Investment criteria are pivotal for Venture Capitalists when evaluating deal flow and determining which opportunities to pursue. Being able to make swift go/no-go decisions enables VCs to allocate more time to the most promising prospects.
In this post and the companion webinar, I delve into the top criteria that VCs use to screen deal flow and decide whether to invest further resources in a startup: alignment with their investment strategy, the strength of the Founding team, and the potential size of the market. By understanding these criteria, Venture Capitalists can sharpen their decision-making process, streamline deal flow evaluation, and optimize their investment choices.
In This Post
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Why VCs Need To Go Through Deal Flow Quickly
Venture Capital is inherently a flow business, with VCs receiving hundreds of potential investment opportunities from a myriad of sources. These sources can range from personal networks, warm introductions, cold pitches, Angel investors, referrals from other VC firms, startups, incubators, accelerators, and demo days.
In a blog post that made waves in the otherwise quiet VC industry, Del Johnson, a vocal advocate for inclusive practices in VC, discusses how even Y Combinator startups struggle to get funding. The prestigious startup accelerator developed an Investor portal to track their batches’ Series A fundraises. Data collected by YC highlighted that even companies from elite accelerators face significant hurdles in raising Series A funds.
On average, successful fundraising took 30 coffee meetings with individual investors, leading to partner pitches in only 50% of cases. Out of these partner pitches, only 30% led to full partnership pitches, with only one in five partnership meetings resulting in a term sheet. The process, which typically takes 8-12 weeks for seed-stage fundraising, is time-consuming even for strong companies. Del Johnson emphasizes that this inefficiency is further exacerbated for non-networked, early-stage founders.
VCs need to sift through their deal flow quickly and efficiently to pinpoint the diamonds in the rough.
#1. Fit With The Fund’s Investment Strategy
Venture Capital firms play a pivotal role in the startup ecosystem by providing the necessary capital and guidance for emerging companies to thrive. However, the Venture Capital landscape can be complex and challenging to navigate for both startups and budding Investors. In this section of the webinar, I show how VC firms’ investment strategies, but also their philosophies and cultures, influence their decision-making processes—starting with deal flow.
How Limited Partners Indirectly Influence VC Investment Criteria
The structure of Venture Capital explains in large part how VCs make deal flow-related decisions. VC firms act as intermediaries between startups and the investors in their funds, Limited Partners (LPs). LPs are typically institutions, such as pension funds, endowments, family offices, and high-net-worth individuals. LPs have a more passive role in the Venture Capital process, as they are not directly involved in making investment decisions. Instead, they trust the GPs to manage their funds effectively and generate returns on their investments.
This strategy typically includes factors such as:
- The startup’s development stage: pre- or post-product-market fit, scale-up, maturity
- The investment’s stage, e.g., early-stage or growth-stage rounds
- Target industry or sector
- Range of the investment size
- Geographic focus
LPs expect GPs to adhere to their stated investment strategies, as it helps ensure that their capital is invested in line with their risk tolerance and return expectations. A tight and coherent investment strategy also serves as a competitive advantage for GPs, as it demonstrates their expertise and competence in managing the funds entrusted to them.
Most VCs probe for the fit of all startups they consider with their investment strategy as quickly as possible. A few minutes reading a pitch deck is enough to pass on opportunities. When they do take a call or a meeting, they politely suggest that the Founders “come back later” (a remark entrepreneurs, who often don’t understand the context, often complain about). Most startups ask Investors for too much too soon. Many VCs, even at the early stage, need more proof of traction before they can commit.
However, these objective criteria all not the only ones that matters. The firm’s philosophy must also be taken into account.
A VC Firm’s Culture Shapes Their Investment Criteria
Recognizing that investment philosophies differ across VC firms is crucial. While some investors, like Jason Lemkin, focus on specific industries, others, like Fred Destin, avoid certain sectors due to market saturation or unclear winners. Startups must be aware of these differing philosophies when seeking investment
We use a filter based on themes we invest in, ticket size, and geography. If the startup goes through the filter, we look for three more attributes.
Brad feld – Foundry Group (source: 20VC)
In the webinar, I present additional examples from Brad Feld, a prolific Investor and one of the best in the industry, and Vinod Khosla, a co-founder of Sun Microsystems and Khosla Ventures. Khosla emphasizes working on high-impact projects, with his firm’s mission including making a positive change alongside aiming for a high internal rate of return (IRR).
