I was an Entrepreneur in Residence (EIR) at Khosla Ventures for a year. Here I share how one tier-1 venture capitalist (VC) quickly evaluates startups.
How should we think about evaluating an investment opportunity in a startup? What metrics should you quickly apply to assess the merits of a startup company? I will share with you the method that one top tier-1 venture capital group uses.
There are four legs to the startup stool. At the Seed round, the startup should have three of the four legs. At the Series A round, the startup should have all four legs of the stool. This particular VC looks for these legs to support the startup stool and uses this method, and others, to generate 40% gross returns.
The first leg of the startup stool: Management. Has management done this before? Do they have successful exits? Are they “can’t miss”? If so, fantastic! First time founders may have more motivation and tenacity, which can overcome lack of experience. Knowledge is less important than GRIT.
The second leg of the startup stool: Market. How big is the market? This particular VC is willing to take a lot of technical risk, but very little market risk. Your preference may vary. In any case, the existing or potential market should align with your expectations for return, check size, and company valuation. Can the market size, fraction of the market the company may secure, and therefore potential company exit valuation support the 10x, 20x, or 100x return that you are looking for?
The third leg of the startup stool: Timing. Why is now a great time for the company? If the company’s solution is too early for the market, the company may run out of money before the market accepts the solution. If the company is too late (perhaps greater than 5 competitors), it may be hard for the company’s solution to displace existing ones. In this analysis, take into consideration that the company’s solution should either be solving a problem that currently has no solution, or is solving the problem much more effectively or economically (e.g. 10x better or cheaper). Also, realize that a solution in development can easily beat a solution on the market. It is important that the company’s solution beat other companies’ solutions in development. The Wayne Gretsky quote applies: the company should be skating ahead of where the market is going, not where it is now. Your own database of deal flow can help evaluate these dynamics.
The fourth leg of the startup stool: Defensible moat (e.g. Intellectual Property). How will the company prevent competitors from copying their solution? In AI SaaS, this might be speed. The AI SaaS company has to go to market within 6 months, or a competitor will. In DeepTech or Biotech, this moat will likely be US or world patents. At the Seed stage, the IP is likely provisional, PCT, or submitted patent applications. Does the company have potentially “blocking” IP – can they prevent competitors from operating within a wide moat around their solution in the market? At the Series A stage, there should be some allowed claims. Perhaps a freedom to operate (FTO) analysis should be performed. In a well-established existing market, it can be OK if licenses are needed for some parts of the company’s solution.
As an investor, you can use these tools to evaluate the potential of the startup you are considering. If a Seed stage startup has three of the four legs or a Series A company has all four legs, that is a fantastic company. Your full due diligence will likely confirm this quick analysis.
Best of luck! Your investing helps create a better future for our society.
Michael Deem is Managing Partner at Angeliki Fund, a physical and digital private equity infrastructure fund. Previously Michael was an Entrepreneur in Residence for Khosla Ventures, a tier-1 venture capital firm on Sand Hill. Michael was part of the founding team of Ion Torrent Systems, sold to ThermoFisher for $2.3B in 2014. He was the 3rd person and performed all the original engineering calculations. He was the 10th person and director of drug design at CuraGen ($100M IPO in 1998). He started the first `Synthetic Biology’ PhD program in the US. He was chair of a top-10 Bioengineering Department, with responsibility for 400 people and $27M annual budget. Michael is an active member of The National Association of Corporate Directors (NACD).