My Seed Stage Deal Assessment Framework
Recently, I've been helping some investors with early stage deal assessment, which has forced me to answer the question: if I were investing, how would I assess a large quantity of deals?
And thus, the following is my framework for evaluating seed stage investments. It’s important to note that these fundraises range from $750K-$2M, and these startups are not yet ready for their growth stage.
It involves three steps:
A quick litmus test to determine if it’s a compelling idea and worth proceeding
Understanding their business and strategy to ensure the founders have a mature, realistic strategy
Risk analysis to determine the risk of the investment based on the team and progress
The Litmus Test
The first step in evaluation is a quick litmus test to see if I see this as a compelling idea. If the answers to any of these four questions is no, then it’s a non-starter.
Problem: Is this team addressing a problem that I agree exists and is worth solving?
Product: Does the team have a compelling product/solution to that problem?
Market: Does this product/solution address a market that’s big enough?
Team: Is this a competent team that I’d like to work with?
Investor fit: Is this a type of startup that we invest in?
If the team passes this litmus test, the next step is to figure out if the team has a clear understanding of their business and strategy.
Understanding their business and strategy
It’s ok for startups to be wrong about things, and it’s expected that not everything will go to plan. However, startups should be able to concisely demonstrate a thoughtful understanding of their business, progress, customer, core competency, risks, and roadmap.
Startups should be able to answer these questions concisely and convincingly, which altogether give a very clear explanation of their strategy.
If a startup answers these questions well (if not in their pitch, then in their answers to follow-up questions), then that demonstrates that they have a very clear understanding of their business and strategy.
1. What’s the vision?
It’s ok for this to be lofty, but it should also be clear. If a startup’s vision is too lofty then it’s meaningless, then ask the second question, “what will this business look like when it succeeds?”
2. Who is your customer?
Startups should be very focused about who their target customer is. It’s ok if they talk about a much larger addressable market that their not yet serving, but they should be able articulate a more focused customer segment based on where they are today and where they plan to be in the next year. Startups who define their customer too broadly or claim they have multiple types of customers (like two sides of a marketplace) without clear prioritization is a big risk.
3. What do you do (or will you do) for your customer better than anyone else in the world?
This should shed light on who their competing with, their core competency, differentiation, and potential defensibility. Be careful with startups who are promising to do many things “pretty good” – it’s better to start with something small an nail it and build on those successes than it is to start broadly and improve everything.
4. What have you accomplished? (AKA what have you proven about the business model)
At the seed stage, progress is not solely defined by customer or revenue traction. In early stages, it’s more important to understand what parts of the business model a startup has nailed down. Depending on the type of startup, that could mean proving that they can build a physical product at a certain cost by developing prototypes, validating that they can sell their product to enterprise by closing two enterprise deals, or validating that users are getting value from their app with high retention numbers.
Many seed stage startups overestimate their progress, and may view an accomplishment as a proof of more than it actually is (i.e. selling to 100 customers doesn’t mean that they’ve figured out how to scale customer acquisition). Asking this question helps vet how realistic the startup is about the areas of their business which have the most certainty.
5. What’s the next milestone? (AKA what are your aiming to prove about the business model)
Just as startups should be realistic about their progress, they should also be realistic (but also ambitious) about what they can achieve next. While many startups will use revenue numbers or other business metrics to explain their next milestone, they should also be able to identify the parts of the business model they’ll be able to nail with that milestone. Good examples include:
Demonstrate that we can sustainably serve enterprise customers and that they value our product
Demonstrate that we can acquire users at a reasonable cost of acquisition
Nail our pricing and margins
There should be a clear connection between the amount they’re raising, the use of funds, and the milestone they’re striving to hit.
6. Where does hitting that next milestone put you on the path to achieving your vision?
Startups should be able to articulate the steps that will come after they hit their next milestone and where that puts them on the path towards their vision.
It’s hard to expect a startup to understand what funding rounds will happen after this one to help them achieve their vision (and things are always subject to change), but they should be able to connect the dots and speak convincingly about what the path looks like from the next milestone to the promised land.
