In an investing world glamorized by Shark Tank, Silicon Valley, and “unicorns,” simple, straightforward communication about what drives VC decisions is rare.
At the early stage of venture investing, raw data is very hard to come by. Obviously! At that point, the company usually hasn’t gone to market yet in any real way. So at the time when many VCs are evaluating a startup for possible investment, qualitative evaluations dwarf quantitative ones.
The old adage “Garbage in, garbage out” is particularly apt for early-stage venture investing. You simply don’t have enough financial metrics to meaningfully model future potential returns for a business that doesn’t exist beyond the PowerPoint slides the entrepreneur has put together (sometimes just hours in advance of the pitch meeting with a venture firm).
So what do you do? Well, it turns out that there are qualitative and high-level quantitative heuristics that VCs use to evaluate investment prospects. And they generally fall into three categories: people, product, and market.
People is by far the most qualitative criterion and, for early-stage investing, likely the most important. When the “business” is nothing more than a handful of individuals—in some cases only one or two founders—with an idea, much of the evaluation will focus on the team. Many VCs delve deeply into the backgrounds of the founders for clues about their likely effectiveness in executing this new idea. The fundamental assumption here is that ideas are not proprietary. In fact, VCs assume the opposite—if an idea turns out to be a good one, assume that many other startups will emerge to pursue it.
So the biggest question is, why do I as a VC want to back this particular team versus any of the other teams that might show up to execute this idea? The way to think about this is that the opportunity cost of investing in this particular team going after this particular idea is infinite; a decision to invest means that the VC cannot invest in a different team that may come along and ultimately be better equipped to pursue the opportunity. So how do you evaluate a founding team? Different VCs do things differently, of course, but there are a few common areas of investigation.
First, what is the unique skill set, background, or experience that led this founding team to pursue this idea? My partners use the concept of a “product-first company” versus a “company-first company.”
In the product-first company, the founder has identified or experienced some particular problem that led them to develop a product to solve that problem, which ultimately compelled them to build a company as the vehicle by which to bring that product to market. A company-first company is one in which the founder first decides they want to start a company and then brainstorms products that might be interesting around which to build one. Successful businesses can ultimately be created from either mold, but the product-first company really speaks to the organic nature of company formation. A real-world problem experienced by the founder becomes the inspiration to build a product (and ultimately a company); this organic pull is often very attractive to VCs.
Many people are undoubtedly familiar with the concept of product-market fit. Popularized by Steve Blank and Eric Ries, product-market fit speaks to a product being so attractive to customers in the marketplace that they recognize the problem it was intended to solve and feel compelled to purchase the product. Consumer “delight” and repeat purchasing are the classic hallmarks of product-market fit. Airbnb has this, as do Instacart, Pinterest, Lyft, Facebook, and Instagram, among others. As consumers, we almost can’t imagine what we did before these products existed. Again, it is an organic pull on customers, resulting from the breakthrough nature of the product and its fitness to the market problem at which it is directed.
The equivalent in founder evaluation for VCs is founder-market fit. As a corollary to the product-first company, founder-market fit speaks to the unique characteristics of this founding team to pursue this opportunity. Perhaps the founder has an especially apt educational background. Perhaps they had an experience that exposed them to the market problem in a way that provided unique insight into a solution. The founders of Airbnb fit this bill. Struggling to make ends meet while living in San Francisco, they noticed that all the hotels were sold out whenever there was a major convention in town. What if, they thought, we could rent out a sleeping spot in our apartment to conference attendees—helping them save money on accommodations and helping us meet our rent obligation? And thus was born Airbnb.
Perhaps the founder has simply dedicated their life to the particular problem at hand. Orion Hindawi and his father, David, founded a company called BigFix in the late 1990s. BigFix was a security software company that focused on endpoint management—the process by which companies provided virtual security for their PCs, laptops, etc. After selling the company to IBM, Orion and David decided to found Tanium, essentially BigFix 2.0. Incorporating all the lessons learned from BigFix and, as important, the changes in technology infrastructure that had occurred over the intervening 10-plus years, Tanium is today a world-class, modern endpoint-security company. Tanium represents the culmination of a lifetime of living and breathing enterprise security challenges.
