What is the difference between pre-seed and seed financing?

What is the purpose of this article?

Enable founders and investors to discuss their assumptions about what each startup financing round means.

You can download a PDF of this article from: What is the difference between pre-seed and seed financing

What are the critical learnings in this article?

  • Investors are looking for the evolving validation of: a large market; a competitively differentiated value proposition; and a team that is able to quickly learn and change.
  • There are no commonly accepted standard definitions. I observe that people have many different interpretations of these words, resulting in confusion and mis-representation.

What are investors looking for?

Investors are looking for a startup with three critical potentials:

  • A large number of cash paying customers with an urgent problem or need they are willing and able to pay for. A large market is needed in order to have a successful startup with a large shareholder value enabling a very profitable exit for the investors.
  • A value proposition and solution which enables a large number of cash paying customers to achieve benefits and value. The startup will fail if the cash paying customers are not getting benefits and value.
  • A great team which is able to continuously learn quickly and adapt. Continuous learning results in the team changing the focus of: who the target cash paying customers are; what the customers urgent problems and needs are; the characteristics of the competitively differentiated solution.

The financing evolution from family and friends through to Series A, B etc. provides ever increasing validation of the three critical potentials outlined above.

Pre-seed

  • First funding after family, friends etc.
  • The goal or end-result, of the pre-seed stage is demonstrating that there is a market need.
  • Prior to pre-seed funding, the startup has:
    1. Created something that works.
    2. Validated that that there are some potential customers with urgent problems/needs they are willing and able to pay for.
  • The startup does not have a complete founding/leadership team, partners, channels.
  • During pre-seed, there is likely little or no revenue.
  • Funding provides a 3-9 month runway.
  • Funds raised: $50K to $1 million.

Seed

  • The goal, or end result, of the seed stage is proving that there are a large number of potential customers that are willing and able to pay for the solution AND there is a solution which can be scaled.
  • Prior to seed funding, the startup has:
    1. Customer traction: e.g. at least one passionate pilot user, some customers that are paying for some beneficial operational piece of the solution or pilot, etc. (This traction excludes consulting and other revenue not reflecting the long term-solution the company is aiming for). The seed stage will further expand the scope of the benefits and the scope of the solution.
    2. Pilot users or customers validate the benefits they are able to achieve.
    3. The right founding team is in place to take the company to the point of being able to scale. The team will expand as the company starts to scale with the funds obtained from Series A funding.
  • Funding provides a 12-18 month runway
  • Funds raised $1-4 million.

Series A

Prior to series A funding, the solution and company have the potential to scale. Series A, and subsequent, funds are used for scaling. Scaling may require changes to: the technology, processes, and talent.

 What are your next steps?

Founders and investors must write down exactly what they mean by terms such as “pre-seed” or “seed”.

What further reading should you do?

What does the startup journey look like?

https://koorandassociates.org/the-startup-journey/what-does-the-startup-journey-look-like/

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Due diligence questions for a startup. V2

What is the purpose of this article

  • Provide a framework for founders and investors to identify due diligence questions.

You can download a PDF of this article from: Due diligence questions for a startup V2

What are the critical learnings in this article?

  • Due diligence begins before a startup asks for funding. Due diligence is not a one time event.
  • Due diligence is based on more than the information a startup provides.
  • Detailed due diligence questions depend upon where a startup is in the investors’ analysis and decision making process. Due diligence increases the further along a startup is in the funding process.
  • Due diligence is done for every kind of startup, including investment funds and angel investment groups.
  • Three overarching due diligence questions apply to any company or fund at any stage: How many cash paying customers are there with urgent problems and needs they are willing and able to pay for? How does the company enable customers and users to achieve more value than the competition? How is the leadership team competitively differentiated?

What is a startup?

A startup is a temporary organization designed to search out a repeatable, scalable, and profitable business model with lots of potential customers who are willing and able to pay to solve their problems and needs.

Startups are not building a solution.  They are building a tool to learn what solution to build.1

A business model describes how a company creates more value for C&U (customers, users) than the status quo and competitors. Who are your target C&U (Customers and Users)? What C&U  problems are your solving? What C&U needs are you addressing?  What benefits and value are you enabling C&U to achieve? What are the human and technology resources needed?  What are the channels and partnerships?

What are the startup stages?

  • You have some assumptions about an urgent problem or need that C&U have.
  • You meet with C&U to hear from their lips: that this is an urgent problem or need that they have, and the value to them of meeting this urgent problem or need.
  • Within a few months you have something in C&U hands which delights them. This is not the whole solution, but something which provides noticeable value.
  • You keep adding customers while enhancing your solution to provide more value to more customers. You may be changing direction several times during this phase.

A startup is no longer a startup when it has successfully searched out a repeatable, scalable, and profitable business model with lots of potential customers who are willing and able to pay to solve their problems and needs.  The startup has learned what solution to build.  The temporary organization structure must change to one that can grow rapidly.

What are the three key sets of questions an investor asks throughout the life of the startup?

  • How many cash paying customers are there with urgent problems and needs they are willing and able to pay for?
  • How does the company enable customers and users to achieve more value than the competition?
  • How is the leadership team competitively differentiated?

The number of detailed questions in each of the three sets increases as the startup progresses through the due diligence process.

 Due diligence begins before there is a funding deal to consider.

  • Early stage funds encourage startups to: enter information into the funds’ databases at the pre-revenue stage and before asking for funds; update the data regularly; provide month updates to the fund; etc. Software tools analyze the data to identify high potential startups.
  • Early stage funds are using software to build large databases of startups based on existing third party databases and their own tools to scan the web. Analytic tools identify high potential startups.
  • Many funds are now using software to determine which startups to actually contact. InReach Ventures in Europe has built custom software which created a database of over 95,000 startups. The software identified 2,000 candidates for management contact.2 Framework Venture Partners (Toronto Canada) has a 20,000 startup database with about 100 datapoints per startup.  Startups from the pre-revenue stage on can submit information and receive benchmark feedback.3

Due diligence also occurs at the deal sourcing stage

Only 12% of deals arise from companies applying to VCs. Each of the deal sources does some degree of due diligence.

Where do VC source early stage deals?4

31% Generated through professional network

23% Proactively self generated

22% Referred by other investors

12% Inbound from company management

09% Referred by portfolio company

01% Quantitiave  sourcing

02% Other

Once there is a deal, each step of the deal process has due diligence.

Harvard Business Review published the findings from a survey of 885 venture capitalists at 681 firms.5

For each deal that closes, on average:

  • 101 deals are considered;
  • 28 deals proceed to a meeting with company management;
  • 10 deals are reviewed at partner meeting;
  • 8 deals have detailed due diligence;
  • 7 deals result in negotiation; and
  • 1 deal actually closes.

What is one example of the questions asked at the screening stage?

Going VC has pass/fail factors in their one page screening test:6

  • Fit with the fund themes and areas of focus.
  • Addressing problems in the fund’s target industries/sectors.
  • Startup stage aligns with the fund’s target stages.
  • Startup target geography aligns with fund’s target geography.
  • Quality of the referral.
  • Strengths of the startup’s partnerships, customer traction and suppliers.
  • Startup’s market size aligned with fund’s target market size.
  • Other

What are the most important factors for VC investment decision making?4

What do VC’s say is the most important factor when they make the final investment decision?

