Deal screening is a crucial process for venture capitalists, as it helps them filter out the most promising and relevant startups from a large pool of potential investments. In this article, we will discuss some of the key criteria and metrics that you use for deal screening, and how they can help you identify the best opportunities for your portfolio.
One of the first things you look for in a startup is the size and growth potential of its target market. You want to invest in companies that are addressing large, underserved, and fast-growing markets, as they have more room for expansion and value creation. To assess the market size and growth, you can use various sources of data, such as industry reports, customer surveys, competitor analysis, and market segmentation. You can also use metrics such as total addressable market (TAM), serviceable addressable market (SAM), and serviceable obtainable market (SOM) to estimate the revenue potential of a startup.
It is important to review the key use case and technology limitations of the proposed solution as these may significantly impact the target market. A simple example might be a mobile application that fundamentally takes advantage of a feature that only exists on one of the major platforms. It would be overly optimistic to state the target market size as including all mobile devices.
When we look at companies, market size and growth can vary quite a bit between types of companies, for example for a traditional early-stage SaaS platform in a new market we might want to see a large TAM ($1B+), and a higher market growth rate today, showing the market's potential to support a $100M+ IPO'd company in the future; a small deep-tech play like a medical device, you might be okay with a smaller market (~$250M), but you'd expect the intellectual property in that company to help you capture a larger percentage of that smaller market yielding a more modest but lower risk return; the largest companies might be in mature markets, and competition could be fierce, we might want to see fast growth (~15%+ CAGR) not just considering size.
When evaluating market size, it’s important to consider two different approaches: Bottom-up sizing and top-down sizing. Bottom up sizing methodology is based on the simple equation: (A) # of Units sold per year X (B) Price = Market Size. Estimate of number of units can be done searching information about demand or socio-demographic data in the market. Price can & should be segmented according to market segments. Top down sizing methodology is based on the equation (A) total market size X (B) % specific to your business X (C) % that you can capture. While estimating total market size (TAM), you should find the portion that you can actually reach (SAM), and then explain which % you can capture (SOM).
Another important factor that you consider in deal screening is the quality and fit of the founding team. You want to invest in teams that have the relevant skills, experience, vision, and passion to execute their idea and overcome the challenges of building a successful venture. You also want to invest in teams that have a good fit with your firm's culture, values, and goals, as they are more likely to have a productive and long-term relationship with you. To evaluate the team quality and fit, you can use various methods, such as interviews, references, background checks, and personality tests. You can also use metrics such as team size, diversity, cohesion, and retention to measure the team performance and dynamics.
Never skip the background check. That’s where you find out the founder faked graduation from college and if they did that you can’t trust them in any other dealings and investing in any start up requires long term deep trust and transparency in the founders who will constantly be in tight corners (because that is the nature of starting up).
Because we invest at the earliest stages, there is not a lot of data or company performance metrics to go by, so we put a lot of emphasis on the team. We want to make sure the founders are self-aware, enough to know their shortcomings and where they need to build capacity to accomplish growth.
Team is always difficult to evaluate accurately. My rule of thumb is to first consider team composition, and try to pick out the gaps, if they are an early stage business they might have strong technical founders, but may not know anything about selling their product, or they might have business and technical skill but no domain expertise (specific to the vertical they are selling in). You'd usually expect the company to try to fill some of those gaps with their advisory board, but ultimately they'd need to supplement their team and show the capability to attract high quality talent. Later stage deals are more about if the team "IPO" worthy, and match the scale of the company, the composition is usually already very good.
Check the online presence and personal brand of the founder and core team members. Are they visible on Google? What type of topics do they talk about on their professional AND personal social media accounts? Reputation risk is real. Smart founders know how to craft their personal brands online so they can boost their company's profile.
A third key criterion that you use for deal screening is the product innovation and traction of the startup. You want to invest in companies that have a unique, scalable, and defensible product that solves a real and urgent problem for their customers. You also want to invest in companies that have demonstrated some traction and validation in the market, such as user growth, revenue, engagement, retention, and feedback. To assess the product innovation and traction, you can use various tools, such as product demos, prototypes, pitch decks, and customer testimonials. You can also use metrics such as product-market fit, unit economics, customer acquisition cost (CAC), lifetime value (LTV), and net promoter score (NPS) to quantify the product value and performance.
I agree with what Victoria says here Plans can be built and rebuilt. But in the end, it is the human factors that count. And perhaps most, determination or grit. Depends who you ask —- but that general quality.
Yes, these evaluations of product value and competitive edge are worth doing but in my experience half the most successful very early stage companies I invested in ended up in markets or with products quite different from where they started. Those founders relentlessly, tirelessly, optimistically, ingeniously quested to find sometimes quite radical solutions when they encountered slow traction. Ie the entrepreneur’s resourcefulness was much more important than the product or market concept
Indirect competition and alternative solutions should also be considered, like the customer's current and possibly manual solutions. This is particularly true for AI and automation companies. Never underestimate how difficult or costly it can be to get customers to change even when a new solution might be technically better.
