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 terminology and metrics V2

The purpose of this article

This article has a two-fold purpose:

  • Provide definitions of startup terminology and metrics. My various articles will refer to this article, which means that I don’t have to include definitions and metrics in each article.
  • Enable a startup to quickly create its own set of terminology and metrics.

There is no single set of commonly agreed upon definitions.  Many startup participants use the same words and acronyms to mean different things.  E.g. many founders I’ve met say that they have an MVP (Minimum Viable Product), when what actually exists is some partially written code.

You may download a PDF of this article from: Startup terminology and metrics V2

What is a startup?

A startup is a temporary organization designed to search out a repeatable,  scalable, and profitable business model.

What is a business model?

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?

What does the evolution of a startup look like?

  • The startup phase, which concludes with the determination that you have discovered a business model that can be scaled and that has a large number of potential paying customers. The search for the business model is focused on learning and understanding the customers. This ongoing and rapid learning usually results in many changes to the business model and the business model canvas. The focus it NOT on achieving immediate profits or immediate efficient operations. Many startups fail before this phase completes.
  • The getting ready to scale phase concludes with the having the talent, technology, and processes to enabling profitable scaling.
  • The scaling phase, focuses on increasing the number of geographies, distribution channels, partners, and customer segments combined with marketing and sales investments. The customers and users are profitable (i.e. life time customer value is much larger than customer acquisition costs). The cash flow and accounting statements may show a huge loss because the customer acquisition costs are incurred upfront while the customer profits are achieved over the lifetime of the customer.

Accelerators, Incubators, Venture Studios

Accelerator

  • An Accelerator is a company or organization that puts a start-up company (which already has a Minimum Viable Product) through a very structured 3-4 month process. This process has the goal of quickly growing the size and value of the start-up to enable future funding.
  • The accelerator puts company’s through a vetting process so that higher likelihood of success companies are made available to investors. This reduces investors’ due diligence time and costs.
  • The Accelerator may take a small financial interest in the company in return for its assistance.
  • Mentorship is provided by experienced start-up executives, investors, and others.

 Incubator

An incubator helps take a start-up to the point where there is an MVP (Minimum Viable Product).

The characteristics of an incubator are:

  • Co-located office space with other start-ups;
  • Links to investors;
  • Access to lawyers;
  • Provides coaching and mentoring, via successful start-up executives and consultants.
  • Networking, based on all of the above

University affiliated incubators usually do not take an equity interest.  Investors may do so.  The process takes 12 to 24 months, with the pace set by the founders. Once there is an MVP, then an Accelerator may work with the start-up.

Venture Studio

A venture studio is an organization that creates startups, typically by identifying a market need, assembling the initial team, strategic direction and providing the capital to launch

What are the steps leading to the repeatable, scalable, and profitable business model?

The startup is learning from each of these stages.

 The business model canvas

A business model canvas is a one-page document which easily defines and communicates the business model.  There are 9 components to the business model canvas: customer segments, customer value proposition, customer relationships, channels, key partners, key resources, key activities, cost structure, revenue streams.

Value proposition

This 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)?

 Wireframe

Provide a visualization of the potential user/customer interface of what will the customers/users will perceive in the MVP.  Note that customer/user interfaces are evolving to include voice interaction, hand gestures, augmented reality, neural monitoring, etc.

Proof of Concept

The purpose of the proof of concept is to gain customer/user and domain expert feedback to validate specific critical assumptions of the MVP

Functional Prototype

The hardware or software prototype is only the hardware or software components of the MVP. The prototype’s purpose is to enable learning from customers/users and support demonstrations to customers/users.

Pilot Solution

This is the MVP, including onboarding, customer support, and exiting.  The customer is not paying for the pilot.  The two-fold purpose of the pilot is to identify any issues which prevent customer/user problems and needs being solved and to identify any issues which prevent the customer/user from being delighted. The pilot is providing specific feedback on the value the customers/users are achieving. The pilot helps determine what price should be charged.

MVP

This should really be called Minimum Viable Solution. A product or service with just enough features to have delighted early cash paying customers by enabling them to solve some urgent problems or needs, and to provide customer/user feedback for future development.  The MVP includes the full solution, including onboarding, customer support, and exiting. What the customer does not see or interact with (i.e. all the behind the curtain resources and activities) will likely be inefficient, have manual components, technology that is temporary, etc.

Customers/users determine whether or not there is an MVP, NOT the startup team.  If the MVP does not solve some core customer/user problems, needs, and meet expectations, there isn’t an MVP.  The startup needs to learn from customers and users what needs to change to enable an MVP.  It may take several attempts before there is an MVP.

Product market fit

The  facts and analysis show that:

  • There is a repeatable, scalable, and profitable business model.
  • There are a large number of potential customers who believe their problems are urgent enough to buy your solution, and they can also afford your solution.
  • The customers and users believe you have a better value proposition than the competitors.

You get to product/market fit by adding more features to the initial MVP until there are a large number of potential customers and users.

Marc Andreessen’s definition of product/market fit:

“The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can.” From:  On product/market fit for startups

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

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 startup’s revenues with their future solution if 100% of the customers demanding a solution to their problem bought startup’s solution. This assumes all potential geographies, distribution channels and partners.
  • Is the startup’s TAM large enough to launch and grow the startup? 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 segments, 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 geographies, distribution channels, and partners, and your ability to deliver and support your solution. 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.

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.

TAM, SAM, and SOM will vary at different points of the 5-year forecast.  TAM, SAM, and SOM will also change as the startup validates assumptions by progressing through: initial assumptions, customers interviews, feedback from prototype in customers hands, feedback from initial revenue producing customers, feedback from MVP, customer feedback as solution capabilities are enhanced to provide value to a greater set of customers, etc.

Startups Financial Metrics

Free Cash Flow

Free cash flow = EBITDA, subtracting all cash commitment, subtracting non-cash items, subtracting increases in working capital

EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization)

EBITDA = (Capital expenses + Net Interest Expenses + taxes + non-cash items + increase in working capital)

 Burn Rate and Runway

The monthly burn rate is the amount of cash the startup is losing each month.  Burn rate = revenue – expenses.

Runway is the amount of time before you run out of cash.  There are multiple runway scenarios e.g. revenue and expenses remain constant; forecast revenue vs forecast expenses, etc..  There may be multiple forecasts.

 CAC (Customer Acquisition Cost) includes all the costs to acquire a new customer:

  • Sales
  • Marketing
  • Onboarding
  • Related compensation of the people.
  • Overhead associated with the people.
  • Technology to support CAC.
  • Legal expenses associated with sales and marketing.

LTV (Life Time customer Value)

What is the lifetime customer profit, after customer acquisition?  This will take into account churn.

A scalable business model is one in which LTV exceeds CAC.

Churn is the % of paying customers who leave each month.  Your target should be at most 2% per month churn.  5% per months means you are in trouble.  You must figure out and fix the churn problem if you hope to grow your company.

COGS (Cost of Goods Sold) What comprises cost of COGS? Everything required to meet the direct needs of current customers.  E.g.

  • Customer support people, and software.
  • Technology e.g. software, cloud services, communications costs.
  • Bug fix and minor enhancement to the software – after all you do need to retain current existing customers.

CAC is not part of COGS.

G&A (General and administration) What comprises G&A?

  • Payroll administration.
  • Recruiting administration.
  • IT security.
  • Corporate development e.g. M&A.
  • CEO salary/benefits.
  • Legal expenses (both in house and external), other than those associated with sales contracts.

R&D/Engineering/new Development?

All of the costs associated with discovering major changes to the business model and enhancing the solution.

Gross Profit Margin

(Revenue minus COGS) divided by revenue.

Let’s use QuickBooks to illustrate the concept of the financial metrics.

There is a GL line item for salaries.

Then then there is a class i.e. where do parts of the salary belong?  (i.e. QuickBooks class)

  • CAC?
  • Cost of goods sold?
  • R&D/Engineering/New Development?
  • G&A?

Investment funds reporting metrics to their investors or limited partners

DPI (Distribution to Paid in capital):  Cumulative distribution to investors  /capital contributed by investors. Including management fees and expenses.

 MOIC (Multiple On Invested Capital) Cumulative realized and unrealized value (an estimate)  of the investment / capital invested by the fund.

TVPI (Total Value Paid In capital): Cumulative distribution to investors + unrealized value (an estimate) /  capital contributed by investors. Including management fees and expenses.