53% team

13% fit with the fund

12% product/technology

07% Business model

07% Market

06% industry

02% fund’s ability to add value

00% valuation (not a typo – 00%)

Why is the team the most important factor at investment decision time?  Capital is unlimited but the talent to search out a large market and supporting business model is very scarce.  The team must have demonstrated that: they can work together, learn a variety of skills very quickly, build relationships quickly, make fundamental changes in direction when required, have integrity and trust worthiness, maximize the results from careful cash management, etc.

Andreessen Horawitz looks for three things in a startup: huge market, differentiated technology, incredible people.7

What are your next steps

If you’re an investor:

  • Ensure you have an investment thesis.
  • Define your due diligence process and questions. You’ll need several stages of due diligence to quickly screen out companies for which you’ll put in the time and resources for detailed due diligence.

If you’re a startup:

  • Write down your answers to the three overarching due diligence questions apply to any company or fund at any stage: How many cash paying customers are there with urgent problems and needs they are willing and able to pay for? How does your startup enable customers and users to achieve more value than the competition? How is your leadership team competitively differentiated?
  • Define how you communicate these answers to investors and your team: in person or video calls, in presentations, in seminars, in your newsletter, on your website.
  • Research your target investors to understand their due diligence process and detailed questions.

If you’re a company past the startup stage:

  • Follow the same steps as a startup, described above.

If you are a company that is not planning at any point to raise capital:

  • Follow the same steps as a startup, described above. Note that you need to communicate with any existing capital providers

 Footnotes

1 Alistair Croll, Benjamin Yoskovitz , Lean Analytics – Use data to build a better startup faster, (Sebastopol California: O’Reilly Media ,2013) Page 41

2 Maija Palmer, “Artificial Intelligence is guiding venture capital to websites”, Financial Times, https://www.ft.com/content/dd7fa798-bfcd-11e7-823b-ed31693349d3

3 Framework Venture Partners, “What is world class – how do we benchmark venture companies?”, https://www.framework.vc/blogs/what-is-world-class-how-do-we-benchmark-startup-companies/

4 Paul Compers, Harvard Business School, Will Gornall, University of British Columbia Saunder School of Business, Steven N. Kaplan, University of Chicago Booth School of Business, Ilya A. Strebulaev, Graduate School of Business Stanford, “How do venture capitalists make decisions”, Medium,  https://medium.com/vcdium/venture-capital-decision-making-c3258bc1b09c

5 Paul Compers, Will Gornall, Steven N. Kaplan, Ilya A. Strebulaev, “How do venture capitalists make decisions”, Harvard Business Review, https://hbr.org/2021/03/how-venture-capitalists-make-decisions

6 GoingVC Team, “Screening Scorecard”, GoingVC,  https://www.goingvc.com/post/venture-capital-due-diligence-the-scorecard

7 Corporate Finance Institute, “How VCs look at startups and founders”, Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/knowledge/other/how-vcs-look-at-startups-and-founders/

 

What further reading should you do?

How do venture capitalists assess teams?

https://koorandassociates.org/selling-a-company-or-raising-capital/how-do-venture-capitalists-assess-teams

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Are you an Angel investor or gambler?

Purpose of this article

Help you identify whether you are an Angel investor or a gambler.

You can download a PDF of this article from: Are you an Angel investor or gambler

How do you recognize if you are an investor?

  • The primary purpose of your investments is to grow and preserve you financial wealth.
  • There may be secondary purposes such as enabling social good.
  • You may have a variety of asset classes. These provide diversification, which may increase the probability of financial return and reduce the probability of financial losses.
  • You are tracking the return of your investments.

There are many other ways to spend money, other than investing

  • For most people, the major of their spending does not go into investments.
  • Hobbies, entertainment, social activities, intellectual stimulation, charities, giving back, and gambling are just some of the ways money is spent. g. I buy 6 lottery tickets a year at $3 each.
  • These other activities are not investing. I might win millions with my lottery ticket. Lottery tickets are not where I invest money.
  • If the primary purpose of your spending is other than growing and preserving wealth, then that spending is not part of your investing.

How do you recognize if your Angel investments are actually gambling?

Let’s assume you’ve decided to make Angel investments with the primary objective of making, growing and preserving wealth.  You may be doing this because you’ve heard that this Asset class outperforms publicly traded equities but that the chances of an individual investment are low. What are the odds of success?  You don’t want to “invest” in a casino or lottery tickets.

What are the facts?

The following findings are from a 2020 study of more than 10,000 individual early-stage portfolios on AngelList.1

  • Angel investments, as an asset class, generate 15% IRR (combination of realized and unrealized gains)
  • Investors who made 1-5 investments had a median return of 0.0% IRR.
  • Investors who made 10 investments had a median IRR of about 6%. 32% of these investors lost money.
  • Investors who made 20 investments had a median IRR of about 7%. About 16% of these investors lost money.
  • Investors who made 50 investments had a median IRR of about10%. About 16% of these investors lost money.
  • Investors who made 100 investments had a median IRR of about 14%

Many, if not most, angel investors have a limited return, although the asset class as a whole performs relatively well. A small portfolio of investments has low median IRR and significant chance of losing some or all of your capital.

 How do you change the odds to be an investor rather than a gambler?

There are four ways to be an angel investor rather than a gambler.

#1 Create a portfolio of 100+ investments

This will require significant amounts of your time and capital.

#2 Spend more than 40 hours on your personal due diligence.2

  • Spend more than 20 hour of due diligence time for each potential investment.
  • Angels who spend less than 20 hours have an average return of 1.1X capital.
  • Angels who spend more than 20 hours have an average return of 5.9 X capital.
  • Angels who spend more than 40 hours have an average return of 7.9 X capital.

You have to consider if you have the skills and knowledge necessary for an effective due diligence.  I don’t know the relationship between increased due diligence and the number of investments.

#3 Join an angel investor group

  • The rationale is to reduce your due diligence workload.
  • I have no advice on how you can conduct due diligence on an angel investor group, considering its members, its processes, and its results.
  • I don’t know the relationship between increased due diligence and the number of investments.

#4 Invest in an angel fund

  • The fund should have a large number of investments in its portfolio.
  • I have no advice as to how you could conduct due diligence on an angel fund, considering management, processes and results.

 Your next steps.

  • You cannot predict the future. The above fact-based analysis is historical. Many changes have occurred in the past few years:  the amount of capital available at the early stage has exploded; many early-stage funds have been created; the number of early-stage investors has grown. You’ll have to determine what the future scenarios could be.
  • The angel asset class as whole may do well, but your personal results depend upon your investment process and thesis. Assess whether you have the appropriate skills and process to be an Angel investor.
  • You need to carefully review and understand published reports from investors and funds. Some state their results as including both realized and unrealized gains.

