The startup journey is filled with many exciting milestones, but one, in particular, stands out.
It's the moment founders acquire their first seed round of investment. Going from bootstrapping a business idea, to accepting investments from family and friends, to having investors demonstrate faith in your startup is a big deal. For many, it's the moment they finally feel validated as a company.
When evaluating potential tech startup investments, VCs consider many different elements, including:
- How big is the market?
- What is the probability that the team can capture the market?
- What’s the current traction?
Though this article is specifically about factors evaluated by investors, it's worth mentioning that founders should also be evaluating investors. Acquiring funding isn't always the right move; before giving up equity, it's important to make sure everyone is on the same page.
While you may be thrilled with generating $10 million a year in revenue, a particular VC may not be happy until you hit $100 million. Thus, clarifying expectations before seeking investments is critical.
With that said, let's delve into the most important metrics considered by VCs when investing in tech startups. Whether you are preparing your first pitch or looking to improve your next deck, there are a few key factors you should be thinking about.
The Most Important Metrics Investors Look at When Investing in a Tech Startup
Before getting started, it is important to remember: There is no exact science that can predict whether or not someone will invest in your company. Though every investor shares the same ultimate goal — garnering a return on their investment— each one may have a very different set of values, preferences, and industry knowledge.
There isn’t a set of five questions that provides a perfect path to these answers. Meetings are directed conversations, not inquisitions. But one thing I do want to point out is that as a seed stage investor, I spend little time on product details for the sake of product details. That is all guaranteed to change by the time an investment is actually made.
Many factors go into determining whether or not to invest (some instinctual, some quantitative), and not everyone will agree on how much weight each should hold. With that in mind, keep reading to find out more about some of the most important startup traction metrics and factors evaluated by seed round investors.
1. Market Opportunity
Investors won't be excited about your vision if you're not pursuing an opportunistic market. Though business opportunities exist in niche sectors, they usually aren't compelling enough to warrant large investments. Massive returns come from massive market shares.
Since the seed investors’ primary objective is ROI, it only reasons that they would prioritize opportunities that promise the largest returns. However, just because you are targeting a market with a large opportunity doesn't necessarily mean your target within it will be successful. Fashion tech company Shopa is a prime example of large market opportunity gone sour:
After attempting to reinvent the multi-billion-dollar apparel market through social sharing, the startup shut down after only three years in business. Despite obtaining one of the largest early-stage investments ever by a UK startup, Shopa unexpectedly realized their idea had a huge flaw: Users weren't socially sharing their purchases (in exchange for vouchers) through the app as much as anticipated. The reason being, they didn't want to end up wearing the same clothes as their friends!
Thus, when determining market viability, VCs assess a variety of metrics beyond market opportunity, including:
- Total Available Market (TAM)
- Market Share
- Market value
- International Expansion
Here's a quick summary of what those are:
Total Available Market (TAM), typically refers to the total revenue of the market that your startup is operating in. It is usually calculated per geographical location over a five year period. As mentioned in our previous example, the TAM of a fashion tech startup could fall under the umbrella of the apparel industry. Underneath that umbrella, the startup could develop technology to specifically target athletic wear, men’s wear, formal wear, and so on.
TAM can be calculated in a few ways — one approach is to estimate how much of the market you could gain if there were no competitors. Another is to estimate the market size that could theoretically be served with a specific product or service. While knowing your TAM is important, don't focus on it too much. Savvy investors understand that a high value of TAM doesn't necessarily translate to a high degree of demand obtained. Many founders mistakenly emphasize massive markets during pitches, only to leave VCs wondering about their sense of reality.
Instead of only focusing on TAM, talk about your potential market share, or sales measured as a percentage of an industry's total revenue. Since Shopa operated in the fashion tech space, their total market share could have theoretically included the entire U.S. apparel industry, worth $280 billion.
Maybe you predict sales ramping up to $200 million in your fifth year of business. That's great; just make sure you can explain why you believe that number is achievable. As a reminder, you can calculate market share by first calculating total company sales over a predefined period (i.e. fiscal quarter or year), and then dividing the company's total sales by the industry's total sales.
Are you in a "hot segment" that has the potential for tremendous growth? Include this information early on in your pitch. For example, say you are developing an app for the food and beverage industry. Maybe the app uses an algorithm to make craft beer recommendations for food pairings based on user preferences and data.
While the entire food and beverage industry might only be growing at 7 percent per year, the craft beer segment may be growing at 14 percent per year. Whenever you can demonstrate that your niche is growing faster than the market it operates in, do so. You can calculate your industry growth rate by dividing the change in market size by the original market size, then multiply the sum by 100.
While valuing mature companies is fairly straightforward — market capitalization and sales multiples can be used to provide a solid foundation — valuing startups is a bit more ambiguous. Without a history of data to draw from, VCs are often forced to evaluate factors unrelated to sales, like company assets, KPIs, and team member experience.