Product innovation could be a factor of unique intellectual property like patents (hard IP), special knowhow or data (soft IP), or a better overall user experience and onboarding flow. If you're not looking at a deep-tech company, then traction is where you want to spend most of your time, product adoption, usage, churn, acquisition cost, LTV. A cohort analysis is usually great here, but consider the stage. If this is an early stage company you may not have much data to go on, so you're really just looking for early evidence of product market fit, later stage companies are all about the numbers, more than anything.
If you are a deeptech startup and raising funding in the initial product development phases, product innovation is of importance - validated by patents, research etc. The long term technical impact that the startup can create also is of importance. Thus creating defensible IP portfolio that would be difficult to replicate will be great criteria
A fourth key criterion that you use for deal screening is the competitive advantage and moat of the startup. You want to invest in companies that have a clear and sustainable edge over their rivals, such as superior technology, intellectual property, network effects, brand recognition, or customer loyalty. You also want to invest in companies that have a strong moat, or a barrier that protects them from competition and erosion of their market share and profitability. To evaluate the competitive advantage and moat, you can use various frameworks, such as Porter's five forces, SWOT analysis, value chain analysis, and core competency analysis. You can also use metrics such as market share, gross margin, return on investment (ROI), and customer churn to measure the competitive position and profitability of a startup.
I have a lot of opinions on this, but don't underestimate this either as an investor or as a startup looking to position your product, this really demonstrates your knowledge of the market. Minimally you want identify (1) the key competitive dimensions, what do customers making a purchase decision actually care about when buying a product in your market including what pains are you solving; (2) the consideration set, what competitors do customers in your target segment compare before making a decision?; (3) what product, business model, or strategy advantage do you have in (1) relative to the set in (2). You might need to talk to a bunch of people in the industry to answer these questions, people aren't always honest online.
Moats categories are split into two categories : The resources moats are what you own : - ?? Core resources: human resources and capital; - ?? Intellectual property (IP): technology, content, and data; - ?? Social capital: brand, social impact, community - ??? Market resources: distribution ownership, network effects The strategies moats are tactics you can implement : - ?? Collaborative innovation: feedback-fueled product iterations, UX; - ?? Business model: localization, vertical integration, horizontal integration, monetization; - ??? Regulatory positioning: fiercest cowboy or sheriff deputy; - ?? Switching costs: time & money investment, legal commitments, data compound.
A fifth key criterion that you use for deal screening is the funding stage and valuation of the startup. You want to invest in companies that are at the right stage for your investment strategy, such as seed, early, or growth stage. You also want to invest in companies that have a fair and realistic valuation that reflects their current and future potential, and that leaves enough room for future rounds and exits. To determine the funding stage and valuation, you can use various sources of information, such as financial statements, projections, comparables, and multiples. You can also use metrics such as pre-money valuation, post-money valuation, dilution, cap table, and internal rate of return (IRR) to calculate the value and returns of a startup.
In my experience, valuation is not an accurate representation of the value of a company, it's more of a measurable way to show the outcomes of a negotiation between the company and its investors. A valuation too high might mean either hidden deal terms or a founder making really big promises that might hurt them the next time they raise. A valuation too low can mean a founder not well compensated for the risk they are taking, and overbearing influencer from the investor group. A fair market valuation in my opinion is the better choice over either of those scenarios. Founders don't always view investors as partners, but they play an important role in the growth of a venture and should be considered as such.
A sixth key criterion that you use for deal screening is the alignment and synergy of the startup with your firm's vision, mission, and portfolio. You want to invest in companies that share your firm's values, goals, and principles, such as social impact, diversity, or sustainability. You also want to invest in companies that have a strong synergy with your existing portfolio companies, such as complementary products, services, markets, or customers. To assess the alignment and synergy, you can use various techniques, such as due diligence, co-investments, referrals, and testimonials. You can also use metrics such as strategic fit, cultural fit, value-add, and cross-selling to measure the benefits and risks of a partnership with a startup.
Consider the investment horizon and the potential exit strategies that could be available. Early stage investments can take 5 to 7 years to mature and sometimes even longer. Exit strategies can include management buyout, sale of the business and ipo. Market conditions, timing and company size may make any of these more or less possible to achieve. Liquidity plays an critical role. The company should have enough cash to fund its investment plan to the point where it can operate sustainably or the exit and follow on investment can be achieved. Companies heavily dependent on further investments to fund capital expenditures or operating losses are obviously more risky than companies that have a clear path to operating sustainability.
The first thing I review is the amount of resources/funds dedicated to sales. Companies who do not devote adequate resources to sales are doomed to fail from the outset.
Go to market & sales strategy: You want to assess how well founders understand their customers and their strategy to conquer the market. To determine the industry knowleadge of the team, you can look at how they qualify their leads, define their personas, segment their market. You should look at sales pipes, conversion rates, loss reasons, churn reasons, upsell, cross-sell opportunities. You should assess why time to market is relevant, and how the team win arguments vs competitors & incumbents.