Footnotes

1 Nigel Koh, Abraham Othman, “How portfolio size affects early-stage venture returns”, AngelList, https://angel.co/blog/how-portfolio-size-affects-early-stage-venture-returns

2 Robert E. Wiltbank, PhD Willamette University, Warren Boeker, University of Washington, “Returns to Angel Investors in Groups, November 2007”

https://www.angelcapitalassociation.org/data/Documents/Resources/AngelGroupResarch/1d%20-%20Resources%20-%20Research/ACEF%20Angel%20Performance%20Project%2004.28.09.pdf

Why won’t angel investors provide funding?

Purpose of this article

This article has a two-fold purpose:

  • Help angel investors identify risks and issues to consider before making an investment.
  • Help founders understand how successful angel investors think.

You may download a PDF of this article from: https://koorandassociates.files.wordpress.com/2020/12/why-wont-angel-investors-provide-funding.pdf

What is a startup?

  • A startup is a temporary organization designed to search out a repeatable, scalable and profitable business model with lots of potential customers who are willing and able to pay to solve their problems and needs.1
  • A business model describes how a company creates value for itself while delivering products or services to customers. What are you building and for whom.  What customer problems are your solving? What customer needs are you addressing?  What benefits and value are you enabling customers to achieve?
  • “Startups are not building a solution. They are building a tool to learn what solution to build. “2

 What is the context for this article?

  • Your startup is pre-revenue or has some revenue. You have already obtained funding from friends and family. You have made the decision not to bootstrap your business.  This is the first time you’re asking for funds from outside investors.
  • You are either an individual angel investor or an angel fund. You are focused on making money from your angel investments.  The risks and issue may be addressed during the pitch process, due diligence, term sheet negotiation, as well as preparation of the closing documents.  You may decide at any point to not invest.

The major reasons an angel investor will not provide funding.

  • This article outlines 11 major reasons an angel investor will not provide funding. These may occur at any point in the investment process, from someone recommending a founder through to the point of transferring money to the founders bank account.
  • There can be countless other reasons an angel may decide not to invest.

#1 The founders are not coachable

  • By coachable, I mean the founders are not able to learn and understand their customers, partners, employees, investors etc. Learning requires unlearning what is obsolete and being able to adopt new mental frameworks, new types of skills and new knowledge.
  • Founders who cannot learn and unlearn will likely fail.  Success usually requires focusing on different target customers and multiple changes to the business model.  The founders also need to learn many new skills, acquire new knowledge, and unlearn what is no longer appropriate.

Three ways to identify an uncoachable founder include:

  • When an investor, coach, or mentor provides advice, the founder immediately rejects the advice and tries to convince the other person they are wrong. There is no attempt and learning or understanding.
  • The founder is unable to explain what new things they’ve learned about their target customers and how the business models have changed.
  • The founder is unable to explain what new skills and knowledge they’ve acquired in order to search out a business model.

#2 The founders do not understand the customers and customer segments.

Customer understanding includes:

  • What are their problems?
  • What are their urgent problems?
  • What are the benefits the customer can achieve if their urgent problem(s) are solved?
  • Are the customers willing to pay for a solution?
  • Are the customers able to pay for a solution?
  • What does the customer journey or day-in-the-life of the customer look like?
  • How do the customers emotionally feel?

The most common reason startups fail is lack of a market.  The founders build a solution before they understand whether or not there are potential customers. The analogy is that many startups first build a cattle ranch to sell meat, and then discover their customers are vegetarians.

#3 Founders do not have a fact-based understanding of customers.

  • There are little or no facts regarding who is going to buy the solution and why.
  • There is a limited, or non-existent, ongoing process for understanding customers and validating assumptions.
  • Before building a solution, there have been a limited number of potential customer interviews and surveys. If the customers are consumers, then there should be at least 100 potential customer interviews combined with several hundred surveys.

Other fact-based approaches to understand potential customers include:

  • Asking customers to buy.
  • What is the trend for potential customers signing up on a waitlist to be informed when your solution is available.
  • What is the trend for potential customers signing up for your newsletter
  • What is the trend for potential customers engaging with the thought capital on your website.
  • Using Google Keyword Planner to: See the historical volumes for keyword searches, the competition for those keywords, and estimate the cost per click.
  • Using Facebook Ads to estimate the number of people interested in key words in a geographic area.
  • Using Google trends to see how popular the key words for your problem and solution are
  • Looking for consumer reviews in places such as Amazon.
  • Creating a website that will allow buying, but when the actual purchase is done, there is a message such as “solution not available”.

#4 Lack of trust and transparency

  • The angel does not feel that they can trust the founder or that the founders are transparent, especially regarding problems and issues.
  • All startups at the angel investment stage have major problems and issues. If the founder does not share these with the angels, then many angels will wonder: are the founders hiding their problems and issues OR are they unaware of them. Coachable founders can change their behaviour to be more transparent.
  • Founders should not make false statements to angels. Once trust is broken, many angels will immediately stop dealing with the founders.

#5 The founders’ startup does not fit the angel’s investment thesis

Founders should research the angels’ investment thesis. Angel funds often publish this on their website.  More effort will be required to understand individual angel thesis.

#6 There is no exit strategy for the angel investors.

The angel investors want to get a financial return at some point. Most successful startups are acquired.  Few startups result in an IPO.  The angel needs to understand:

  • Who are the likely buyers?
  • Why would they buy the startup?
  • At which milestones would they buy?
  • When will the milestones be achieved?

If the founders lack this knowledge, they need to have an advisor who can answer these questions.

#7 The startup will be difficult to scale if product market fit is achieved.

Example of these scaling difficulties include:

  • Needing significant amounts of expert talent for each unit of future revenue. Expert talent is often a scarce or expensive resource.
  • Needing significant amounts of capital for each unit of future revenue.
  • Future low gross margins

#8 The founders, management team, and advisors lack relevant talent

  • Thinking back to what a startup is, the talent pool is an organization designed to search out a repeatable, scalable and profitable business model with lots of potential customers who are willing and able to pay to solve their problems and needs.
  • The skills, experience, knowledge of the startup team is much different from a team that is successfully scaling a profitable business model.
  • Founders with deep experience in running a long-established and proven business may have to learn many new things in order to search out a new business model.
  • The skills to understand customers on an ongoing basis are very different from the skills to build a solution.
  • In addition to coachability, the founders need to be able to unlearn invalid assumptions and business models and create new business models. This is known as pivoting. I’ve seen too many founders try to sell a solution with little demand rather than create solution with massive demand.

#9 There is not a large potential market

  • TAM refers to total potential revenue assuming: 100% market share, all potential geographies, distribution channels and partners.
  • This revenue comes from customers who believe they have a problem or need urgent enough to pay for and are also willing to pay for it.
  • The customers must also believe the founders have a solution which better than the competition at enabling customers to achieve benefits. g. the TAM for smart phone is massive.  The TAM for smart phone with a keyboard is tiny.
  • The common mistake I see is that the dollars numbers in their market size slide are unrelated to the market for their solution. The following is a made-up example:  The startup wants to create a new type of brake light for cars.  The market size slide has the total dollar volume for car sales, not for dollar volume for purchases of brake lights.

#10 Lack of an achievable go-to-market strategy

  • Unclear how the customers will find the startup and purchase from the startup?
  • Unclear what distribution channels and partners are required.

