How investors evaluate startups
A vast majority of startups don’t raise series A. 2022 saw only a third of the number of Series A than Seed rounds in Africa. This is because the rubber hits the road at Series A, and investors are no longer gambling on the possibility of a hypothetical opportunity. By this stage, you need to be a real business with solid fundamentals. But what does that even mean?
Raising funding is hard. Investors all have different mandates and needs. This leads many founders not to know what to show or how to meet the investors’ expectations and explain their investment case in the best possible way.
Every investor will have their own preferences and focus areas. It’s crucial that you research each investor to find out what they like and where their biases are. Look for their investment mandate, type of companies in their portfolio, engagement on social media, and references from other founders or investors.
What investors look for
Despite the differences in opinions and mandates, there are some structural preferences that all investors share. These are tied to the structure of how Venture Capitalists are funded and the inherent requirements of their model and terms.
Balancing return/risk
The first thing an investor is evaluating your business on is if the returns are worth the risk. They’ll be exploring “how big this can be?”, but more specifically, looking at the amount they’re investing and what their percentage might be worth.
A typical VC needs every bet to be a possible home run — meaning that they’ll need at least 20x their money back at exit. For example, if they’re taking 10% for $500k investment and they’re likely to dilute to around 4% through 3 more funding rounds. That means that 4% at exit needs to be worth at least $10M… and the exit price should be at least $250M in 5–7 years. If they don’t believe that, they’ll never invest.
Probability
The equation outlined above is made up of many assumptions. The next step is to unpack what those are and how likely they are to be true. These will include data on how big the market is and how much of that market could become customers. Multiply this by how much each customer might pay to gauge a reasonable MRR or ARR and compare that to the required valuation from above. Each assumption needs to be evaluated with data from research on how likely it is to happen.
The other part of the probability is to evaluate what could go wrong. They’d ask: “ What are the uncertainties or influences that can kill this?” These risks could be competitors, market shifts, customer apathy, lack of required skills, etc. Identifying them upfront and articulating how you will prevent that can go a long way when presenting to investors.
Note on Financials: This is why investors ask for financials as part of Due Diligence. It’s less about what the hockey stick graph looks like and more about the levers that you have to pull to get there. A financial forecast means that they can interrogate the inputs and assumptions that you’ve made. It’s more about understanding how you’re thinking about the mechanics of the business than what the final number is — but it does need to be compelling enough to balance the risk/return evaluation.
Evidence
The final step for them is to evaluate the evidence that you’ve achieved so far to see how your current trajectory relates to what you’ve outlined above. You need to try to show why the assumptions are realistic with actual data and activity. The data and traction that you have so far can either help or hinder the narrative. You also want to use the data to show how you’re removing risks and uncertainties in the opportunity.
Bonus points for if you can also show evidence that you have a unique insight or some ‘secret knowledge’ that other people are missing. With data, of course…
Timing
The final lens that an investor is going to be looking at your business is less related to the previous ones. This is ultimately answering the “Why now?” question. What trend are you riding, what’s changed in the market, or what stars are only aligning now that makes this possible where it wasn’t before? Being able to indicate why there is time pressure to invest and grow now is also a positive reinforcement to create urgency with the investor to close.
The one thing that is implicit in all these steps is that you’re the right team to execute this. The reason it’s implicit is that your team’s experience and backgrounds need to back up the narrative around Probability, Evidence and Timing. It’s probably the most important aspect of a pitch for an early-stage startup. Find ways to thread this into your narrative all the way through, and don’t just leave it up to a final slide at the end.
Next time you need to fundraise, it’s worth putting yourself in the investor’s shoes, and ensuring that you have compelling answers to all of these areas. Good luck!
This was initially a talk that I did for Enyata, and you can watch the video recording here. Part 2 on how to build a startup with solid fundamentals is coming soon!