Next steps

Create definitions and metrics for your startup.  This will help everyone (founders, employees, advisors, investors, etc.) have a common understanding about you actually mean when you use certain words.

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

Due diligence questions for an early stage startup.

The purpose of this article

The two-fold purpose of this article is to:

  • Enable early stage startups, prior to scaling, to understand the due diligence questions they may encounter from an investor.
  • Enable an investor to structure a set of due diligence questions.

You may download a PDF of this article from: Due diligence questions for an early stage startup

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:

  • Marketing, sales, delivery resources and activities.
  • hannels and distribution partners.
  • Customer segments.

The early stage due diligence questions are one of the inputs to the Investment Memo

The purpose of the Investment Memo is to 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.

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.

The  investor asks the startup five sets of due diligence questions

#1 How does the company create value for its customers and itself?  What is the company building and for whom?  What urgent customer needs and problems are being solved?

        • Target customers:
    • Who exactly will you be creating value for?
    • Who will pay you? What are the differences between users and customers segments, if any (e.g. Google – user do searches for free.  Companies pay to advertise.
    • How will they recognize themselves?
    • Who will be your most important customers?
    • What is the market size? TAM (Total Addressable Market), SAM (Serviceable Addressable Market), and SOM (Serviceable Obtainable Market)1
    • Who is your initial target segment?
  • Customer Value Proposition: A value proposition is the customers perception of value. This perception can be influenced by: facts, emotions, family & friends, social media, etc. The value proposition = (All the customer achieved benefits) / (All the customer incurred costs) All the customer achieved benefits can include problems solved, gains achieved, financial and non-financial (e.g. time savings, convenience, status, etc.) All the customer incurred costs can include financial (purchase costs, costs to switch to your company, other adoption costs, and ongoing costs) and non-financial (time, inconvenience, loss of status, etc.)
    1. What value will the customers perceive they will achieve? This is very different from your opinion as to what value you will deliver.
    2. What problems do your customers think you will solve?
    3. What customer needs will be fulfilled?
    4. Why does the customer believe the value of your solution is better than the status-quo or the competition?
    5. What does the customer believe will be the impact of your solution? E.g. 10 times improvement in something?
    6. What is your MVP (Minimum Viable Product)? What is the smallest set of urgent problems and needs you can solve for a target customer segment, while delighting the customers, and having them pay you?
    7. What is the path to enhance your MVP until you believe you have a solution that can be scaled to meet the needs of a large customer segment?
  • Customer Relationships: What type of customer relationship do your customers expect to have with you?
    1. How will customers be acquired, kept, and grown?
    2. Why type of relationship does each customer segment expect you to establish and maintain? ? g., if it’s a software product, how often will there be updates with new features?  How easy will it be to install a new version?  Will customer service be a chatbot or a live person?
    3. What types of relationships have you already established?
    4. What is the cost of each type of customer relationship?
    5. What is CAC – customer acquisition cost?
    6. How many customers are you losing – churn rate?
    7. What is LTV – lifetime customer value? In the initial startup stages, LTV will be less than CAC, because of the need to obtain an initial pool of customers by doing inefficient things that don’t scale.  As the startup is getting ready to scale, it will have figured out how to make LTV exceed CAC.
  • Channels: Channels are how to connect the value proposition to the target customer. There are three different types of channels. Communications – used to communicate with potential customers.  There may be many communications channels. Sales – where customers and sellers agree on the transaction. Usually there are fewer sales channels than communications channels. Logistics – how to deliver the solution to the customers.
    1. Through what types of channels do the customers want to be reached? In other words, what channels are most effective? E.g. website, app, social media, face-to-face, marketplaces, etc.
    2. What channels already exist?
    3. Which channels are most cost efficient?
    4. Which channels are integrated with customer processes?
  • Key Partner: A channel may also be a partner, if the answer is “yes” to one of the following questions: Is the partner a leading entity with a brand and market position that adds to your credibility? Does the partner add expertise and resources to your solution in a way that increases the value of the solution for the end customer? Is the partner (and their brand/expertise/resources) required to land a contract with the key target customers?
    1. Who are the key partners?
    2. Who are the key suppliers?
    3. What key activities, supporting your value propositions, to your partners perform?
    4. How effective are your current partners and suppliers?
    5. What types of partners and suppliers do you need?
  • Key Resources: Resources mean any relevant intellectual property (IP), technical expertise, human resources, financial and physical assets, key contracts and relationships. In other words, resources refer to anything within your control that can be leveraged to create and market your value proposition (e.g., a patent pertaining to your value proposition, key contacts within the industry).What resources are necessary to:
    • Enable the customer to achieve their value proposition?
    • Maintain channels and partnerships?
    • Build relationships with customers?
    • Build revenue?
  1. What resources exist today?
  2. How effective are they?
  3. What are the plans to close the gaps?
  • Key Activities: What are the key activities to enable customers to achieve their value proposition, and generate revenue for the startup. What key activities are necessary to:
    1. Enable the customer to achieve their value proposition?
    2. Maintain channels and partnerships?
    3. Build relationships with customers? Marketing? Sales, Customer service?
    4. Build revenue?
    5. R&D?
    6. Billing?
    7. What activities exist today?
    8. How effective are the current activities?
    9. What are the gaps and plans to close the gaps?
  • Cost structure: What is the cost of delivering the value proposition, including the resources needed and key activities involved.
    1. What are the largest costs?
    2. What are the fixed costs and variable costs?
    3. What activities are the costliest?
    4. What resources are the costliest?
    5. What is the burn rate? (i.e. excess of costs minus revenue)?
    6. What is the runway? (i.e. how many months before all the cash is gone)
  • What will you charge your customers and how will you charge your customers?
    1. What is the value the customers are willing to pay for?
    2. How much are they willing to pay?
    3. How much are they paying today?
    4. What is the pricing model? Subscription, one-time, freemium, advertising, etc.
    5. What are the revenue streams? These could include: subscription-based per person per month, free for a basic service, with multiple tiers of extra services with fees, etc.
    6. How are they paying today? Cheque, credit card, etc.
  • Who is the talent and how are they relevant to the startup’s success?
    1. Appropriate biographies of the management and advisors.