#11 The angel doesn’t perceive a working-relationship fit.

  • The angel, for a variety of reasons, believes the working relationship with the founders would be too difficult or unenjoyable.

Your next steps

  • As a founder, have someone assess your startup using the above set of 11 items. You need the truth, so the assessment should not be from family, friends, or close colleagues.
  • As an angel investor, determine how the 11 items above fit into your investment decision making process. Which ones are deal-killers?  Which ones fit your risk profile?  Which one will you be able to mitigate over time, and how?

Footnotes:

1 adapted from: Steve Blank, “What’s a startup – first principles”. https://steveblank.com/2010/01/25/whats-a-startup-first-principles/

2 Alistair Croll, Benjamin Yoskovitz , Lean Analytics – Use data to build a better startup faster, Sebastopol, California, O’Reilly Media, 2013, Page 41

Successful angel investors are focused on the exit.

Purpose of this article

This article has a two-fold purpose:

  • Help angel investors identify the exit questions and issues they need to consider when assessing potential angel investments and managing their exit.
  • Help founders understand what successful angel investors may be thinking regarding exits.

This article considers success to be the cash return the angels receives upon exit.  One of the key measures is IRR (Internal rate of return).

You may download a PDF of this article from:  https://koorandassociates.files.wordpress.com/2020/11/successful-angel-investors-are-focused-on-the-exit-1.pdf

How to read the article

This article identifies four sets of issues, questions, and analysis angels should consider. This article is not intended to educate angels regarding the techniques and tools to address the issues, questions and analysis,

#1 Alignment of goals.

Do the founders and angels have the same goals?  The angels want to get cash out, which almost always occurs via a sale of the startup.  Do the founders expect to sell the startup? Are the founders focused on the startup being their lifetime calling or reaching the stage where the startup provides a comfortable income for the founders?

Do the founders and angels have the same commitment regarding when to sell the company?  Perhaps on day 1 the founders and investors agree.  Then a buyer comes along which meets the original expectations. What happens if a VC then comes along with a term sheet with a high valuation that the founders want to accept?  Great news with the founders but the investors may end up being stuck in the company for a much longer period time as well as taking the risk that growth never happens or the VC terms preclude a sale.

The founders and angels are aligned on day one for a longer-term sale.  Then VC provide funding with liquidation preferences and accruing dividends.  The eventual sale does occur but the bulk of the cash goes to the VCs with little return for the angels.

What is the financial plan and cap-table leading to exit?  What will the rounds, types of investors, valuation, and key business milestone?

What criteria have the founders and angels agreed upon regarding when to sell. What happens if follow on investors want to change the criteria? What legal protections and agreements are possible to bind the founders and angels?

#2 Will an appropriate exit be possible?

Before an angel writes a cheque, she needs to determine:

  • Who might buy the startup?
  • Why? E.g. a PE firm looking for a 15-year investment or a high-tech company needing specific IP and talent?
  • What would they value it at and why?
  • What must the startup have accomplished?

It is risky to make a cheque and not know if an exit is possible.

The angel’s due diligence process will require validating exit assumptions, through research and even contacting potential future buyers.

The startup financial forecast will include a line for exit planning expenses e.g. going to attending conference and events which attract buyers; building relationships with potential buyers.

#3 What is the potential impact of dilution on founders and angels?

The financial plan and cap table will include all items which may impact capital inflow or capital outflow upon exit including SAFE, convertible debt, preferred shares, debt, government grants, anti-dilution provisions, option pool, etc.

#4 What is the value of pro-rata rights for angels?

  • Pro-rata rights can enable an angel to maintain her percentage equity ownership in follow-on rounds of a successful startup. The angel must determine if they have the financial resources to be able to take advantage of pro-rata rights.
  • The financial plan and cap table can show the financial implications of pro-rata rights.

Your next steps

  • As an angel investor, you require a financial plan and cap-table which leads to an exit. You’ll need the skills and knowledge to create this if the founders lack the skills and knowledge.
  • As a founder, you require a financial plan and cap-table which leads to an exit. You may need an advisor with these skills and knowledge to help you create these.
  • The founders and angels need to discuss the above four sets of issues.

Venture Capital Investment Decision Making Process

Purpose of this article

Provide startup founders and early stage companies with a broad understanding of the investment decision making process used by VC (Venture Capital) firms.

This article provides a broad generic framework.  The actual process will depend upon the specific VC firm e.g. investing in pre-revenue startups or a $50 million revenue company.  The company  seeking capital needs to learn the decision-making process used by the VC firms they approach. Many VC firms publish on their website information regarding their process.

This article does not address the VC process regarding their existing portfolio companies. i.e. what happens after the deal is closed and the cash is in the startups bank account.

You may download a PDF of this article from: Venture capital decision making process

There 8 steps in a generic VC process

  • VCs are looking to say No as quickly as possible. They may be getting thousand of applications a year, thus the need for careful time management.
  • The VC may say No at any point and may not give the rationale. Recognize that decisions are often a gut-feeling.
  • After saying No, the VC may ask the startup to stay in touch via monthly updates. This often happens. The VC can observe through a number of monthly updates the achievements of the startup, what the startup has learned, and how the startup has dealt with problems and issues.

#1 Sourcing Deals

  • Most of the deals VCs end up investing in come from referrals by people they know and trust.
  • Many VCs also actively look for deals.
  • Some VCs use software to mine the web looking for startups. InReach Ventures in Europe has used custom software to create a database of 95,000 startups.
  • Startups directly apply to VC firms.

 #2 Initial Screening

  • Most VC firms have a set of a few deal-killer criteria to immediately say no to most applications.
  • A VC will spend 3 minutes and 44 seconds reading a pitch deck, on average.1

 #3 Initial partner call or meeting

  • Most VC firms will have a set of criteria to enable a fast No.
  • The key decision at this point is whether or not a VC is interested in learning more.

 #4 Quick Analysis by an associate

  • Follow up with the startup regarding questions from the partner.
  • Assess the pitch deck and answers provided by the startup.
  • Assess the competition.
  • Recommendation on whether or not to proceed.

 #5 Due diligence decision made by a partner

The partner makes the decision to devote a significant amount of associate time to due diligence, which includes:

  • Customer reference calls.
  • Founder reference checking.
  • Deep competitive analysis.
  • Drawing upon technical experts to assess the solution.
  • Drawing upon industry experts to validate analysis of customer problems and needs.
  • Compare the startups to others at a similar stage.
  • Legal due diligence to validate the startups current legal documents.
  • Financial due diligence to validate revenues and costs.
  • An investment memo is prepared with recommendation whether or not to proceed

#6 Partner meeting

  • The partner sponsoring the startup, presents the investment memo to the other partners.
  • The partners make a decision as to whether or not to proceed. The decision-making process is specific to a VC firm.  g. sometimes a unanimous agreement is required.

 #7 Term Sheet

  • How much financing?
  • What type of financing?
  • Terms and conditions regarding the financing?
  • Clarity on how key decision are made and who has what veto powers. g. what decisions require shareholder approval? What decisions require board approval? This is often in a shareholders agreement.

 #8 Closing.

  • A number of documents need to be signed.
  • Cash needs to be transferred into the startups bank account.

