How do VC analysts evaluate the business model, numbers and financial plan of a venture? What tools, frameworks and methods do you use?
Evaluating a prospective investment requires getting to know a company over time. There are four main stages of evaluation:
a) The “first read” (which can be an instant reaction to determine whether the deal matches the firm’s strategy),
b) The first meeting (in which the team can be evaluated in person or over the phone, and questions can be asked about the company’s resources and business plan),
c) Preliminary due diligence (which includes assessing whether there is a market for the company’s solution, competition, basic financial analysis, and initial customer and management references), and
d) Full due diligence (a deeper dive into all aspects of the company’s operations and plan, culminating in an “investment memo” or “investment decision” presentation for approval by the partnership). It’s normal to identify possible deal terms, including valuation, to complete an investment memorandum.
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Frameworks for new ideas, new innovations, and entrepreneurial models don't truly provide a good measurement of the connections between a company and success for an investor. I haven't seen VC's use SWOT analysis, Porter's 5 forces or Blue Ocean Strategy mapping in any real significant way.
The venture market is looking to reduce risk along a couple of vectors:
1.) Technical - Can the product be built in the way the founders say it can be built? This is where proof of concept and prototyping really matter if the product is anything but a standard development cycle (ie. standard App, SaaS, traditional Agile software cycle).
2.) Marketing - Can you reach customers at scale in a cost-effective manner? This implies that you understand your market well enough to identify high quality paying customers and know how to reach those customers through cost-effective channels. I have seen some VC's review the customer adoption lifecycle and develop market percentages (ie. from the book Crossing the Chasm, https://ondigitalmarketing.com/learn/odm/foundations/5-customer-segments-technology-adoption/). But I haven't seen this from a large majority of firms.
3.) Market - This is the biggest risk VC's take and the one you'll have the most difficulty and the one that is the most important to overcome. Will the dogs eat the dog food? Once you build it will they come? These are the kinds of questions VC will ask and no one has a solid model on how to answer. Other than customer velocity. If you can show increase customer adoption velocity on a MoM basis, that in itself is the real-world data and can be extrapolated.
There are other components to a company: management, financial, operational, that VC's will dig deep into. And those have their own metrics and heuristics.
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VCs invest in startups with extreme rarity. Unless the business is already churning Revenue and preferably Profit, VCs are simply not interested. We deal with them on a regular basis, and their criterion is extremely tight. Startups can be difficult to pinpoint as to demand, price points and anticipated growth. They are far riskier than banking on mature operations that have patterns for much of these issues already in historical place and simply need capital to make they grow wider and faster. Startups suggest risk, and VCs are risk adverse - as are banks and other institutional lenders. The tools to use in dealing with investors of any kind for a startup tend to be based on market conditions from competitors and general industry research. Trade organizations are often great sources for this kind of data. Size of the market, growth patterns, industry forecasts, margins and profit percentages can frequently be found in these areas. And markets can change quickly and frequently, so monitoring these sources on an ongoing basis is crucial. We are doing two (2) research projects right now, and it is exciting and tedious, all in the same breath. If we can help, let us know.
For the sake of parsimony, I’ll start by simply agreeing with others in this thread in terms of the difficulties associated with obtaining VC and the propensities to support established businesses versus a start-up or good idea. I’d also add that they will want considerably more ownership than an originator or team would expect up front as well as control in most cases. The old adage is that no one wants to support you unless you already have the resources on your own.
Appreciate too that your pitching your own capabilities just as if you were in a job interview. Ideas and potential opportunities are great, but can you (and partners) actually get the job done? Moreover, as can be seen across answers here, developing business and marketing plans are a highly reiterative process. As you face critiques and new ideas, you’ll gain a better idea about what to include and what to refine over time. It can be a year or more of effort from an initial idea to a detailed plan based on extensive due diligence and 100’s of conversations with people across areas of expertise.
Give the open-ended nature of your question, it’s difficult to give specific advice, but there are some obvious considerations that must be addressed. You’ll first need to establish demand based on your targeted markets. If you’re in an established industry, then it’s fairly straight forward to discern some base demand and revenue benchmarks. For example, in a scenario where I was establishing demand for a bar-restaurant, we relied on cash register totals and other financial info from nearby comparable establishments.
Then, using info from a range of sources (industry/trade reports, market assessments, etc.), those initial revenue numbers could be tweaked over time to reflect market predictions. I/We typically generated 5- and 10-year analyses and don’t forget that it must convey the initial transition into the market; how soon before the business is operating at full capacity? If you’re in a new market, then you’ll be forced to argue more by analogy, using the closest comparable businesses or low-ball generic heuristics (i.e. .5-1% marketing response rates).
Once you have an idea about potential revenues, you’ll need to build a general and then operational budget. You’ll have to factor in every detail as if in the real world. For example, what are the personnel/staffing, property, equipment, manufacturing, marketing, distribution, legal, accounting, financial, insurance costs and so forth? As previously noted by others, this will require considerable due diligence and associated interactions with a plethora of potential supporters. Expect an emphasis on softer numbers such as marketing costs and response rates and your reasoning/defense of them. No one will even consider you if you don’t convey detailed realistic marketing plans that demonstrate reasonable efficiencies/returns per each promo method and media, given the potential target markets.
At this point, you should have some idea about the potential profitability and thus whether to continue or not? The next and critically important step is to then build up models that show an operational budget and cash flows. Usually conveyed via weekly and/or monthly time units, you’ll be simulating costs and revenues that occur each week/month over at least the first 3 to 5 years of operations. You’ll be answering important investor question such as when “break-even” status and positive cash flows occur. Cash flow is a biggie in that many businesses fail because they can’t last long enough to overcome an early cash flow deficit.
Finally, have a range of best- and worst-case scenarios and reflect their direct impact on your daily financials. What happens if revenues are 20% less than expected or marketing efforts are half as effective as expected? These impacts might look reasonable in terms of general or static budgets, but even nominal reductions could have big impacts on your monthly cash flow. All this knowledge also conveys a reasonable assessment of risk and the subsequent boundaries and pitfalls, all of which are key investor questions.
As you build up this numeric model of the business, you’ll need to weave it into a compelling, coherent and detailed business/marketing plans to share with potential investors and pertinent 3rd parties. Even a more generic plans may be a 100 pages long. Visuals are paramount in both your written and meeting presentations; use a professional artist for key renderings or diagrams. Supporting research should be clearly conveyed to defend your ideas. Have resumes in the bibliography of you, any potential partners and employees, general supporters and organizations, and business/chain alliances. Have two plan versions prepared, one long/detailed and one very brief/ general. You don’t want to give away the farm to a person/organization until they’ve shown interest, spent time with you and otherwise identified themselves as a legitimate potential investor, but then be prepared to bare all.
It’s a lot to tackle and it’s an uphill battle for those not financially endowed, but I hope this gives you some important considerations and of course I’m here if you need the help.