 #2 What are the plans?

  • Gantt chart on one page of the next 24 months.
  • Cash flow forecast. There may be multiple cash flow forecasts illustrating multiple scenarios.

#3 Investor specific

  • Oral presentation deck which supports the oral presenter and is not intended to be read on its own.
  • Standalone presentation deck is intended to be read on its own and therefore has much more information than the oral presentation deck.
  • Cap table lists out each type of equity ownership capital, the individual investors, and the share values. A more complex table may also include details on potential new funding sources, mergers and acquisitions, public offerings, or other hypothetical future transactions.

#4 What is being asked of the investor?

  • Type of capital and amount?
  • Being lead investor?
  • Serving on board or advisory board?
  • Access to investor’s network of other investors, customers, employees, etc.?

#5 Legal documents

e.g. Charter documents, corporate organization, etc.2

#5 Historical results

Company history, past milestones, historical growth, etc.

 Your Next steps

  • If you are a startup, immediately begin to organize your data room to be able to address potential investor due diligence. The bulk of the information in your data room will also help your startup succeed.
  • If you are an investor, create your list of documented due diligence questions.

Footnotes

1 This article contains definitions https://koorandassociates.org/selling-a-company-or-raising-capital/startup-terminology-and-metrics/

2 This is a sample legal due diligence checklist  http://www.1000ventures.com/venture_financing/due_diligence_checklist_byvpa.html

Startup terminology and metrics.

Startup terminology and metrics.

 The purpose of this article

This article has a two-fold purpose:

  • Provide definitions of startup terminology and metrics. My various articles will refer to this article, which means that I don’t have to include definitions and metrics in each article.
  • Enable a startup to quickly create its own set of terminology and metrics

You may download a PDF of this article from: Startup terminology and metrics

What is a startup?

A startup is a temporary organization designed to search out a repeatable and scalable business model.

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?

A startup evolves

  • The startup phase, which concludes with the determination that you have discovered a business model that can be scaled and that has a large number of potential paying customers. Many startups fail before this phase completes.
  • The getting ready to scale phase concludes with the having the talent, technology, and processes to enabling profitable scaling.
  • The scaling phase, focuses on increasing the number of geographies, distribution channels, partners, and customer segments combined with marketing and sales investments.