One startup told me that the deal fell apart at this point – the cash was not transferred.

 Your next steps

  • Define what value you require from a VC. Is it only money? Their network of potential experts and customers? Etc.
  • Reach out to VCs well before you need the money. The best way is via referral.
  • Research each VC to understand them. When and how do they expect to exit?
  • While the VC is doing their due diligence, you need to do your due diligence regarding the VC. g talk with other portfolio companies, both current and past, to understand what it was like to have the VC as an investor.
  • Start sharing your monthly update with the people who’ve agreed to receive it: your potential investors, your advisors.
  • The potential investor update is different from the update sent to existing investors and the update sent to customers (potential and existing).
  • Remember that potential investors may well read your monthly update on their phone, and only devote a few seconds to it.

Footnotes

1“What we learned from 200 startups who raised $360 million”, Professor Tom Eisenmann, Harvard Business School, and DocSend

https://www.slideshare.net/DocSend/docsend-fundraising-research-49480890

Further reading

How does a startup communicate with potential investors?

https://koorandassociates.org/selling-a-company-or-raising-capital/how-does-a-startup-communicate-with-potential-investors/

How do you invest in a private company? V2

Purpose of this article

  • Outline questions to ask as you’re considering whether or not to invest in a private company. The questions are focused on a long-term established company.  The company would not be a candidate for early stage or venture capital investing.
  • This article asks questions which may not be part of a standard financial, legal, and human resources due diligence.
  • This article does not cover all of the required due diligence tasks, which include financial analysis, legal reviews, intellectual property reviews, etc.

There are 10 sets of questions to consider:

  • Question #1 focuses on the company’s potential market size and understanding of it’s customers.
  • Question #2 focuses on the potential to grow the value of the company.
  • Questions #3-#10 focus on your relationship with the company and how you’ll get value from your investment.

You may download a PDF of this article from: How do you invest in a private company V2

#1 What is the current and future market place demand for the company’s solution?

Who are the target customers and users? What is their value proposition? Value proposition is the customers and users perception of value.  What are all the financial and non-financial benefits achieved? e.g. time savings, convenience, status, reducing negative emotions or risks, benefits achieved (financial and non-financial) achieved by the customers?  What are all the costs incurred by the customer (purchase costs, costs to switch to your company, other adoption costs, ongoing costs)?

Market Size Metrics

Market size = (The number people (or organizations) with an urgent problem or need that they are willing to spend money) times (the amount they are both willing and able to spend).

What is TAM (Total Addressable Market)?

  • What would be the company’s revenue if 100% of the customers demanding a solution to their problem bought the company’s solution. This assumes all potential geographies, distribution channels and partners.  The number of customers demanding a solution will be fewer than the number of customers that have the problem or need.
  • The best way to calculate TAM is with a bottom up calculation, starting with a clear description of the target customer segments, their problems and needs, and then considering the subset of customers who will actually provide revenue, and the revenue per customer. Recognize not everyone in every country will be able to afford the solution.

What is SAM (Serviceable Addressable Market)?

  • This is the portion of the TAM that is within the reach of the company’s current geographies, distribution channels, and partners, and the company’s ability to deliver and support their solution. This still assumes 100% market share of those customers demanding a solution.

 What is SOM (Serviceable Obtainable Market or Share of Market)?

  • SOM will be lower than SAM for three reasons: there will be competitors, customers who are demanding a solution may not actually buy a solution, and there will be an adoption rate ranging from early innovators to laggards.

Customer Metrics

New customer value achievement leading indicator (e.g. for Slack it was 2,000 team messages sent within 60 days).

New customer success metric (e.g. % of new customers achieving new customer value achievement indicator within 60-90 days).

NPS (Net Promoter Score) The single most important question is asking  “Would you recommend our solution to others?”  (Follow on questions could be “If so, why?  If not, why not?”) This metric is known as NPS.  What is your NPS? Above 0 is good. Above 50 is excellent. Above 70 is world class. How do you compare to your industry and competitors? What has been your NPS trend?

The Net Promoter Score concept was initially developed by Bain.  The following is a link to the Bain website homepage for Net Promoter Score, which contains several short articles:

http://www.netpromotersystem.com/about/why-net-promoter.aspx

The following is a quick overview of using Net Promoter Scores:

https://www.forbes.com/sites/shephyken/2016/12/03/how-effective-is-net-promoter-score-nps/#1b1391b423e4

What have been the findings and trends from ongoing customer interviews and surveys?

What are the scenarios for future market size?

What will be the impact on customer problems and needs due to potential startups, actions of current competitors, and established companies entering the market place either organically or by acquisitions? Remember what happened to Blackberry.  The customers no longer had problems and needs which the keyboard-based Blackberry could solve.

#2 What will drive the value growth of the company?

There are four ways to grow the value of the company:

  • Remain focused on the problems and needs of current customers, but increase the number of customers by expanding geographies, channels, and partners.
  • Target new customers, with different problems and needs which the current capabilities of the company can solve by creating new solutions.
  • Eliminate unprofitable customers, customer segments, geographies, channels, and partners.
  • Improve the internal operations of the company: develop current talent, acquire new talent, eliminate inappropriate talent, improve or change the processes, improve or change the technology. Talent includes: the board of directors, CEO, C-Suite, employees, advisors, consultants, contractors, and outsourcers.

The above four value growth opportunities could be addressed organically, by acquisitions or divestitures.

How are you going to help drive the value growth of the company, in addition in addition to your capital?

  • Using your network to help obtain customers, employees, and other investors?
  • Using your knowledge, skills, and experience to serve on the board of directors or advisory board?
  • Coaching and mentoring the CEO or C-Suite?

#3 Who will buy the company or your shares in the future?

  • A strategic buyer?
  • A financial buyer?
  • An owner/operator?
  • Employees?
  • IPO?

#4 Why will they buy it?

  • Growth potential?
  • Operational improvement potential?
  • Access to company’s customers, distribution channels, and partner?
  • Access to company’s talent and intellectual property?
  • Leading and defensible market position?
  • Non-concentrated channels and partners?
  • Sustainable margins?
  • Proven management team with successors?

#5 What will they pay for it?

  • Multiple of EBITDA or free cash flow?
  • Terms and conditions?

#6 What is the exit plan?

  • You or major shareholder(s) die?
  • One shareholder wants to exit?
  • Your plan to exit in Y years? If so, how?

#7 How will you and other shareholders take value out of the company?

  • Final sale of the company?
  • Interim financing enabling your partial or total exit?
  • Dividends?
  • Products or services?

#8 How will decisions be made?

  • What decision will be reserved for shareholders and what is the decision process?
  • What % of equity and what % of shareholders will be required for decisions?
  • What veto power will individual shareholders have?
  • Does the CEO have any veto power?
  • What decisions, if any, will be made by the board of directors?
  • What is the delegation of authority to the CEO?

#9 What is your fit with the other shareholders and management team?

  • Do you have a common set of values, morals, and ethics?
  • Can you work together?

#10 What will be in the shareholder’s agreement?

  • What the shareholder objectives are?
  • The answers to questions #6, #7, and #8.