While this post is primarily intended for Investors making their way into VC, it also highlights why startup Founders should do their homework before contacting potential Investors: browse VC firms’ websites, examine portfolios, read their blog posts, follow investors on Twitter or LinkedIn, and leverage resources like my newsletter and Crunchbase. However, they need to be mindful of potential discrepancies between what Investors say and their actual investments, making it even more critical to carefully evaluate their portfolios.
I also discuss examples of investment strategies for a16z, Initialized Capital, and Cowboy Ventures.
#2. Team Fit With The Execution Challenges
The second critical investment criterion experienced VCs use to screen deal flow is the team’s quality. That’s all some VCs look at, especially in the early stages of a startup’s development. In this section of the webinar, I present in detail the precise qualities VCs are looking for, and nuance them by comparing them to the execution challenges the startup requires to overcome to succeed.
What Are The Qualities VCs Look For In Startup Founders?
A comprehensive academic study led by top researchers in the field a few years ago revealed the most important qualities for a strong Founding team: ability, industry experience, passion, teamwork, and entrepreneurial experience. I provide more details in the webinar about each.
The criterion that most surprises VCs and Founders I train to Venture Capital is industry experience. It plays a crucial role in venture success, as Founders with substantial knowledge in their domain not only understand the problems and value chain better but also possess valuable networks. This often gives Investors confidence in the entrepreneurs’ ability to navigate their business landscape.
I have never seen a venture success for which one person deserves all the credit. The winners always seem to be the founders who can build a kick-ass team.
Brian Jacobs – Emergence Capital (Source: Harvard Business Review)
Teamwork, by contrast, is an expected feature in the ranking of VC’s criteria. More precisely, Investors try to evaluate if there is any major skill gap on the team (including employees). The composition of a strong team varies depending on the nature of the startup. For instance, a more technical or high-tech startup would likely benefit from having a CTO as a co-founder, while all an e-commerce website running Shopify may need is a mid-level developer. The key functions and expertise needed within a team depend on the startup’s focus.
In the webinar, I illustrate this point with the Airbnb case study, based on the famous email exchange between Paul Graham and Fred Wilson. You can also dive into the qualities VCs look for in Founders–and the framework they should use instead–, in my webinar How Venture Capitalists Evaluate Successful Startup Founders — And What They Should Do Instead.
The next section addresses a question I often get asked by fundraising Founders: how likely is it to get funded as a solo Founder?
Founding Team vs. Solo Founder
How does the absence of a well-rounded team influence a Venture Capitalist’s decision to invest? While solo Founders might have a clear vision and drive, it can be challenging for them to handle all aspects of building a startup. A complementary team, bringing diverse skills and experiences, often garners more interest from Venture Capitalists, who are keen on mitigating risks.
We’re generally reluctant to fund single founders. And yet the most successful startup we’ve funded had a single founder at the time he applied.
Paul Graham – Y Combinator (Source: FORBES)
The Dropbox case study provides a counter-illustration of sorts. While it’s true that Drew Houston brought on Arash Ferdowsi as a co-Founder, creating a Founding team for Dropbox—allowing them to get into Y Combinator—it is important to recognize that Houston is often credited for much of the company’s success. In this sense, the Dropbox case can be viewed as a nuanced example that highlights the impact a driven, visionary Founder can have on a startup’s trajectory. Nonetheless, the importance of having a strong Founding team in place remains a crucial factor in Venture Capital decision-making.
The last of the three key investment criteria VCs apply to their deal flow is often not well understood by fundraising Founders. Venture Capitalists invest in startups attacking a large market.
#3. Exceptional VC Returns Demand Large Markets
The third essential factor that experienced VCs consider when evaluating potential investments is the size of the market opportunity. A startup’s ability to capture a sizable portion of a large market is often critical to achieving exceptional returns for the Venture Capital fund. In this section, I delve deeper into the importance of large markets and their relationship with VC investment criteria, providing insights into the crucial role that market size plays in VC deal flow decision-making.
Team vs. Market: Which One Comes First Among VCs’ Investment Criteria?
The team versus market debate has long been a point of contention within the Venture Capital industry, much like the dispute between color and drawing partisans in Renaissance art, where artists like Titian championed color while others, such as Michelangelo, prioritized the line. In the art world, passionate proponents of both sides engaged in fierce intellectual debates about the primary element of a masterpiece.
Similarly, in Venture Capital, some investors prioritize the market potential, while others emphasize the importance of the founding team.
When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.
Andy Rachleff (Source: The PMARCA Guide to startups)
Market-focused investors often use the aphorisms such as the one quoted above, from Benchmark’s co-Founder Andy Rachleff (who also coined the term “product/market fit”). Marc Andreessen, the co-founder of Netscape and the eponymous VC firm Andreessen Horowitz, posits that the most important factor is the market, as a great market will pull a product out of a startup. A product doesn’t have to be perfect, it just needs to work and satisfy the market’s needs. Pmarca, as he’s known from his Twitter handle, claims that a great team or product cannot redeem a bad market.