MVP (Minimum Viable Product)

A product or service with just enough features to have delighted early cash paying customers by enabling them to solve some urgent problems, and to have obtained customer feedback for future development

 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

Market Size

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 startup’s revenues with their future solution if 100% of the customers demanding a solution to their problem bought startup’s solution. This assumes all potential geographies, distribution channels and partners.
  • Is the startup’s TAM large enough to launch and grow the startup? 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 segments, 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 geographies, distribution channels, and partners, and your ability to deliver and support your solution. 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.

What is SOM (Serviceable Attainable 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.

TAM, SAM, and SOM will vary at different points of the 5-year forecast.  TAM, SAM, and SOM will also change as the startup validates assumptions by progressing through: initial assumptions, customers interviews, feedback from prototype in customers hands, feedback from initial revenue producing customers, feedback from MVP, customer feedback as solution capabilities are enhanced to provide value to a greater set of customers, etc.

 

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

Financial Metrics

Burn Rate and Runway

The monthly burn rate is the amount of cash the startup is losing each month.  Burn rate = revenue – expenses.

Runway is when you run out of cash.  There are multiple runway scenarios e.g. revenue and expenses remain constant; forecast revenue vs forecast expenses.  There may be multiple forecasts.

 CAC (Customer Acquisition Cost) includes all the costs to acquire a new customer:

  • Sales.
  • Marketing.
  • Onboarding.
  • Related compensation of the people.
  • Overhead associated with the people.
  • Technology to support CAC.
  • Legal expenses associated with sales and marketing.

LTV (Life Time customer Value)

What is the lifetime customer profit, after customer acquisition?  This will take into account churn.

A scalable business model is one in which LTV exceeds CAC.

Churn is the % of paying customers who leave each month.  Your target should be at most 2% per month churn.  5% per months means you are in trouble.  You must figure out and fix the churn problem if you hope to grow your company.

COGS (Cost of Goods Sold) What comprises cost of COGS? Everything required to meet the direct needs of current customers.  E.g.

  • Customer support people, and software
  • Technology e.g. software, cloud services, communications costs.
  • Bug fix and minor enhancement to the software – after all you do need to retain current existing customers.

CAC is not part of COGS.

G&A (General and administration) What comprises G&A?

  • Payroll administration.
  • Recruiting administration.
  • Finance
  • IT security.
  • Corporate development e.g. M&A.
  • CEO salary/benefits.
  • Legal expenses (both in house and external), other than those associated with sales contracts.

R&D/Engineering/new Development?

All of the costs associated with discovering major changes to the business model and enhancing the solution.

Gross Profit Margin

(Revenue minus COGS) divided by revenue.

Let’s use QuickBooks to illustrate the concept of the financial metrics.

There is a GL line item for salaries.

Then then there is a class i.e. where does the salary belong?  (i.e. QuickBooks class)

  • CAC?
  • Cost of goods sold?
  • R&D/Engineering/new Development?
  • G&A?

Next steps

Create definitions and metrics for your startup.  This will help everyone (founders, employees, advisors, investors, etc.) have a common understanding about you actually mean when you use certain words.

How does a startup raise capital from investors?

The purpose of this article is to provide a framework for startups to create their specific plan to raise capital from investors.   You may download a PDF of this article from: How does a startup raise capital from investors

This article has a limited scope and does not address all situations.

  • The focus is on startups, not established companies raising billions from an IPO or Private Equity.
  • The assumption is that the startup is not bootstrapping i.e. launching and growing the startup using the founders’ personal savings and borrowing combined with friends and family.
  • The types of investors include: individual investors, angel investor groups, various types of investment funds including venture capital, and family offices.
  • This article does not address government funds (loans, grants, tax credits, etc.), accelerators which invest equity, venture studios1, corporate venture capital2, listing on a stock exchange, crowdfunding, etc.
  • This article does not address the many different types of capital: common stock, preferred stock, convertible notes, venture debt, SAFE, etc.
  • This article refers to fact-based research. This research is from the U.S.  I was not able to find applicable fact-based research for the Toronto ecosystem.

The startup may utilize multiple sources and types of capital.

What can you learn from fact-based research?

