In an investing world glamorized by Shark Tank, Silicon Valley, and “unicorns,” simple, straightforward communication about what drives VC decisions is rare.
At the early stage of venture investing, raw data is very hard to come by. Obviously! At that point, the company usually hasn’t gone to market yet in any real way. So at the time when many VCs are evaluating a startup for possible investment, qualitative evaluations dwarf quantitative ones.
The old adage “Garbage in, garbage out” is particularly apt for early-stage venture investing. You simply don’t have enough financial metrics to meaningfully model future potential returns for a business that doesn’t exist beyond the PowerPoint slides the entrepreneur has put together (sometimes just hours in advance of the pitch meeting with a venture firm).
So what do you do? Well, it turns out that there are qualitative and high-level quantitative heuristics that VCs use to evaluate investment prospects. And they generally fall into three categories: people, product, and market.
People is by far the most qualitative criterion and, for early-stage investing, likely the most important. When the “business” is nothing more than a handful of individuals—in some cases only one or two founders—with an idea, much of the evaluation will focus on the team. Many VCs delve deeply into the backgrounds of the founders for clues about their likely effectiveness in executing this new idea. The fundamental assumption here is that ideas are not proprietary. In fact, VCs assume the opposite—if an idea turns out to be a good one, assume that many other startups will emerge to pursue it.
So the biggest question is, why do I as a VC want to back this particular team versus any of the other teams that might show up to execute this idea? The way to think about this is that the opportunity cost of investing in this particular team going after this particular idea is infinite; a decision to invest means that the VC cannot invest in a different team that may come along and ultimately be better equipped to pursue the opportunity. So how do you evaluate a founding team? Different VCs do things differently, of course, but there are a few common areas of investigation.
First, what is the unique skill set, background, or experience that led this founding team to pursue this idea? My partners use the concept of a “product-first company” versus a “company-first company.”
Scott Kupor is a managing partner at Andreessen Horowitz. He has overseen the firm's rapid growth to 150 employees and more than $7 billion in assets under management.
In the product-first company, the founder has identified or experienced some particular problem that led them to develop a product to solve that problem, which ultimately compelled them to build a company as the vehicle by which to bring that product to market. A company-first company is one in which the founder first decides they want to start a company and then brainstorms products that might be interesting around which to build one. Successful businesses can ultimately be created from either mold, but the product-first company really speaks to the organic nature of company formation. A real-world problem experienced by the founder becomes the inspiration to build a product (and ultimately a company); this organic pull is often very attractive to VCs.
Many people are undoubtedly familiar with the concept of product-market fit. Popularized by Steve Blank and Eric Ries, product-market fit speaks to a product being so attractive to customers in the marketplace that they recognize the problem it was intended to solve and feel compelled to purchase the product. Consumer “delight” and repeat purchasing are the classic hallmarks of product-market fit. Airbnb has this, as do Instacart, Pinterest, Lyft, Facebook, and Instagram, among others. As consumers, we almost can’t imagine what we did before these products existed. Again, it is an organic pull on customers, resulting from the breakthrough nature of the product and its fitness to the market problem at which it is directed.
The equivalent in founder evaluation for VCs is founder-market fit. As a corollary to the product-first company, founder-market fit speaks to the unique characteristics of this founding team to pursue this opportunity. Perhaps the founder has an especially apt educational background. Perhaps they had an experience that exposed them to the market problem in a way that provided unique insight into a solution. The founders of Airbnb fit this bill. Struggling to make ends meet while living in San Francisco, they noticed that all the hotels were sold out whenever there was a major convention in town. What if, they thought, we could rent out a sleeping spot in our apartment to conference attendees—helping them save money on accommodations and helping us meet our rent obligation? And thus was born Airbnb.