. Understanding the VC due diligence process can help founders better position their companies to secure funding.
1. Evaluating Startup Founders and Teams
One of the most important elements VCs evaluate is the startup team itself. They prefer to invest in strong, well-rounded teams versus individual founders. Here are some of the key qualities VCs look for:
Assessing Technical vs Business Expertise
VCs like to see startup teams with at least one technical co-founder and one business co-founder. This combination enables the company to build great products while also running the business effectively.
For example, Airbnb’s technical founder Joe Gebbia paired up with business-minded Nathan Blecharczyk to balance out the founding team’s experience.
Technical-only founding teams can struggle on the business side. On the other hand, non-technical founders have a harder time assessing and recruiting engineering talent. The ideal mix is at least one of each.
Evaluating Relevant Experience
Previous startup experience is highly regarded, as founders with runs on the board tend to execute better. Experience in the target industry or market is also valued since it provides valuable insider insights.
But lack of direct experience can be overcome by demonstrating deep passion and hustle. Brian Chesky and Joe Gebbia from Airbnb had no hospitality experience before upending the travel industry.
Assessing Coachability and Adaptability
Founders need to be open to feedback and self-aware about their limitations. VCs want to invest in teams ready to learn and improve, not stubborn founders who think they have all the answers already.
The best founders are coachable, rapidly incorporate feedback, and adapt as situations change. Inflexible founders who bullheadedly stick to their original ideas often struggle.
Evaluating Shared Values and Cohesion
Alignment of vision, values, and work styles is important between co-founders. Without cohesion at the top, startups often crumble due to infighting. VCs look for strong personal rapport and chemistry.
Friends with a track record building things together make for ideal co-founder pairings like Jobs and Wozniak, Hewlett and Packard, or Biz Stone and Evan Williams. Their bonds kept them unified through challenging times.
Assessing Commitment Level
The best founders have an almost fanatical commitment to their startup. VCs are looking for full-time devotion and hustle, not side projects or distractions. Signals like quitting jobs to go all-in demonstrate commitment.
For example, Max Levchin slept in the PayPal offices while getting their early traction, demonstrating the tireless ethics VCs love to see.
By thoroughly assessing the team qualities above, VCs gain confidence that the startup can pivot successfully even if the original idea doesn’t work out. Great teams adapt until they find product-market fit.
2. Predicting the Next Big Market Trends
Identifying the next big trend before it hits mainstream is crucial for VC investing success. Here are some indicators VCs study to predict upcoming trends:
Researching Macroeconomic Shifts
Changes in the broader economy like recessions, industry declines, and demographic trends shift consumer behavior. VCs spot opportunities created by these shifts.
For example, Seal & Co. identified the acceleration of e-commerce triggered by the pandemic before most people saw it coming. This trend fueled breakout growth for Shopify and other e-commerce infrastructure companies.
Analyzing Emerging Technologies
New technologies like blockchain, AI, quantum computing, and AR/VR spawn innovative applications. Investing on the ground floor allows VCs to profit from widespread adoption.
Social networking and smartphones were two emerging technologies that Forward Partners identified early on, leading them to lucrative bets like Spotify.
Studying Consumer Behavior Changes
Evolving consumer preferences create opportunities. For example, the remote work boom fueled growth for new collaboration and productivity tools.
When Bodega transitioned from vending machines to a mobile app, they spotted changing consumer delivery expectations far before the masses. VCs pounced on this shift.
Uncovering Unmet Market Needs
Customer pain points that current solutions fail to address signal opportunities. Interviewing customers about frustrations highlights gaps startups can fill.
DocuSign noticed corporate frustration with paper-based systems and legacy E-signature solutions, leading them to a $54 billion opportunity. VCs seek out these white spaces.
Understanding Industry Pain Points
Like consumers, businesses also face unsolved problems. Enterprise IT pain points like data silos and legacy systems open doors for modern solutions.
VCs identified the need for cloud data warehousing to help businesses analyze data better, fueling Snowflake’s stratospheric rise.
Tracking Competitive Dynamics
Industry disruption and swirling competitive forces create openings for startups. Astute VCs identify markets ripe for innovation based on competitive activity.
CB Insights spotted the emerging competitive gap in diabetes management, leading to a prescient early investment in Livongo.
By studying trends along the dimensions above, VCs aim to invest in companies riding the wave of massive trend shifts before valuations skyrocket.
3. Assessing Startup Traction and Momentum
In addition to market opportunities, VCs deeply assess a startup’s traction and growth metrics. They focus on indicators of product-market fit versus vanity metrics:
Analyzing User and Revenue Growth
Monthly active user growth and revenue growth month-over-month are the top metrics. Hockey stick trajectories indicate product-market solid fit.
VCs like to see 5–10% month-over-month growth at a minimum. Triple-digit growth indicates exceptional early traction.
Evaluating Engagement and Retention
Metrics like daily active usage, session length per user, and churn rates indicate if users truly value a product. High engagement and retention demonstrate fit.
For example, Duolingo boasted session lengths of over 30 minutes and extremely low churn thanks to its addictive language lessons. This outstanding engagement signaled a big opportunity.
Reviewing Sales Pipeline Health
Robust sales pipelines provide reliable future revenue visibility. Strong conversion rates from prospects to customers validate fit.
When Clearbit shared its early pipeline models with Sequoia Capital, the figures demonstrated both product-market fit and sound financial planning.
Analyzing Burn Rate and Cash Flow
Valleys of death loom if cash is mismanaged. Efficient burn rates and capital runway projections demonstrate financial acumen.
Airtable was raising at a $20 million valuation in 2016 partly because they had impressive capital efficiency with a 24-month runway.
Identifying Product-Market Fit Signs
Organic word-of-mouth traction, waitlists, consistently strong NPS scores, and low churn indicate product-market fit. VCs love to see these signals.
Plaid’s tremendous early growth, retention, and customer love made them a fintech darling among Sand Hill Road investors.
Hard metrics that prove compelling growth and engagement matter much more to VCs than vanity metrics like app downloads, registered users, social followers, or email signups. Traction demonstrates that dogs are eating dog food.
Why People Outweigh Ideas in VC Investing
After thoroughly analyzing team, trends, and traction, VCs must make the ultimate investment decision balancing people versus ideas:
Understanding Founder-Market Fit
A startup’s fate ultimately depends on the founder’s ability to realize its vision. The best ideas only succeed with the right people executing them in the right market. VCs bet on outstanding talent setting out to dominate a massive opportunity. Ideas are secondary.
Recognizing Great Teams Can Pivot
Many wildly successful startups like Twitter, Slack, Instagram, and Trello pivoted from their original ideas. With adaptable, determined founders, the starting idea becomes almost irrelevant.
Identifying Mediocre Team Risks
Conversely, mediocre founders struggle to adapt even when pursuing a hot, proven idea in a growth market. Working with the wrong team is too risky despite other strengths.
Remembering Ideas Don’t Execute Themselves
Even the most brilliant ideas and sizeable markets don’t guarantee success. For a startup to thrive, everything depends on the talent executing the vision and their commitment to figuring things out no matter what obstacles arise. Without the ingenuity of a tenacious team, even the most promising ideas will flounder.
Bottom line
For founders, understanding how VCs assess opportunities leads to better positioning when pitching startups for investment. Build a stellar team, internalize market trends, prove traction with hard metrics, and validate product-market fit — and your odds of convincing VCs to invest will dramatically improve.
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