7. What’s the most pressing business risk?
Every startup has dozens of risk, some big and some small. If a startup is blind to their most pressing risk, then it’s likely to make them fail. By answering this question well, a startup can demonstrate it’s realism, humility, and understanding of their business.
There are two things that are important about their answer: risk magnitude (how big of a risk it is) and risk urgency (is it the most pressing risk).
With any business, being able to scale customer acquisition is always a huge risk, but it’s not necessarily the most pressing one for an early stage startup.
The answer to this question should also answer the question: “if you fail in the next 18 months, what will be the single reason why?”
It should be something that’s insightful and unique to their business and product, not something generic like “execution” or “not enough funding”
How are you mitigating that risk with this next milestone?
Now that they’ve articulated their most pressing risk, it should be clear how their next milestone mitigates that risk. Otherwise, there’s a possibility that they’re ignoring their most pressing risk, which is a big problem.
If a startup has answered these questions convincingly, then not only is this a compelling business idea, but the startup also has a really impressive understanding of their business and strategy. Finally, it’s time to assess the risk of the investment.
Compelling startups and teams can have highly variable risk profiles. At the seed stage, the biggest risk factors are (1) team and (2) progress. It's worth noting that every startup is really risky, but startups that score high on this risk analysis should make investors confident that their's a relatively high chance of success.
Team Risk Factors
Founder-market fit: does the team deeply understand the market their in or will there be a steep learning curve?
Founding team product proficiency: How well-suited is the team to build their product themselves?
Founding team operational proficiency: How well-suited is the team to scale a business?
Customer traction: To what extent have customers validated the business model?
Defensibility Progress: To what extent have they begun building a moat around the business?
For each of these, we grade these on a scale of 0 (bad) to 3 (amazing). While a single ‘0’ in any of these categories can potentially be disqualifying, having a 3 in any of these categories can potentially be the sole reason for making an investment. Most startups will stay in the 1-2 range for most of these.
Personally, I think an investment is not worth the risk unless the ‘0’s are cancelled out by ‘3’s. The
0: Founding team is brand new to the space they’re entering and may not understand important nuances
1: Founding team has spent some time in the space they’re entering or have become well-educated about the space through other means to develop a compelling unobvious insight
2: Founding team has spent enough time in the space they’re entering to the point where it’s expected that they can navigate it proficiently
3: Founding team are domain experts in the space they’re entering
Founding team product proficiency
0: Founding team does not include someone who can build the product
1: Founding team includes someone who’s capable of building the product (top 50% percentile of people you’d want building this product out of the people who could)
2: Founding team includes someone who’s a great fit to build the product (top 20% percentile of people you’d want building this product out of the people who could)
3: Founding team includes someone who’s an expert at building the product (top 5% percentile of people you’d want building this product out of the people who could)
Founding team operational proficiency
0: Founding team does not include someone with significant operating experience
1: Founding team includes someone with some operating experience who’s focused on the business (i.e. a few years in a product management, operations, or business development role)
2: Founding team includes someone with significant operating experience who’s focused on the business (e.g. served in an executive position in a company)
3: Founding team includes someone with experience successfully founding and exiting a startup in the past
0: No one is using the product yet (e.g. beta signups)
1: Customers are using the product and getting value out of it.
2: Customers are using the product and paying for it.
3: Multiple paying, happy customers (demonstrated through retention) with the desired business model (e.g. customer-pricing fit)
0: There’s no defensibility and no articulated path towards defensibility
1: There’s no defensibility but the founders are thoughtful about how they may ahceive it through execution down the road (i.e. developing IP, achieving network effects)
2: Progress has been made on the path to defensibility (i.e. IP via product development, a growing user base)
3: A defensible position has been achieved (i.e. IP, network effects, etc.)
Ultimately, investment decisions are largely made based on the amount of deal flow the investor has. Big name VC's that get access to the best deals are able to have a high bar and invest in the best deals with the highest expected return. Rookie VCs on the other hand, need to be willing to take more risks.