How VCs Evaluate Startups

Published in

Startup Stash

4 min readMay 23, 2022

Your business is starting to take off. Your customer base is growing, and your small team can barely keep up. In order to scale quickly and seize this opportunity, you need cash. You decide to raise money from a venture capital firm.

But how do you position yourself to maximize your chances of getting funded? To do so, it’s critical to understand what early-stage investors look for when making investing decisions. This article will describe the main factors venture capitalists look at when deciding whether or not to invest.

While you may know every intimate detail of your company, the investor evaluating your company does not. Furthermore, they may be evaluating several other potential companies concurrently with yours. You need to show them that you check all the following boxes, or at least have a strategy for doing so.

The team

The founding team is the most often cited factor among venture capital firms. To illustrate its importance, a common analogy is that of the “jockey” and the “horse”. The horse represents the start-up idea and the jockey, its founder. Many VC firms prefer to bet on the jockey rather than the horse. This is due to an asymmetry: a talented founder can turn a mediocre idea into a million-dollar company, but a mediocre team may never be able to execute on a million-dollar idea.

What makes a great team? Firstly, experience. A team with experience building companies will have a much easier time getting funding than one that doesn’t. Secondly, investors look for domain expertise. This includes deep industry knowledge and relevant contacts that come from working in a given field for years.

Another factor is the passion and motivation of the founding team. Investors want to know that the original team intends to stick with the company for the long haul. It’s even better if the company serves a larger purpose or scratches a personal itch of the founders because their personal stake in the company will help them ride out the storms.

The market

Investors don’t analyze your start-up in a vacuum. They must also take into consideration the market you have chosen to enter. To do so, venture capitalists ask two fundamental questions about the market: “Is it big?” and “Is it growing?”.

A “big” market can be defined as one in which companies can generate over $1 billion in revenue. Investors want to invest in start-ups entering big markets because their hope is that the company will some day be big enough to IPO, which is how VC firms generate most of their returns.

Investors also want to know that the market is growing and not stagnant. A stagnant market is typically dominated by a handful of established companies, and it’s very difficult to challenge these companies head-on. In contrast, a growing market gives newcomers the opportunity to become the dominant player. Investors in your company want you to become the dominant player, rather than challenge existing ones.

The product offering

A solid product offering is a key to securing funding. Specifically, you must demonstrate to investors that your product is unique, technically feasible, and fills a customer's need. Failure to meet any of these criteria will hinder your ability to secure funding.

Venture capitalists also want to know what your competitive advantage is: Why should they invest in your company and not someone else’s? Maybe it has to do with your superior technology or industry experience. Whatever the answer, it should clearly set your business apart from the competition.

The business plan

Investors want to know what you intend to do with their money. They are looking for specific strategies for how you are going to utilize their funding to dominate your chosen market. These include:

A go-to-market strategy
A sales/fulfillment strategy
A product development plan
Realistic financial projections

Good investors understand that these plans are subject to change as the company develops. Nevertheless, formulating an initial strategy is useful for the company, and demonstrates to investors that you will not spend their money haphazardly. As Dwight D. Eisenhower said, “Plans are useless, but planning is indispensable.”

Financial metrics

Venture capital firms rarely use investment banking methods (Discounted Cash Flow, etc…) to evaluate start-ups. This is because the start-ups’ futures are very uncertain, and most of the returns for VC firms come from big exits rather than near-term cash flows. Instead, start-up investors focus on more concrete metrics, such as:

Annual Recurring Revenue: the revenue generated via subscriptions in a year.
Customer Acquisition Cost: the amount it costs to acquire one new customer.
Customer Lifetime Value: the amount that an average customer brings in over their entire relationship with the company.
Gross Margin: the difference between sales and cost of goods sold.
Burn Rate: the rate at which a start-up spends outside funding.

Different venture capital firms look at different financial metrics when evaluating companies. Additionally, the importance they give the numbers varies widely, depending on both the investor and the funding stage. Typically, financial analysis will be less important at earlier stages of financing, and becomes more important as the company grows.

While not exhaustive, this is a comprehensive list of what VCs look for when evaluating companies. A great pitch should address all of these factors, as it demonstrates that you understand the investor mindset and reassures them as to the quality of your leadership.

Photo by Scott Graham on Unsplash.

How VCs Evaluate Startups

Written by Giancarlo Benedetti