Evaluating Products & Markets

I received a lot of great feedback on a previous post about evaluating founders, and the same question came through several times (mainly from people who are starting companies): “what do you look at next?”  Looking at initial diligence, there are a few boxes that need to be checked with any intro meeting, and once I feel that I have a good understanding of the team, I want to dig in on the product and market.  Here is how I try to determine if the product and market represent a real opportunity:

What is the problem that your product is going to solve for?  One of the quickest paths to a “no” from a VC Associate is to fail to convey the existence and magnitude of a problem.  Last spring, I looked at three companies in the pet care space (though only one made it in the door for a pitch) – each one had a solid team of execution-oriented founders, some initial traction, and a unique business model that worked at a unit level.  I was never convinced by the magnitude of the problem.

Do people love their pets?  Yes.  Are they willing to spend money on them?  Yes.  Can you make a business out of caring for pets?  Yes.  Do people need a new way to monitor and care for their pets?  I don’t think so.  Is the process of caring for one’s pets so broken that the market is begging for a tech-enabled solution?  No.  Is this something that I can champion internally?  Definitely not.

That’s not to say that there isn’t an opportunity there.  As an example, people didn’t necessarily realize that we really wanted a new platform for intra-city private transportation – Uber, Lyft, and others have shown us that we did.  There are some ideas that will completely shift paradigms, and as the quote attributed to Henry Ford says, “If I had asked people what they wanted, they would have said faster horses.”  It is true that many of the best ideas will require foresight into problems that are harder to distill, which is why I try not to be dismissive of something like a dog walking app that, while not mind blowing on the surface, could be transformative.  Is it, however, up to the entrepreneur to convince me that this is the case.

What does your product do (e.g. what is your solution)?  Interestingly enough, I often have to jump in early on in a discussion to hit the pause button and ask “OK, can we step back and talk about what exactly it is you are doing” – likely a combination of too many pitch meetings and curse of knowledge.  It’s good to remember that this is the crux of your business, and it is not an area to breeze over.  Who are your customers?  What is your value proposition?  How do you plan to deliver it?  These are not difficult questions, so be sure to give them their due.

How big is the market?  This is one where I often get frustrated by figures that show either (1) a lack of understanding of how a market works, or (2) an intention to mislead.  Neither is good.  The U.S. healthcare market may be $3 trillion, but that is not the addressable market for your wearable.  Not every company has to be a unicorn (depending on who you are pitching to), and it’s important to understand that smaller, earlier stage funds may not be thinking that way at all when it comes portfolio construction.

An airtight understanding of a realistic addressable market and its trends, and a plan for how you will gain your share of that market are key to showing your own understanding of the business and the investment opportunity.  This can be bottom up or top down (ideally a bit of both) and should be a narrowly defined market based on your product offering and target customers.  Don’t throw up a number you can’t justify, as it’s an easy place to start poking holes.

Who else is doing it & why are you better?  Some people hate the generic competition slide, but I don’t.  Once I understand what you’re doing and what problem you are trying to address, I want to know (1) who is doing it now, (2) who else is trying to do it, (3) why hasn’t anyone done what you’re doing, and (4) how are you better?

Having a firm grasp of the competitive landscape is key, and a failure to demonstrate this will be an immediate red flag as to your own precision and thoughtfulness.  Don’t be afraid to bring up the competition because it is my job to turn over every rock in the space during diligence, and if there is something out there, I will find it.  I’d much rather hear it from you, and more importantly, hear why you’re going to beat them.

Deeper evaluation of the value proposition and defensibility will come.  Technical diligence, IP analysis, and references will all be part of a full diligence process, but what I need to see right away is how your idea could be special.

What is your time to market & how do you scale?  These questions can be treated separately, but it’s important for an investor to get a sense for (1) exactly where you are at in the product development/go to market process, and (2) the capital needed and runway you will have with this round of funding.  This helps to set milestones, make strategic decisions, and will ultimately play into other key elements of the diligence process such as the financial and competitive analyses.

What are the risks?  Most startups fail, and even though you may be confident in your idea and your ability to execute, it’s naive and dangerous to assume success.  While much of your pitch will require energy, passion, and confidence, this is a good place to show humility and rationality.  Are there macro risks?  Is there a dangerous incumbent that could wipe you out (hint: if you are eCommerce, this is Amazon)?  How defensible is your IP?  What assumptions have you made about the market and your customers?  What happens in a bear scenario of customer adoption and scalability?

If there were no risk, venture capital wouldn’t exist – and by pre-emptively surfacing these and addressing them, you will earn additional trust and credibility.

