William Poon: Cornell Tech FM
Original Article BRV Due Diligence Framework Pt. 2
Startups will need to show the investor that they’ve been making traction. If the founders are still shopping around an idea for the past 6 months without building anything, it signals that there might not be much more than an idea. Traction will include anything from development of the product, growth in the form of pilots, users, revenues, etc.
Are there paying customers?
- How many users does the startup have? If they’re still building out the product, have they done any pilots? If they’ve started selling do they have any revenues? What are the margins and unit economics?
- For enterprise startups, they might have LOIs or other signals that can help mitigate demand side risk.
- There are a lot of metrics that startups can use to communicate how they’re doing. The investor can use these metrics to evaluate the health of the startup as well as whether they’re on the right path. It’s also important to ask the team for their definitions because they might vary in usage. Below are just a few examples.
DAU, daily active users
- How many people use your product on a daily basis? What’s the percentage of the entire user base?
MoM (Month-on-month) Growth
- How much is the startup growth month every month? This can look at revenues, users, etc.
- How many customers are they failing to retain on a month to month basis? How sticky is their business model?
- What does the founding team think might be causing this churn? Ex. Are they giving away free trials that don’t convert into paying users? How often does the user get charged?
NPS, Net Promoter Score
- Do they have a Net Promoter Score? This score shows how willing customers are willing to introduce the product to a friend.
CAC, Customer acquisition cost
- How much does it cost them to acquire one customer, and is it going down over time? What’s their plan to reduce it? This is also very expensive when looking at enterprise startups.
- It’s helpful to understand the team’s advertising and marketing strategy and how they’ve used their current CAC numbers to drive future growth.
LTV, Lifetime Value
- How much money will the startup make on one customer in the time of their business relationship? It depends on how long the relationship will last and how much the startup will make from each transaction.
- You can look at this ratio and compare it to competitors in the industry to gain insight on whether the company is on the right track with their strategies.
- Contracts and LOIs will typically be used with enterprise or B2B startups. This shows how many deals have been made or whether there is interest from potential customers.
What makes this startup special? What’s their special sauce that other startups can’t simply copy? This could be intellectual property in the form of patented technology, a strong brand, a niche industry that requires knowledge that only the founders possess, etc.
Direct and indirect competitors
- Investors want to know if the startup founders know who their competitors are. The biggest red flag is if the founders tell the investors that they have no competitors. This communicates that they’re not thinking about the market landscape, are not aware of their competition, and will not be prepared to compete against them. Competitors might also be alternative solutions that provide a substitute solution to the same problem. The founders should know who their competitors are, how they match up to them, and what features they have that make them competitive.
Is there a sustainable competitive advantage?
- This is what’s known as the “moat” in investing. A strong moat will allow the startup to become the market leader and will protect it from other startups.
The startup team as well as the advisors are extremely important. Just because you have a good idea does not mean that you’re the right person to bring it to market. A founder might have had a great idea about an innovative way to build a bridge but they’ve spent their entire academic and work experience in biology. The main idea behind this is whether the team has the knowledge, skills, experience, and network to accomplish the goal of growing a successful startup. Perhaps most importantly is — do they have the drive needed to run a startup? They have to be so passionate about the problem that there’s nothing else they think about or would do other than this startup. Are the founders people that the investors will want to build a relationship with? Are they willing to grow, learn, and accept feedback from others? Are they honest and trustworthy? Will they tell you when something is going wrong in the startup?
- Does the team have previous startup experience? This communicates that they know what they’re getting into. Startups are hard and most will fail. The team needs to fully understand this. Founders also will spend a significant amount of time fundraising and should be able to do this or be open to being trained on this process. Perhaps one of the best signals are founders that have successfully exited from a previous startup, whether through an acquisition or IPO.
Relevant industry expertise
- As mentioned above, do the founders have the right experience either in the industry or the skills needed to build the startup? If the team is entirely comprised of engineers, can they also sell and market the product? Or, if they are only business people, will they be able to build the product?
Origin story and motivation
- Why is the team tackling this problem? Often overlooked, this is extremely important. It shows whether the founders are willing to do everything in their power to make this a success.
Skin in the game
- Is the team full-time or are they working full-time and this startup is just a side hobby? Have they invested their own money or have their friends and family on the cap table? Having their friends and family on the cap table provides additional pressure on the team to work hard to succeed. No one wants to lose their parents’ retirement money.
Any missing pieces
- What are the missing pieces on the team? As they look into the next 6, 12, 24 months, what do they need to accomplish and do they have the team needed to complete the tasks? If not, how are they filling in the gaps?
The investor will want to know that they can make money from investing in the startup. Otherwise, the investor could have better luck at the casino or invest in index funds. VCs are typically looking for 10x or more returns. VC is a hits business and because of the high failure rate, the more startups they invest in with a high potential for return, the better the returns will be.
Use of funds and funding associated milestones
- How much money is the startup raising? How much has been raised to date and in what form?
- Is there already a lead investor? Can these existing investors vouch for their working relationship with the founding team? Are other investors excited about this startup and willing to share their own due diligence?
- What’s the stage of the round? Seed, Series A? Names might not matter as much but the investor should have a gist of where the startup is which will signal whether they’re raising an adequate amount of funds.
- What is the startup’s “runway”? In other words, how much money does the startup have to work with until the next round of fundraising?
- Startup founders should have a good grasp of how their business trajectory will generate high returns for their investors. Most typically, this will be an “exit” either through acquisition or an IPO. For startups, there are two primary ways that investors can get their money back: acquisition or IPO.
- How much money does the startup need in its lifetime to get to an acquisition or IPO? This also tells the investor whether they will need to participate in follow on funding or how much they might get diluted over time. Who are potential acquirers? Have they made similar acquisitions historically?
- What types of clients or strategic partnerships could lead to acquisition?
- It’s very hard to estimate how much money the investment will bring the VC firm but it’s important to have a general idea of what the possibilities are. Since there’s a lot of information on IPOs available, that might be the best source to see what other startups in a similar space or business model have been priced at. Using M&A/IPO comps as well as Industry EV/sales multiples will be a helpful indicator of how much the startup will be valued at.
- Use Capital IQ, CB Insights, Deal Pipeline as sources for information.
I hope that this in-depth explanation will help founders, investors, and other student-run VC funds in the future. If you have any questions please feel free to contact us at firstname.lastname@example.org
Contribution from Thatcher Bell, Jennifer Chu, and Nicole Beck.