200 startups that successfully closed their round.4

  • 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.
  • The longest successful round raise took 40 weeks.
  • Approximately 90% of the startups closed their round by contacting less than 75 investors.
  • Companies that failed to raise a round gave up after an average of 6.7 weeks.
  • Funding led by a seed stage fund is more efficient that one led by angel investors. (average time to fundraise: 9.6 weeks vs 13.5 weeks; average number of investors contacted: 29 vs 68; average number of investor meetings: 27 vs 45; average money raised: USD $2 million vs USD $989,000). However only 3% of seed stage startups are funded by seed stage funds.
  • The average time spent by an investor to read a pitch deck is 3 minutes and 44 seconds, with 12% of investors reading the deck on their phones.

The key implications are:

  • If you have not closed your round after contacting 100 investors, you must do a fundamental rethink about whether or not you have a viable startup or whether your targeting the wrong types of investors.
  • Don’t give up early. 20% of the time it may take 20 weeks or longer.
  • You must research to understand what each seed fund is looking for. Your pitches and material should answer the fund questions before they ask them.  My observation is that many startups don’t do this research and as a result are quickly eliminated by the seed funds.

How much time should you target between fundraising rounds?5

A fund-raising round can take a long time. This research study examined 13,916 financing events.

  • 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

What are the 3 greatest contributors to startup failure?6

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.

My personal observation is that I’ve lost track of the number of startups where:

  • The only understanding of the market size is a slide they copied from a consulting firm that said the market size was $10s of billions. Seed stage funds immediately eliminated these startups because there was no understanding of market need or size.
  • There was no monthly cash flow forecast which considered the length of time required to raise capital and the time between fundraising rounds.
  • The founding team was incomplete and could not communicate their relevant experience.

Few pre-revenue companies are funded by third parties

  • Only 3% of angel funded companies are pre-revenue.7
  • There are pre-revenue funds, but they represent a tiny fraction of all funds.

My own observation of angel investments is that the majority go to revenue generating companies.

The framework for raising capital has 13 stages.

The 13 stages overlap and are not all sequential.

Stage #1 24-month cash flow forecast, by month with monthly milestones – this is a minimum time frame

  • The cash flow forecast reflects the time necessary to raise capital and time between financing rounds.
  • Plan to use your own funds, plus friends and family funds, to get your company to the point of have a few delighted cash paying customers.
  • The planned milestones reflect the major accomplishments investor would expect to see. There is a clear relationship between capital used and business accomplishments.

Stage #2 Decide upon the types of capital and capital sources in this round

Define your requirements for an investor e.g.

  • Are they a lead investor?
  • Do they have they same values and interests in growing your business as you do?
  • How soon do they want to exit?
  • What is there reputation?
  • Are they easy to work with? What do other startups say about them?
  • Should they have relevant industry experience?
  • What functional experience should they have?
  • What capability should they have to introduce: other investors, potential customers, potential suppliers and partners, potential employees, etc.
  • Should they have the financial capability to continue to invest in future rounds?
  • What value could they provide on a board of directors or advisory board?

Stage #3 Build your information pyramid8

  • The information pyramid outlines the varying types and quantities of information the startup communicates to potential investors. This includes the various types of oral and written pitches.
  • The top of the pyramid has limited information, with each succeeding layer having more.
  • The pyramid includes your data room for due diligence.
  • A startup has a plan and process for managing this information pyramid with potential investors.
  • The approach varies depending upon the stage of the startup e.g., a founder dealing with friends and family is different from a billion-dollar IPO.

Stage #4 Prepare a list of capital sources

  • All your existing investors are potential capital sources.
  • Based upon your requirements from Stage #2, prepare a target list of capital sources.
  • Try to make this target list global in scope. Angel groups from the U.S. are investing in Toronto startups. Some global funds from the early stage to post Series A are investing in Toronto. Many U.S. funds are investing in Toronto.

Stage #5 Arrange warm introductions and send out cold call emails

  • Only 12% of closed deals result from cold call emails to funds. Warm introductions are critical to fundraising success.9
  • You have to research your own network to find out who knows someone at your target investors.
  • Touch base with those people. Send them an email which they can forward to the target investor they know.
  • Use a CRM to manage the amount of information you’re collecting, and people you’re phoning and emailing.

Stage #6 3 weeks of non-stop meetings

Schedule investor meetings for a 3-week period.  Your CRM will be crucial

You will be totally consumed during this time,

Stage #7 Investor Due diligence

  • Interested investors may conduct due diligence within 3 weeks.