In a strange way, sometimes familiarity can breed contempt—and conversely, the distance from the problem that comes from having a completely different professional background might actually make one a better founder. Though not venture backed, Southwest Airlines was cofounded in 1967 by Herb Kelleher and of course has gone on to become a very successful business. When interviewed many years later about why, despite being a lawyer by training, he was the natural founder for an airline business, Kelleher quipped: “I knew nothing about airlines, which I think made me eminently qualified to start one, because what we tried to do at Southwest was get away from the traditional way that airlines had done business.”
This has historically been less typical in the venture world, but, increasingly, as entrepreneurs take on more established industries—particularly those that are regulated—bringing a view of the market that is unconstrained by previous professional experiences may in fact be a plus. We often joke at a16z that there is a tendency to “fight the last battle” in an area in which one has long-standing professional exposure; the scars from previous mistakes run too deep and can make it harder for one to develop creative ways to address the business problem at hand. Had Kelleher known intimately all the challenges of entering the airline business, perhaps he would have run screaming from the opportunity instead of deciding to take on all that risk.
Whatever the evidence, the fundamental question VCs are trying to answer is this: Why back this founder against this problem set versus waiting to see who else may come along with a better organic understanding of the problem? Can I conceive of a team better equipped to address the market needs that might walk through our doors tomorrow? If the answer is no, then this is the team to back.
The third big area of team investigation for VCs focuses on the founder’s leadership abilities. In particular, VCs are trying to determine whether this founder will be able to create a compelling story around the company mission in order to attract great engineers, executives, sales and marketing people, etc. In the same vein, the founder has to be able to attract customers to buy the product, partners to help distribute the product, and, eventually, other VCs to fund the business beyond the initial round of financing. Will the founder be able to explain their vision in a way that causes others to want to join the mission? And will the leader walk through walls when the going gets tough—which it inevitably will in nearly all startups—and simply refuse to even consider quitting?
When Marc and Ben first started Andreessen Horowitz, they described this leadership capability as “egomaniacal.” Their theory—notwithstanding the choice of words—was that to make the decision to be a founder (a job fraught with likely failure), an individual needed to be so confident in their abilities to succeed that they would border on being self-absorbed and egotistical. As you might imagine, the use of that term in our fund-raising deck for our first fund struck a nerve with some potential investors, who worried that we would back insufferable founders. We ultimately chose to abandon our word choice, but the principle remains today: You have to be partly delusional to start a company, given the low odds of success and the need to keep pushing forward in the face of a constant stream of doubters.
After all, nonobvious ideas that could in fact become big businesses are by definition nonobvious. My partner Chris Dixon describes our job as VCs as investing in good ideas that look like bad ideas. If you think about the spectrum of things in which you could invest, there are good ideas that look like good ideas. These are tempting but likely can’t generate outsize returns because they are simply too obvious and invite too much competition, which squeezes out the economic rents. Bad ideas that look like bad ideas are also easily dismissed; as the description implies, they are simply bad and thus likely to be trapdoors through which your investment dollars will vanish. The tempting deals are the bad ideas that look like good ideas, yet they ultimately contain some hidden flaw that reveals their true badness. This leaves good VCs to invest in good ideas that look like bad ideas—hidden gems that probably take a slightly delusional or unconventional founder to pursue. For if they were obviously good ideas, they would never produce venture returns.
Ultimately, what all these inquiries point to is the fundamental principle that most ideas are not proprietary, nor likely to determine success or failure in startup companies. Execution ultimately matters, and execution derives from a team’s members being able to work in concert with one another toward a clearly articulated vision.
Excerpted from Secrets of Sand Hill Road: Venture Capital and How to Get It, by Scott Kupor, with permission of Portfolio, an imprint of Penguin Publishing Group, a division of Penguin Random House LLC. Copyright © Scott Kupor, 2019.
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