Your next steps

  • Define your investment decision-making criteria and process. This includes: the financial aspects of your overall long-term financial plan, and your long-term life plan.
  • Which criteria are deal-killers?
  • Define the overall due diligence process – structured data collection and data analysis.
  • Execute your structured data collection, data analysis, and decision-making process.

Recognize that emotions and gut-feelings will still play a key part in your final decision.

Further reading

  • How can a private company sell securities in Ontario?

https://koorandassociates.org/selling-a-company-or-raising-capital/how-can-a-private-company-sell-securities-in-ontario/

 

Pitch evaluation – what are deal killers?

Purpose:

This article has a two-fold purpose

  • Encourage startup founders to research the deal-killer evaluation criteria used by investors to quickly determine whether to devote further time to learn about a startup. Given the massive number of startups looking for funding, time constraints force investors to be able to say “no” as quickly as possible.
  • Encourage board of directors and CEOs of established companies to also develop their own deal-killer criteria as a filter for the many proposals and recommendations made to them.

This article:

  • Reflects my personal point of view. Investors, board of directors, and CEOs will have their own deal-killer criteria.
  • Is not intended to score a pitch or enable a relative ranking of pitches.

You may download a PDF of this article from: Pitch evaluation – what are deal killers

My deal-killer criteria are based on 3rd party research regarding the 3 greatest contributors to startup failure?1

This research study analyzed 101 startup failures and identified the most frequently cited reasons for failure.  Usually there were several reasons for failure.

  • 42% of the time built a solution looking for a problem i.e. no market need.
  • 29% of the time running out of cash.
  • 23% of the time, not the right team.

Deal-killer criterion #1 What is the size of the market need?

How many customers believe they have an urgent enough problem or need that they

  • Are willing to spend money to address;
  • Have the money to address;
  • Have put a value, including what would pay, on addressing the problem or need.

Has the pitch described the customers’ value-proposition?

This is the customers perception of value.  What are all the financial and non-financial benefits achieved? e.g. time savings, convenience, status, reducing negative emotions or risks, benefits achieved (financial and non-financial) achieved by the customers?  What are all the financial costs incurred by the customer (purchase costs, costs to switch to your company, other adoption costs, ongoing costs and non-financial costs (e.g. time, social status, existing relationships, etc.)

To understand the customers perception of value requires direct input from potential customers, by a combination of interviews and surveys.  Most of the pitch I hear reflect the either the founders opinions/hopes of the startup or a one-page slide showing market size in the $10s of billions, based on a consulting/research study.  These startups are taking the ”build it and they will come approach” of first creating the solution and then hoping that there are customers.

What is TAM (Total Addressable Market)?

  • What would be the startup’s revenues with their future solution if 100% of the global customers demanding a solution to their problem bought the startup’s solution? TAM is the case with no competitors.
  • The solution built in the first 12 months is only a subset of the solution which in 5 years time will address TAM i.e. TAM depends upon the specific nature of the solution at a point in time. Note the phrase “demanding a solution”. You must not include in TAM ghost customers who are not demanding a solution.  If customers don’t know they have a problem and are not demanding a solution, the startup is planning to fail.
  • There is a critical difference between customer needs and customer demands. Customers have a large number of needs.  Demand is customers deciding that they will spend time, effort, and money to get a solution for what they believe is an urgent need.  Often this means that customers will spend less money to meet other needs.
  • Is the startup’s TAM large enough to launch and grow the company? For example, the global smart phone TAM is huge, but the global TAM for smart phones that have a keyboard is tiny.
  • The best way to calculate TAM is with a bottom up calculation, starting with a clear description of the target customer segment, its needs, and then considering the subset of customers who will actually provide revenue, and the revenue per customer. Recognize not everyone in every country will be able to afford the solution.

What is SAM (Serviceable Addressable Market)?

  • This is the portion of the TAM that is within the reach the startup’s distribution channels and partners, and your ability to deliver and support your solution. Geography may be a constraint. This still assumes 100% market share of those customers demanding a solution. SAM will change over time, as growth occurs in geography, the number of distribution channels and partners, and the volumes from each distribution channel and partner.
  • How will customers connect with the startup?  If they are seeking a solution, how will they find the startup?  How will the startup make customers aware of the solution?

What is SOM (Serviceable Attainable Market or Share of Market)?

SOM will be lower than SAM for two reasons: the startup may have competitors, and every customer who is demanding a solution may not actually buy a solution.

Deal-killer criterion #2 When will the startup run out of cash?

This is rarely presented in the pitch. If there is time, follow-on questions can provide insight:

  • How many months out does the monthly cash flow forecast go (many startups lack this)?
  • Given current customer income and costs plus existing cash in the bank, how many months until cash is gone?
  • Assuming that there are three future forecasts, how many months until the cash is gone in the most conservative forecast?
  • How many weeks have they assumed that it will take to close the current financing round?
  • How many weeks have they assumed from the end of the current financing round until the next financing round?
  • The average seed stage round takes 12 ½ weeks. 20% of the startup require 20 weeks or longer. 20% of the startups require 6 weeks or less.2
  • A fund-raising round can take a long time. This research study examined 13,916 financing events.3 The average time between fundraising rounds was 20.6 months. The time between rounds ranged from 6 months, to 35 months, 68% of the time.  e. 16% of the time less than 6 months and 16% of the time longer than 35 months
  • The above fact-based research was done prior to COVID-19.

Deal-killer criterion #3 Does the team have relevant experience?

  • Assess the skills and experience requirements implied by: the target customers, the value proposition, the nature of the solution to be built, the needed partners and suppliers, etc. Have the founders demonstrated that the team (which includes investors and advisors) has the relevant experience, skills, and network.
  • Most founding teams have gaps. Have the founders identified the gaps and milestones to close the gaps.

How do I use the deal-killer criteria?

I focus on whether the founders are doing the right thing, that they have the right approach and mindset.  I don’t expect the perfect research and perfect analysis.

Deal-killer criterion #1 What is the size of the market need?

  • If the founders do not believe they need direct input from customers, the deal is dead. Most of the startups I meet fall into this category.
  • If the founders market size slide shows a massive number and at the same time does not reflect understanding of TAM, SAM, and SOM the deal is dead.  I cannot tell from a pitch if the founders don’t understand the concept or are being deliberately deceitful. Unfortunately, many founders are not coachable on these concepts.  I’ve also met deceitful founders.

Deal-killer criterion #2 When will the startup run out of cash?

Founders rarely give enough information in a pitch to assess this. There’s rarely enough time in a pitch Q&A session to ask the detailed questions regarding cash flow. The questions can be a follow-up action for the founders after the presentation. This is a deal-deal killer if:

  • The monthly cash flow forecast does not exist.
  • The founders have an extremely optimistic view of how quickly funds can be raised.
  • The founders are already almost out of cash.

Deal-killer criterion #3 Does the team have relevant talent and experience?

  • I don’t expect the team have had a long history of experience in the target marketplace, target technology, etc. Historical knowledge often becomes obsolete.  What’s key is current knowledge and the mindset to keep that knowledge up-to-date.
  • I expect that the team has learned about the customers, the customer perception of value, competitors, partners, technology etc.
  • The team includes: founders and key leaders, advisors, board directors, and major investors.