With startups, revenue is a factor, but not always the most important factor to investors. While there are several approaches to valuing startups without revenue, here are the ones investors are most likely to use:
- The Berkus Method
- The Risk Factor Summation Method
- The Scorecard Method
- The Cayanne Consulting Calculator
Conversely, if you’ve already got a steady stream of cash flow, investors may look at your overall value based on revenue. Most investors look for a ten to twenty times return on investment (ROI) opportunity.
Here is how to calculate a baseline market valuation with revenue:
- Calculate your Revenue Run Rate (your most recent month’s sales multiplied by 12).
- Calculate your weekly or monthly Revenue Growth Rate.
- Calculate an adjusted RRR (apply the RGR to the most recent month’s sales and extrapolate over the course of a year).
- Multiply your adjusted RRR by a factor of ten to put yourself “in the ballpark” of a rational valuation figure.
When calculating baseline valuations, it's important to remember that it is simply a starting point. Here is a great article that goes into more detail on valuing early-stage startups.
How much opportunity is available for future expansion? While you may not be going overseas tomorrow, investors like to know when there is potential for the future. Obviously, if international expansion is simply not part of your business plan, don't mention it. However, if it is, you might say something like this:
"While we have no plans of going after the European market this year, the [niche] industry is growing at a rate of [X] percent annually. Should we decide to expand in the near future, the opportunity is there."
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2. Proven Traction
Arguably, the easiest way to get investors onboard is to prove traction. How much momentum has your startup achieved to date? What sort of supporting data do you have to prove progress?
You may insist there is a huge demand for your product, but without numbers and supporting stats you have nothing. Investors want to know your claims are backed by data, such as:
- Number of active users
- Number of registered users
- Amount of engagement
- Partnerships/clients achieved
- Amount of traffic generated
As you know, growing a brand takes significant time and effort. Which is why you should ideally approach VCs early in the process. Show them your alpha product this month, and they'll be much more impressed when you can demonstrate how much organic growth you have experienced 12 months from now.
"It really depends on the category/business. But for most companies, month-over-month organic growth is a very useful metric. Depending on the base, 20–50% MoM growth can be good — retention, referral, and churn are all things we look at, too."— Aileen Lee, Founder of Cowboy Ventures
When arranging an early meeting, simply be transparent with your intentions. Emphasize that you want the investor to be able to judge progress adequately when you are at the investment stage.
3. Team Strength
You could have the best product in the world, but without the right team to push it through, you may as well be playing Minecraft. While some VCs may care about management more than others, no VC will write a check for a team they don't trust.
Since team strength is such an important factor, consider including a bio slide in your first deck. Assuming you have the credentials, your audience will be that much more attentive throughout your presentation. If top team members complement your skills, be sure to mention that as well. With that said, don't assume you need a lofty resume to make a strong impression. When it comes to entrepreneurship, passion counts.
When asked by product Hunt what factored most into his firm's investments, Om Malik emphasized the people:
"Since we do seed and early stage investments, the answer is very simple: People first and foremost. Ideas come next, and the potential market comes third. I think seed investors who are in for the long haul need to love the entrepreneur [enough to] have a fair and honest and constant communication while building the company. "— Om Malik, Partner at True Ventures & Founder of Gigaom
Standout entrepreneurs are more than their background; they are enthusiastic sales people, recruiters, and evangelists. The bottom line: Highlight how your strengths uniquely complement your mission.
4. Personal Preferences
No matter how many times you have done it, pitching to seed investors and VCs is intense. As previously mentioned, different investors have different criteria for evaluating opportunities. The reality is you don't always know exactly what they are looking for in the grand scheme of things.
While an investor's primary goal is ROI, most of them prefer to invest in products they have experience in working with and feel a personal connection with. Thus, if you are selling a revolutionary app focused on language acquisition, you are more likely to attract enthusiasm from a VC who happens to be a polygot.
While there are factors you can't always predict, the more clearly you can answer the aforementioned items in this article, the more likely you are to get investors onboard. But, as the saying goes, practice makes perfect.
Practice Your Pitch at RocketSpace
One of the best ways to fine-tune your pitch? Receive feedback on it from experienced entrepreneurs within your industry. RocketSpace's tech campus brings together serious startups, with seriously well-executed ideas, to create a supportive coworking community with some unique opportunities.
Since we exclusively admit Seed to Series C funded tech startups, with minimum viable products, you can be sure that you are working alongside like-minded peers.
Beyond providing shared workspace, we help startups prep for funding by providing:
- Exclusive community events geared toward raising investor capital.
- Introductions to corporate partners, mentors, and VCs.
- Ongoing social events for connecting with other tech startup founders and entrepreneurs.
After working alongside highly successful tech startups over the years, we’ve noticed something: The same questions regarding pitching VCs came up over and over again.
To help tech startups with prepping for VC pitches, we have put together this free eBook: 12 Tips to Raising VC, Silicon Valley Startup Guide. Get your copy below: