How do VCs value companies and potential?
Hey VC professionals,
I was just curious as to what main metrics the most successful VC firms looked at when evaluating a company and how does it value it? Is it sometimes just based on founders charisma?
thanks!
When evaluating a company, VC professionals often look at several key metrics and factors to determine its value and potential. Here’s a breakdown based on insights from Wall Street Oasis:
Market Size and Growth Potential: VCs are interested in markets with large and expanding potential. A startup operating in a growing market is more likely to achieve high returns.
Team Quality and Execution Capability: The team's ability to execute the vision is crucial. VCs often look for a combination of market knowledge, passion, and the ability to adapt and execute. The charisma of founders can play a role in their ability to lead and inspire, but it's the overall team capability that often weighs more.
Product or Service Uniqueness (Innovation): The uniqueness of the product or service, especially how it stands out in the market, is critical. Innovation is a significant driver, as it can lead to a competitive advantage.
Business Model Scalability: Scalability is key in VC investments. The business model should demonstrate potential for exponential growth without a corresponding increase in costs.
Networking Effects: As noted by Benchmark Partner Bill Gurley, a strong networking effect where each additional user enhances the value of the service can be a powerful growth driver. Companies like Uber and Airbnb are examples where networking effects have played a significant role.
Traction and Metrics: Actual data like user growth, revenue growth, customer acquisition cost, lifetime value, and burn rate are scrutinized to understand the current health and future potential of the startup.
Exit Strategy: VCs also consider the exit potential of the investment. They look for clear strategies for how they can exit the investment via avenues like acquisitions or an IPO.
While founder charisma can influence a VC's decision, especially in early-stage investments where hard data might be limited, it is generally one of many factors considered in the valuation process.
Sources: VC startup idea - PE or VC interest? Are these numbers viable?, https://www.wallstreetoasis.com/forum/venture-capital/early-stage-vc-101-5-questions-you-better-be-able-to-answer?customgpt=1, Article: VC is deforming capitalism. #dumpsterfire, Thinking Like an Investor, Why NOT to do Venture Capital
There’s a handful of reasons why some founders are picked and others aren’t, assuming you’re asking about pre-product, pre-revenue.
Some common questions: What’s the industry, how competitive is the deal, is this a first time founder, what’s their background, why does this founder have a right to win, why now, is there a product?, is this a winner take all market, are they trying to disrupt a legacy player, etc etc
Basically, it comes down to 2 things that are a sum of the questions above.
1) Founder risk: If you’re a first time founder with 0 work experience, but a great idea, you’re going to be really hard to be on and you’ll either command a lower valuation or higher dilution in your earliest rounds. If you don’t have a right to win, you’re hard to back. On the other hand, maybe this is your 3rd company and the last 2 exited to strategics. Or you’ve spent 5 years at X tech company feeling/solving Y problem and so you’re the right person to start Z company. Or maybe your track record as a founder is that you worked as VP of sales and drove higher quota attainment, lower churn, and more efficient reps. Or maybe this founder knows a GP at the fund and the GP wants to take a bet on them. All of these attributes give founders a real right to win and command higher valuations.
2) Market risk: Some markets command higher valuations than others. Right now it’s AI, one time it was Crypto, and in the future idk. Outside of the hype cycles, some markets are more valuable because their tech produces higher margins. Take food delivery apps, why did so many raise at ridiculous valuations, well because it’s a winner take most market and it’s a massive TAM. With the eventual creation of an oligopoly, the economic incentives are huge. On the flip side, look at IoT companies, while software enabled hardware is great, many companies are constrained to single verticals or sell both software + hardware which drives down margin. Another important driver is what paradigm shift is creating tailwinds for your market, or rather is this just a good idea with no recent unlock. Tailwinds create disruption, good ideas create competition.
You can definitely start a company in an unattractive market as a first time inexperienced founder, however, I’d imagine your ability to raise capital would be hindered greatly.
Finally deal dynamics play a role, but I doubt that’s what you were asking about. If you’re wondering how 5 on 25 was determined, I guess it has to do with a mix of dilution from further rounds and giving seed investors enough equity for a board seat. You’ll see larger seed rounds like 25 on 125 or 125 on 625 and those are mainly adjusted upward for the factors above.
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