Your next steps

  • Define you own deal-killer criteria.
  • Define in detail the criteria and process for evaluating the team’s relevant talent and experience.
  • Pitches for major change to an established company (e.g. transformation) will require a third party to assess the board of directors and key advisors and consultants for their relevant talent, skills, experience, and personal networks.

Footnotes

1 https://s3-us-west-2.amazonaws.com/cbi-content/research-reports/The-20-Reasons-Startups-Fail.pdf

2“What we learned from 200 startups who raised $360 million”, Professor Tom Eisenmann, Harvard Business School, and DocSend

https://www.slideshare.net/DocSend/docsend-fundraising-research-49480890

3 https://medium.com/journal-of-empirical-entrepreneurship/how-much-runway-should-you-target-between-financing-rounds-478b1616cfb5

What are the different kinds of startup pitches? V2

This article has a two-fold purpose:

  • For startups at the pre-Series A stage, outline the different kinds of startup pitches.
  • For established companies, outline different ways to describe their companies, business units, and major projects.

You may download a PDF of this article from: What are the different kinds of startup pitches V2

The purpose of the pitch is to convince investors when you first meet them that they must learn more about you, and your company.  Investors are swamped with pitches every day; therefore, most investors seek to be able to say “No” as quickly as possible to minimize their time.

Many investors and funds have deal killer criteria.  These are the few criteria, which if you don’t address in your pitch, result in the investor immediately saying “”No”.

Investors will not write a cheque based just on the pitch.  Investors wanting to learn more about you results in further presentations, meetings, and due diligence.

There are two types of pitch decks:

  • The in-person deck. This deck supports the someone doing a presentation.  The bulk of the information is communicated orally. The deck is very visual with a limited number of words and numbers.
  • The standalone pitch deck. This is designed to be read without someone speaking. This deck contains the all the key talking points, words, and numbers.  This deck is often left behind after a presentation and often emailed to potential investors.

There is a difference between a pitch (which is what the founder says) and the pitch deck (which are the slides).

The objectives of the pitch are:

  • Convince investors why the company must exist.
  • Be memorable – the investor must remember you the next day. Otherwise you won’t be called back.
  • Be professional – look and speak as if you already are the CEO of a successful company. This includes your body language, how you stand, and how you speak.
  • Create a trust, confidence, and emotional connection between the investor(s) and presenters.
  • Create the excitement and interest in the investors to learn more, while demonstrating your oral presentation skills and ability to have a Q&A dialogue.
  • Be able to communicate with an audience that has no previous information about you. Assume that the investors are not experts regarding your customers, your industry, or your technology.

You need to answer seven common key investor questions:

  • What do you do?
  • How big is the market?
  • What is your progress?
  • What is your unique insight?
  • What’s your business model?
  • Who is on your team?
  • What do you want?

More detailed information regarding these 7 questions is available at;

https://blog.ycombinator.com/how-to-pitch-your-company/

Your approach during your presentation should be:

  • Engage the investors emotionally with the story about the startup.
  • Make a great first impression. The first few seconds can make or break you.

The one sentence pitch

“My company (company name) Is developing (a defined offering) to help (a target audience) (solve a problem) (with secret sauce).”

The one sentence pitch is further described in this link to the Founder Institute:

https://fi.co/madlibs

The 2 sentence Email Test

The Email Test. Write up a two-sentence explanation of what your startup does then email it to a smart friend. Ask them to explain it back to you in different words. If they ask any clarifying questions, you need to revise your pitch. It’s important to revise your two-sentence pitch because you can’t add explanations as you would in conversation.

Further information is available at:

 Your one-minute pitch

When you have only 60 seconds to make your pitch, the critical elements are:

  • Who are you? < 5 seconds. One sentence.
  • What’s the customer problem? < 20 seconds. 3-5 sentences.
  • What’s your solution? < 25 seconds. 2-3 sentences
  • What’s your ask? < 5 seconds. One sentence.
  • What’s the one sentence everyone in the audience needs to remember? < 5 seconds/

What can we learn from a study of 200 pitch decks that were successful in fundraising?1

How long does an investor spend to look at a pitch deck emailed to them? 3 minutes 44 seconds

How many seconds does an investor spend on each part of the pitch deck emailed to them?

  • Financials……..……23.2
  • Team……….……….22.8
  • Competition………..16.6
  • Why now?…………….16.3
  • Company purpose…15.3
  • Business model…….14.9
  • Product…………..….13.9
  • Market size………….13.3
  • Problem………….….11.3
  • Solution………………10.6

 What was the average structure of the pitch deck, what % of startups had the section, and what was the average number of slides in each section?

  • Company purpose…73% 1.8 slides
  • Problem…………….88% 2.0 slides
  • Solution…………….69% 1.2 slides
  • Why now……………46% 1.7 slides
  • Market size…………73% 1.4 slides
  • Product………….….96% 5.0 slides
  • Team …………..…100% 1.2 slides
  • Business model……81% 3.4 slides
  • Competition………..65% 1.4 slides
  • Financials…………..58% 2.3 slides

 What are investor expectations for your pitch?

  • Do your research to find out what investor expectations are for your pitch.
  • Many investment funds and angel groups publish their expectations on their website. Ask other startups who have presented to the investors.
  • Prior to your pitch to investors, ask them what are critical items they want to understand and hear. Validate these by repeating them at the beginning of yoru presentation.  Success is harder if all you do is give the identical pitch to every single investor and haven’t spent time to learn about them.

The following are some examples of investor expectations:

Maple Leaf Angels (Toronto)

The following is a link to their pitch deck template on their website.  They also publish their criteria for evaluating pitches and their data room expectations.

https://mapleleafangels.com/wp-content/uploads/2020/07/Elevate-Your-Pitch-Template-Deck.pdf

The following are links to what three organizations have defined as their pitch deck expectations

  • MaRS Discovery District in Toronto

https://www.marsdd.com/mars-library/how-to-create-a-pitch-deck-for-investors/

  • Sequoia

https://www.sequoiacap.com/article/writing-a-business-plan/

  • Y Combinator

https://www.ycombinator.com/library/2u-how-to-build-your-seed-round-pitch-deck

 Your next steps

  • Create the different kindsof startup pitches.
  • Before you present, research you target audience to understand their expectations.
  • Change your oral and written presentation to meet the critical requirements of your target audience.

 Footnotes:

1 “What we learned from 200 startups who raised $360 million”, Professor Tom Eisenmann, Harvard Business School, and DocSend

https://www.slideshare.net/DocSend/docsend-fundraising-research-49480890

Further reading

  • Excellent insights into creating and giving your pitch

https://medium.com/crane-taking-flight/fundraising-why-you-shouldnt-just-copy-sequoia-s-pitch-deck-template-4b32ac60d93a?

  • What is “Company purpose”

https://medium.com/@iskender/the-perfect-pitch-deck-designed-by-a-vc-902842ce7f38

 

Startup investment memo

The purpose of this article.

The two-fold purpose of this article is to:

  • Provide an investment memo template for a startup investor, investment fund, or angel group.
  • Enable early stage startups to understand how they will be assessed.