Keep in mind, this a preliminary framework to understand if a deal is worth digging in on; these questions will each ultimately generate pages and pages of analysis.  It does two things for me that I find valuable – (1) helps me be as efficient as possible by screening out deals that don’t satisfy high level criteria, and (2) gives me a framework from which I can dive deeply into diligence if it’s something I like.

Agree?  Disagree?  Am I missing something critical?  Let me know!


Recycling in Venture Capital

The topic of recycling in venture capital has come up a lot recently, mainly in talking to GPs who are either (1) thinking about raising a first fund, or (2) raising a second or third fund, while looking to transition to a more institutional LP base.  With a ton of things to worry about, recycling seems to that gets de-prioritized for GPs at this stage – that is a mistake.

Roger Ehrenberg of IA Ventures and Brad Feld of Foundry have both outlined their views on recycling (they like it); my goal here is to succinctly lay out the issue and the math behind it.

The problem – If you have a $100M fund and assume (for simplicity) that you charge a 2% management fee over a 10 year investment period, you end up with $80M to invest in companies, with the remaining $20M going to the management fee.  Thus, even if you deploy that entire $80M, you are only investing 80% of the fund.  VCs are judged on net returns to LPs, so investing only $80M is putting yourself at a disadvantage right out of the gate (on $80M invested, you need to return 1.25x just to return the $100M fund).

The Solution – Recycling.  In the case of an early liquidity event (let’s say a $20M exit), that capital can either be distributed to LPs or recycled back into companies.  S0, if you have a $100M fund, and recycle that early $20M return, you know have $100M to invest into companies out of your $100M fund (the initial $80M plus the recycled $20M).  Taking this a step further, if you are able to recycle $40M in early returns, you could potentially have $120M (original $80M plus $40M in recycling) to invest out of your $100M fund – you’re already $20M “in the money” at cost!  From the funds I’ve seen, 120% is a pretty common recycling ceiling in fund documents.

So why doesn’t everyone do it?  In general, established/successful funds managers know how this works and aim to get over 100% invested, if possible.  The main problem I’ve seen is with funds who scraped together their own capital and an HNWI-heavy LP base for an early fund(s), and who are now hoping to raise from more traditional LPs (e.g. fund of funds and endowments).  Venture capital is a long term game, and institutions with that time horizon prefer to plow early returns back into companies, getting as much out of their fund commitment as possible.  Less experienced GPs and individual investors could potentially be more interested in an early payout, creating a conflict of interest.  While LPs will have different opinions on recycling, GPs who don’t aim to maximize the dollars put to work in companies are doing themselves a disservice and hurting the financial return for both themselves and their LPs.

The Math

To get a 3x net return to LPs on a $100M fund, assuming an annual 2% management fee over 10 years ($20M) and 20% carry ($55M), you need to produce $375M in returns.


So, on a gross basis (at the company level), here is what you have to return at different percent invested levels:


Notice that, without recycling, to generate a 3x net return without recycling (investing $80M), you need a gross return of 4.7x.  Compare that to the scenario where you invest $120M, needing only a 3.1x return.  That is an incredibly large difference, and it is all due to recycling.

Looking at it a different way, assume that you are able to return 4x gross (congrats!) on any amount of deployed capital:


On a gross return basis, each of these scenarios is equal, but comparing the extreme cases of 60% and 120% invested, you get a $192M and $48M swing in payouts for LPs and GPs, respectively.

There are, of course, assumptions above (early liquidity opportunities, recycled dollars being put to work effectively, etc.), but the point remains – recycling benefits both GPs and LPs, and it is critical for fund managers to build an LP base with aligned, long term incentives.

Evaluating Startup Founders

If you ask any early stage investor what is the most important aspect to a deal, she will say, almost without fail, “team”.  Market, product, etc. are all key, but no matter the horse, you need the right jockey.

I always consider my own pillars of execution (aggressiveness, humility, pro activeness, and precision) when evaluating others, but this is the framework through which I evaluate startup founders and their teams:

Do they have domain expertise?  This is a pretty obvious one, but it’s not always quite so simple.  In, for example, a healthcare services company, there are many different vectors along which founders can spike – have they practiced medicine?  Have they run operations at a hospital?  Do they have healthcare (or any) startup track record?  Have they experienced something firsthand and conducted a ton of customer research to validate a problem?  Do they have a deeply drawn out thesis in a relevant area?  Hardi Meybaum of Matrix recently said on Harry Stebbings’ The Twenty Minute VC that MBAs with strong market/industry analysis, but no domain expertise, are able to find great opportunities, but often aren’t able to dig deeper on the underlying reasons why those opportunities have not yet been tackled.  He also adds that “having high empathy for the customer” is key, and without domain expertise, that can be difficult to master.  I agree.