Stage #8  Term sheet negotiation and agreement

  • Negotiating and finalizing a term sheet may take up to 6 weeks.
  • At least one of your advisors needs to assist you as you contemplate business terms.
  • A lawyer with deep experience in startups is valuable.

Stage #9 Get the money in the bank

  • Fundraising is only complete once you have the money in the bank. Some founders have told me that they’ve had investors who failed to actually provide the money.

Stage #10 Implement your revised governance framework

  • Your investors may be involved in decisions. This decision-making involvement must be documented to ensure a common understanding, along with establishing the necessary processes.
  • Your investors may also have stated their ongoing information requirements. You’ll need to put the necessary processes in place.

Stage #11 Send out monthly updates to potential investors8

  • You must stay in touch with the investors who did not invest.
  • Your monthly update demonstrates month by month accomplishments, with the focus on increases in the number of customers and revenue.
  • Consider including advisors and others in this monthly update.
  • Your CRM will manage who you send the updates to and track who actually opens them.

Stage #12 Send put monthly updates to existing investors10

  • You must send out monthly updates to those who have entrusted you with their money.
  • Do this even if its only friends and family.
  • Your CRM will manage who you send the updates to and who actually opens them.

Stage #13 Keep the information pyramid up-to-date, especially the pitch deck

  • You will need to enhance your CRM to meet the additional information reporting requirements of your investors,
  • You never know when an investor that you’ve decided you want, will express major interest.
  • You have to be ready.

Your next steps

  • Prepare your 13-stage fundraising plan to reflect your startup’s specific situation.
  • Implement a project management tool and CRM.

Footnotes

1 A venture studio is an organization that creates startups, typically by identifying a market need, assembling the initial team, strategic direction and providing the capital to launch.

2 Corporate venture capital is where a large firm takes an equity stake in a small but innovative or specialist firm, to which it may also provide management and marketing expertise; the objective is to gain a specific competitive advantage.

3 SAFE stands for Simple Agreement for Future Equity. At the early stage of a startup, it can be difficult to accurately assign a value to the company because there is usually very little data. A SAFE is a form of convertible security that allows you to postpone the valuation part until later on. A SAFE is neither debt nor equity, and there is no interest accruing or maturity date.

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

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

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

7 Angel Capital Association and Hockeystick, “2019 ACA Angel Funders report “

8 This outlines the various components of the information pyramid. https://koorandassociates.org/points-of-view/selling-a-company-or-raising-capital/how-does-a-startup-communicate-with-potential-investors/

9 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”, April 2017, Page 41  This survey of VC firms included: 63% of all VC US assets under management, 9 of the top 10 VC firms and 38 of the top 50 VC firms.

10 https://koorandassociates.org/points-of-view/selling-a-company-or-raising-capital/how-can-portfolio-companies-update-investors/

Valuing a pre-revenue startup

You can download a PDF of this article from: Valuing a pre-revenue startup

The purpose of this article is to:

  • Help investors value pre-revenue startups
  • Help pre-revenue startups understand what makes a fundable pre-revenue startup and what they need to communicate to pre-revenue investors.

There is very limited angel investment in pre-revenue companies.1

  • Only 3% of angel deals were done with pre-revenue companies.
  • 60% of angel deals were done at the seed stage and 25% at the Series A stage.
  • The average pre-revenue valuation was $4 million U.S.

An individual pre-revenue startup must have the potential to provide an angel investor with an average of 33 times their return on invested capital. 

  • Luis Villalobos studied 117 investments made by 4 angel investors, who invested a total of $9,936,534. 101 investments, totaling $8,646,402 returned a total of $5,614,653 – a loss of 35%. Average time to exit was 2.9 years,
  • The remaining 16 investments, totaling $1,290,132 returned $42,926,748 – a cash on investment return of 33.3, with an average time to exit of 8.6 years.
  • The overall investment portfolio return was $51,092,249 on the $9,936,534 investment – a cash on investment return of 5.1X. The IRR is about 22%, given the 8.6 years to make profitable returns. The IRR does not consider the time devoted by the angels to selecting and managing their investments nor any out of pocket costs.
  • Luis’s study is illustrative. The number of angels and investments is not statistically significant.
  • Broader research of U.S. angel groups has shown than when the group does more than 40 hours of due diligence per startup, cash on investment returns for the group is 7.1X2

The pre-revenue startup must have the potential to achieve an exit valuation of 100 to 150 time its pre-revenue valuation.