This article is linked to “Due diligence questions for an early stage startup”1

You may download a PDF of this article from: Startup investment memo

There are three phases to an early stage startup.

Startup

  • A startup is a temporary organization designed to search out a repeatable and scalable business model. Lots of learning experiments are carried out. The focus is on getting some delighted cash paying customers.
  • A business model describes how a company creates value for itself while delivering products or services to customers. What are you building and for whom? What urgent problems and needs are you solving?

 Preparing to scale

The startup believes it has a business model which can meet the needs of a large number of cash paying customers. The focus shifts to putting in place cost-efficient and easily scalable technology, processes, and talent.

Scaling

The focus shifts to growing the:

  • geographies
  • marketing, sales, delivery resources and activities.
  • channels and distribution partners.
  • Customer segments.

The purpose of the Investment Memo .

Recommend whether or not the investment is appropriate to proceed to the term sheet stage. The Investment Memo is based on:

  • The answers from the early stage company to the due diligence questions.
  • Additional facts gathered from third party questions.
  • Analysis of the collected facts.
  • Investor judgement, based on a variety of criteria.

In an early stage fund, the investment memo is presented to the partners to explain why the investment should be made, or not made.

The investor will have used simple criteria to quickly filter out early stage companies before devoting time in due diligence E.g.

  • After spending less than 5 minutes reading an emailed application.
  • After a 15-minute phone call or meeting.
  • After listening to a pitch at an event.

A deal-killer recommendation.

Each investment fund will have some deal-killer criteria. If the startup-meets any one of these criteria, there is no deal.  The deal-killer criteria vary by fund.  E.g. market size is too small, founders are not trust-worthy, no potential customer interviews or surveys, etc. Deal-killer criteria could include not answering, or unable to answer, critical due diligence questions.

In this situation, the investment memo only one-page long.

Investment Memo with no deal killers – the process.

 The detailed structure of the Investment Memo follows the structure of the due diligence questions for the startup.

For each question, indicate whether the questions were answered, whether or not there are any issues, and what validation was done.  Validation can include: talking with 3rd party experts, doing independent primary and secondary research, preparing analysis separate from that submited by the startup.  I’ll indicate below some possible approaches to validation in each section of the investment memo.

There is a one-summary, which includes the recommendation.  Each section in the summary has 1-2 lines.

Recommendation: either proceed to a term sheet OR recommend not to proceed with the reasons why.

Each of the six sections in the one-page summary also contains: recommendation: yes or no and why, plus any critical read flags

  • How does the company create value for customers and itself?
  • What are the plans?
  • Investor specific
  • What is being asked of the investor?
  • Legal documents
  • Historical results.

Detailed report

Each section of the detailed report starts with the summary information from the one-page summary.

Each section/subsection of the report contains:

  • Indication of whether or not the due diligence question was answered
  • Indication of whether the answer was a “pass” or “fail”.
  • Any red flags.
  • Any input from third party experts.
  • Any input from the investors primary and secondary research.
  • Any results from the actions noted below.

#1 How does the company create value for customers and itself

Target Customers

  • Interview potential and current customers.
  • Assess market size determination (TAM, SAM, and SOM) and review sources cited.

Value proposition

  • Review some or all interview notes from potential or current customers.
  • Review some or all survey responses from potential or current customers.
  • Review analysis of interview notes and survey responses.
  • Interview potential and current customers

Channels

  • Review some or all interview notes from potential or current customers.
  • Review some or all survey responses from potential or current customers.
  • Review analysis of interview notes and survey responses.
  • Interview potential and current customers regarding their expectations.
  • Review detailed financial information to validate appropriate allocation of costs & revenue to: CAC (Customer Acquisition Costs) and calculation of LTV (Life Time Value)
  • Review calculation of the churn rate.

Key Partners

  • Interview current and potential partners.

Key resources

  • If patents, check with patent offices
  • If trademarks, run a trade mark check
  • If contracts, call third parties to validate
  • Have all required resources been identified?

Key Activities

  • Have all required activities been identified?

Cost structure

  • Assess whether the cost-drivers are in fact cost-drivers.

Charging customers

  • Review some or all interview notes from potential or current customers regarding value and pricing.
  • Review some or all survey responses from potential or current customers regarding value and pricing.
  • Review analysis of interview notes and survey responses regarding value and pricing.
  • Interview potential and current customers regarding their expectations regarding value and pricing.
  • What are competitors or similar companies charging?

Talent

  • Assess team bios for relevant skills and experience
  • Run a background check on the team.
  • Are the founders emotional or irrational under pressure?
  • Do the founders have empathy?
  • Are the founders unable to clearly and easily communicate their pitch.
  • Are the founders arrogant or overconfident?
  • Are the founders transparent and honest?
  • Are the founders fully committed or is this a part time effort?

#2 What are the plans?

  • Does the 24-month Gantt chart reflect the key milestones?
  • Is the 24-month Gantt chart plausible?
  • Review the detailed allocation of costs and revenues to validate the calculation of LTV and CAC.
  • How does the LTV to CAC ratio change in the cash flow forecast? How does it vary by customer segment, channel, and partner?

#3 Investor specific

  • Are the presentation decks (oral and standalone) consistent with the rest of the due diligence material.
  • What are the issues with the current and forecast cap table? Do the founders have enough equity.
  • What are the options for an investor exit?
  • How long has the fundraising round been open, what’s been committed, by whom?
  • Who is the lead investor and what is their reputation?
  • Are previous investors following on? If not, why not?

#4 What is being asked of the investor?

  • What are the issues regarding terms and valuation?

#5 Legal documents

  • Who has the legal right to make what kinds of decisions under what conditions? Review loan agreements, voting trust agreements, shareholder agreements, board of directors and committee mandate, delegation of authority to CEO, etc.

#6 Historical results

By target segment, by channel, by partner, by cohort.

  • Monthly growth rate in number of cash paying customers, and revenue.
  • New customer value achievement leading indicator (e.g. for Slack it was 2,000 team messages sent within 60 days).
  • New customer success metric (e.g. % of new customers achieving new customer value achievement indicator within 60-90 days).
  • NPS (Net Promoter Score)
  • How many similar competitors have failed in the past? Why? How is this startup different?

Next steps

Regardless of what type of investor you are:

  • Prepare your list of deal-killer criteria and deal-killer unanswered questions.
  • Prepare a one-page investment memo.
  • Customize the due diligence questions and due diligence report to reflect the specific nature of investor and the nature of the investment. The due diligence questions, due diligence report, due diligence cost and time invested will be very different for an angle investor contemplating a $25,000 investment in a pre-revenue company vs an investment funding contemplating a $10 million investment in a company that is scaling.

Footnotes:

1 Due diligence questions for an early stage startup: https://koorandassociates.org/selling-a-company-or-raising-capital/due-diligence-questions-for-an-early-stage-startup/

Further Reading

Definition of startup terminology and metrics: https://koorandassociates.org/selling-a-company-or-raising-capital/startup-terminology-and-metrics/

Red flags for any investor to consider:  https://medium.com/swlh/red-flag-list-for-vc-deals-9beea446270d