The breadth and depth of a founder’s knowledge will vary, and the expertise will likely comes from a combination of experience and research, but if I meet with someone who doesn’t really understand the customers, suppliers, competition, technology, unit economics, and market dynamics of her startup, I interpret that as a lack of thoughtfulness and precision.

Are they passionate?  I’ve heard people argue that a founder needs to be passionate for the product and problem she is trying to solve; I’ve also heard that while that is great, sometimes a general passion to start a company and be an entrepreneur is enough.  The latter is probably OK sometimes, but I need to see the former to be really interested.  Company building is (generally) not glamorous work, and it’s hard for me to believe that someone who isn’t truly passionate about their idea and space will have the fortitude and commitment to see a company through the inevitable turmoil ahead.

Are they tough/Do they have grit?  Call it whatever you want, but a high level of sticktoitiveness is required to succeed as a founder.  Thinking back to times when you have overcome adversity may give you a flashback to past job interviews or MBA applications, but there is a reason people ask – and that reason is even more important with startup founders.  You will never know for sure without the stress test of real world tribulations, but being confident that a founder can display dogged perseverance in the face of adversity is critical in the evaluation process.

What are their motivations?  Related to passion – this can be tricky because it’s easy to tell investors you want to build a unicorn, but a $20M acquisition when you still own 50% of the company is a life changing amount of money to most founders (and a miss for VCs).  This is another one where you’ll never know for sure just how far a founder is willing to push the envelope, but you can get a feel for it when evaluating their passion and grit.  It’s also good to just ask a founder what her goals are, with the understanding that there is no shame in shooting for a small (by venture standards) win.  There are plenty of good businesses and good CEOs out there – but my job is to find venture-backable businesses and CEOs; those are not the same thing.

Can they execute?  I can generally get a good feel for expertise and passion in an intro conversation (and potentially even before, with some research), but execution can be a bit tougher to gauge.  At the very early stages, the ability of a founder to execute is absolutely critical, yet there is often a chicken and egg problem that you will have to make a bet on.  Best case scenario, you meet a serial entrepreneur who has shown the ability to push a company from zero to one and/or moved the needle elsewhere in some meaningful way.  That, unfortunately, is rarely the case, and I find that the best way to make a call here is to (1) evaluate their skill set (how are they special? domain expertise, rockstars in sales, tech, operations etc.), (2) observe how they handle the diligence process (are they aggressive and precise), and (3) reference the shit out of them (get as many data points as you can).

I have been on a deal before where we loved the idea, believed in the opportunity, and saw a broken business model that could easily be fixed; as the diligence process began, however, it became clear that we simply weren’t dealing with a top performer.  Incoherent pipeline materials, weak financial models, and a general lack of precision and timeliness in response to our inquiries all raised red flags as to the CEO’s ability to execute.  He had built a Potemkin Village – there was no way this guy was ever going to move the needle for us as a fund.  If someone we believed in came in with the exact same company, we would have moved forward – I took this as a good lesson in disciplined investing.

Are they “Truth Seekers”?  I first heard this term from Josh Hannah of Matrix (also on the Twenty Minute VC), and I think it’s an excellent way to evaluate just about anyone that I might be interested in working with.  I love meeting founders with insatiable appetites for knowledge, who devour new information in order to make data-driven decisions.  Founders who are able to preempt my questions about gaps in their business, while acknowledging those weaknesses and exhibiting a willingness and excitement to address them, are incredibly fun to work with.  Hannah says that he likes founders (especially pre-product/market fit) who seek to find and be transparent about bad news, have tempered egos, and know that they don’t have it all figured it out (e.g. not a cult leader with a reality distortion field) – it may not be complicated, but much like humility, it’s not necessarily common.

There are many different ways to evaluate the all important “team” aspect of a startup, and each situation will be different – there is no one size fits all matrix.  I find the above useful as I enter into a conversation, and as things unfold, I press where necessary, remembering that I am being simultaneously evaluated along similar parameters.

Thoughts or comments?  Get at me here.


Venture Capital & Tech Readings

This year at Booth, I’m serving in a Career Advisor role for the venture capital group, and I’ve been asked quite a bit about what people who are interested in the industry should be reading.  There is a ton of stuff out there, and it can be overwhelming, so I tried to put together a page of interesting stuff that would help people get started.

I’ve published the list here, where I’ll periodically make updates.  If you think I’ve missed something important, please let me know and I’ll add!