I would trust a great team to eventually find a suitable market to grow the startup, but I would not bet on an average team that maybe got lucky in launching in the right market, and will most certainly not adapt to changes in the environment.
Why Venture Capitalists Look For Large Markets
VC funds invest in early-stage companies with the expectation that only a few of these investments will generate substantial returns, compensating for the majority of investments that may fail or generate modest returns. This dynamic, where a small number of successful investments drive overall returns, is referred to as the power law. It’s essential for VC funds to identify and invest in these outliers, as their performance heavily influences the fund’s success.
I don’t know how to write a business plan, but I know how to read them. You start at the back, and if the numbers are big, we look at the front.
Tom Perkins – Kleiner Perkins (Source: Something ventured)
Tom Perkins, the legendary co-Founder of the eponymous VC firm Kleiner Perkins, highlights the importance of prioritizing large market opportunities in Venture Capital investing. By stating that he starts at the back of the business plan, Perkins is referring to the financial projections, which reveal the potential scale of a startup’s operations and the size of the market it’s targeting. If the numbers are “big,” it implies that the startup is addressing a substantial market, which piques the interest of VC investors like Perkins. This approach aligns with the power law dynamic mentioned earlier, where VC returns are primarily driven by a few investments in companies that achieve exceptional growth and high valuations.
Large market size is a critical factor in determining the potential for extraordinary returns. In general, larger markets can support larger companies, and larger companies tend to generate more significant returns. This is why VC funds are often attracted to startups addressing substantial markets, as it increases the likelihood of achieving higher valuations and better returns on investment.
In the webinar, I take a concrete example of a $100 million fund investing in a B2B SaaS startup that targets a $1 billion market to demonstrate this point introduced by another legend, Don Valentine from Sequoia.
How VCs Assess Market Potential
Venture Capitalists use one of two popular methodologies to assess market potential when evaluating startups: the TAM, SAM, SOM method and the Beachhead approach.
The TAM, SAM, SOM method evaluates the market potential by segmenting the market into three parts:
- Total Addressable Market (TAM): This refers to the total revenue opportunity available for a product or service across all market segments. It provides an upper bound on the market size and represents the highest potential demand
- Serviceable Available Market (SAM): This is a more refined measurement, representing the portion of the TAM that a company can serve, given its product or service offering, target customers, and other constraints such as regulations or geography
- Serviceable Obtainable Market (SOM): This is the most focused measure, referring to the market share a company can realistically capture within the SAM over a specified time frame, considering its growth trajectory, resources, and competition
By breaking down the market into these segments, VCs can assess a startup’s potential to capture a meaningful share of the market and determine if it is a worthwhile investment. Head over to my post TAM SAM SOM Explained From The Investor’s Point Of View for more detailed explanations of how to use this method to screen VC deal flow.
There’s no TAM, there’s no SAM, only early beachhead customers.
Jim Goetz – Sequoia (read this post for more)
The beachhead approach, by contrast, is a bottom-up way of looking at markets. It emphasizes the importance of identifying and targeting early “beachhead” customers. Instead of focusing on the total market size, it revolves around understanding the most relevant and accessible customers who are likely to adopt a startup’s product or service in its early stages.
The beachhead strategy involves identifying a specific market segment that has a strong need for the startup’s offering, is willing to pay for it, and can be efficiently reached. By establishing a solid customer base in this segment, the startup can then expand into adjacent market segments, gradually increasing its market share. I provide case studies of beachhead strategies in my post dedicated to this approach.
This method encourages VCs to focus on a startup’s ability to effectively target early customers and leverage their initial success to penetrate broader markets. It prioritizes a more granular understanding of the target customer base and the startup’s capacity to build traction with these customers over a traditional market sizing analysis.
Conclusion: tl;dr
Venture Capitalists need to screen deal flow quickly to identify promising opportunities efficiently and stay ahead of the competition in the fast-paced, high-stakes Venture Capital landscape. This post has examined three primary investment criteria that experienced Investors utilize to evaluate potential investments: the fit with their investment strategy, the Founding team’s quality, and the size of the market opportunity.
Although these criteria are crucial, they are not exhaustive, and other factors, such as scalability, exit routes, and competitive landscape, also play a role in the decision-making process. I invite you to join the webinar to explore the nuances of each criterion, alongside practical examples and methodologies provided.
