How to estimate the value of a startup?
It can often be difficult for entrepreneurs to understand what criteria the investors are followed in the selection of projects. What do you need to get the attention of investors and funding to start your own business ideas?
Business accelerator 500 Startups partner and entrepreneur Elizabeth Lin tried to explain in her blog simply how VCs evaluate good business ideas, and why some people get checks have not yet started, while others have to make dozens of pitches. Let's look at the basic and most faithful to our mind ideas.How does a social app such as Snapchat get funded vs say a developer tools company like New Relic? Obviously, their milestones and KPIs are very different.
In this post, I’m going to very *simplistically* dive into some high level categories and talk about how early stage investors consider each. Loosely speaking, I’ve divided companies into 4 categories in my mind — this is not an industry standard — this is just how I personally see things. But, most early stage investors probably think along similar lines:
- Super high tech companies
- High infrastructure companies
- Free consumer apps
- Everything else — aka companies that can make money immediately
Also, there is a lot to say in each category, but there isn’t enough space in this blog post to do so here. Disclaimer: all of this really only applies to software investors.
Super high tech companies
I think a lot of software companies would like to think they belong in this category, but the reality is that most software products are pretty easy to build. Even the vast majority of all those “AI” and “big data” and “machine learning” pitches that I see are not in this category. Open source libraries (such as TensorFlow) make technology more accessible for less skilled or self-taught developers such as myself to use. So a lot of previously “super high tech” ideas are no longer that high tech.
So what is in this category? Essentially my definition for companies in this category is that the technology is so difficult to build that only a small subset of people in the world can build it. So as a result, this is a constantly moving target. I suppose the way that I actually benchmark this in my head (just to be perfectly candid here) is I ask myself if a product is something that I think I could personally teach myself to build within a year as a mediocre self-taught developer. And if the answer is yes, then it’s not really that high tech. And it turns out a lot of ideas just are not that high tech. (There are just a lot of things you can learn these days on YouTube and by Googling…)
As a result, the most important criteria in this category is the team. To be more specific, I’m talking about the team’s backgrounds. (Team is important in every category, but in this category, it is extra-important that the team is the right team to do this particular idea.) Teams that thrive in this category have strong and often niche backgrounds in whatever it is they are doing. For example, in the self-driving car category, most of the teams that stand out have previously done a PhD in a related topic or participated in the DARPA Grand Challenge for a few years or have worked for a company (Google et al) on a self-driving car / vision related project. So if you are competing in this category, your team’s resume / pedigree is really critical — more than anything else. You don’t see a lot of “self-taught” folks in this category.
High infrastructure companies
Traditionally, software investors have loved being in the software industry because the capital costs are low and also because you can get something into the market quickly. However, a lot of software investors are now dabbling in fields that don’t necessarily have these characteristics. Investors are pouring a lot of money into health and fintech companies, and many of these companies have a number of hurdles that companies need to overcome. Getting licenses, FDA approvals, etc are not trivial but they are also barriers to entry for would-be competitors.
As a result, for these kinds of businesses, investors often don’t expect that companies can earn revenue right out of the gate, because they may not legally be able to. Similar to the super high tech category, investors often look at the backgrounds of the team very closely, because understanding clearly what needs to be done is really important. Has the team worked in the same area prior to starting the company? Is the company already in the middle of overcoming regulatory hurdles? Does the team know exactly what they need to do to go into business? These are some of the most important criteria to investing in seed-stage teams.
Free consumer app companies
In contrast to the last two categories, successful founders of free consumer apps tend to come from any background. Companies in this category include companies like Twitter, Facebook, Instagram, Pinterest, Snapchat, etc… These are all companies that need a TON of users, great retention and engagement and continued-fast-growth of user adoption in order to later make money off ad revenue.
If your startup is in this category, you’ll need to craft a story around:
- How this hyper growth is happening organically? Do you have virality built into the product? How do new users find your product without your having to pay money? Etc…
- High engagement - users spend a TON of time on your platform / app / site; when Facebook first raised their seed round, investors were compelled by just how many hours per day their users were using their platform
- High retention rate
In fact, the business model matters very a little…most investors who invest in free consumer apps don’t particularly care about monetization at the early stages. But, you need to be growing FAST. Really really fast. And, investors just want you to keep growing quickly and retain / engage these people. (But you should at least be able to articulate a high level plan around the future monetization.)
So, you’ll want to show that you are making progress on optimizing your free customer acquisition funnel (e.g. growing quickly) and that you are also improving stickiness over time.
The thing about this category is that it’s REALLY HARD. I mean REALLY HARD. Growing a business is already quite hard, but a couple of things to consider:
- Because you are not monetizing, if you are unable to fundraise, it becomes difficult to keep the boat afloat.
In the beginning, this may not be a problem — you can bootstrap. But once you get to say a series A or B level and you have say 30 people on payroll, if you cannot raise, it’s really difficult to bootstrap a company of that size.
- The fundraising landscape gets more competitive as you progress
In general, for all companies, going from the seed to the A to the B rounds is difficult. The number of series B investors is way smaller than seed investors. But it is even harder for free consumer companies, because there are even fewer “free-consumer investors”. In this category, you are competing with other pure-consumer apps who may be doing something different but vying for the same consumer attention. And certainly when it comes to competing for fundraising dollars, you will be benchmarked against other free consumer apps on user base and growth of that engaged user base.
“Everything else” companies
Lastly, there’s everything else. The vast majority of pitches that I see tend to end up in this category. These are products that can and should generate revenue right out of the gates in both B2B and consumer ideas. Obviously within this category there are a LOT of verticals that are looked at very different — everything from e-commerce to B2B SaaS to marketplaces. And what specific things investors look for very much depend on the particular vertical and business model, and that is a topic for many more blog posts. BUT, the one commonality amongst all startups in this category - regardless of vertical — is that most investors would really like startups to start monetizing right out of the gate.
Team backgrounds matter in this category but not nearly as much as in the first two categories, because anyone can start a business in this category. And execution / traction is often a measure of the team rather than their resumes.
The reason for outlining all of these categories is that it can be rather confusing as an entrepreneur to know what you need to achieve in order to get funding. On one hand, you may see some friends in fintech getting funded when they have zero traction, and on the other hand, if you’re in e-commerce, you may need to hit $1M GMV runrate to capture that same investor’s attention. And it just doesn’t seem to make sense. But hopefully this illuminates why investors think somewhat along these lines.
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