The angel investor is targeting an average cash on investment return of 33 times.  The dilution efforts of later round investments tend to be a factor of 3-5 therefore the pre-venue startup needs an exit valuation of 100-150 times its pre-revenue valuation in order for the angel investment to grow 33 times.

There are many challenges to valuing a pre-revenue company

  • There are very few facts and no historical trends, due to the fact that there is no revenue. Quantitative analysis it not possible,
  • Financing can be in different forms: common stock, preferred stock, SAFE (Simple Agreement for Future Equity)
  • Liquidation preferences may vary.
  • What is the value of having a board seat?

The Scorecard Valuation Method by Bill Payne (October 2019 revision)3

Bill Payne has developed a method for thinking about the valuation of a pre-revenue startup.  This method depends upon the knowledge and judgement of the investors.

General concepts

  • The method is a process to use the angle investor’s judgement to determine a valuation.
  • The method is not a spreadsheet which analyzes numerical data.
  • A valuation is always determined, unless there is a deal killer resulting in the startup being rejected with no valuation.
  • Each investor may have their own weights, scoring criteria and scores.
  • Each investor may have their own deal killers e.g. one fund only invests when the startup CEO has already been a CEO, another fund only invests if the CEO has a coach.
  • The method does not make an investment recommendation. The investment decision depends upon many factors including due diligence.
  • As noted above, there are many challenges to valuation. The method only considers some of the factors.
  • Valuation is ultimately a judgement call.
  • 70% of the valuation assessment is based on: team, opportunity size, and the solution. 30% of the 70% is for the team.  The team needs to have the ability to learn and change as they may need to focus on a different submarket with a different solution.  25% of the 70% is for the size of the opportunity.  The opportunity must be large in order to have an exit valuation of 100 to 150 times pre-revenue valuation. 15% of the 70% is for the solution.  Funding is only available if there is a great solution with the potential for massive growth.

The Scorecard Valuation Method has 5 steps

Step #1 Calculate the median pre-money valuation for pre-revenue startups

There are many sources for this information: e.g. the historical facts from an angel group, the U.S. “Angel Funders Report” by the Angel Capital Association”.

Then you need to think about adjustments e.g. Should Toronto valuations consider valuations from other cities and countries?  Should adjustments be made for the type of startup – AI vs Fintech vs healthcare?

Step #2 Score the target startup vs the average pre-revenue startup.

Score the target startup in terms of better or worse than the average startup.

A draft set of scoring criteria is in “Appendix Scoring Criteria”.  Those are the criteria used by Bill Bayne.2

Step #3 Multiply the Weighting by the Scoring to obtain the Weighted Score.

Step #4 Sum the individual Weighted Scores to obtain the Total Weighed Score.

Step #5  Multiply the median pre-revenue startup valuation by the Total Weighted Score to obtain the valuation.

The following is an example:

You can view the table if you download the PDF from: Valuing a pre-revenue startup

If the median pre-revenue startup valuation was $4 million, then this target company would have a valuation of $4.6 million.

Investors – your next steps

Customize the method and incorporate into your investment analysis process.

Startup – your next steps

  • Ask your advisors to customize the process and then assess your startup.
  • Enter your startup’s data into Gust.com (a platform which connects startups with angel groups and other funders). Use the free evaluation tool to asses your startup.
  • An educational illustrative valuation tool is available at https://www.caycon.com/valuation

Footnotes

1 Angel Capital Association and Hockeystick, “2019 ACA” Angel Funders “, Pages 4,7 Report”https://www.angelcapitalassociation.org/angel-funders-report/

2 Matthew C. Le Merle, Louis A. Le merle, “Capturing the expected returns of angel investors in groups December 2015 “ https://koorandassociates.files.wordpress.com/2020/03/7340d-fiftherawpfinal-c.pdf

3 Bill Payne https://www.angelcapitalassociation.org/blog/scorecard-valuation-methodology-rev-2019-establishing-the-valuation-of-pre-revenue-start-up-companies/

Appendix Scoring Criteria

You can view the three page table of scoring criteria if you download the PDF from: Valuing a pre-revenue startup