How Do Investors Evaluate Startups?

How Do Investors Evaluate Startups?

Fundraising — 9 min read

When you’re preparing for a meeting with an investor, it’s important to remember that they evaluate startups like yours all the time. Venture capital firms hear pitches from far more startups than they invest in. They know exactly what they’re looking for; they know the red flags, they know all the tricks, and you’re going to have to bring your A-game to impress them. Understanding ahead of time what venture investors look for is one of the best ways to do that.

It's Stage-dependent

Your strategy for raising venture capital is very much dependent on the stage of your startup because not every factor is relevant to every stage. While it’s still important to consider all the variables in the mix, investors look for different things at different stages.

Pre-seed or seed: team and market

While you’re looking for seed funding, it’s understood that you are unlikely to have much traction yet. Without significant traction to analyze, investors are going to be looking for other ways to predict how far your startup will go. This is the time to sell them on your team and your market opportunity. 

Investors want to learn about your team in detail at the seed stage. They’ll want to know the basics like each team member’s skills and background, but they’ll also be very interested in how well you work together and how you resolve conflicts. At this point, they’re not just looking at your team members’ individual merits, but at how well the team functions as a whole. They want assurance that your team has the right dynamic to go the distance.

Venture capital Investors are also paying close attention to your market during the seed stage. This helps them get an idea of the kind of opportunity that’s on the table. The greater the market’s size and potential for growth, the better. They’ll want to see that you’ve mapped out your market segmentation and created a customer persona. 

Series A: traction

During your series A funding, investors are going to start expecting some hard evidence. This is the stage when they will be most interested in traction and a strong trajectory. Your current traction is enough to get your foot in the door, but to close the deal you’ll need to demonstrate that you can turn that traction into exponential growth. Investors aren’t looking for a linear trajectory—they want to be convinced that their investment is going to send your revenue (and their returns) soaring.

Series B and beyond: unit economics

The seed stage is all about selling your team and introducing your market, and series A is about proving your team can gain a foothold in that market—now you have to prove you can actually succeed in the space you’ve carved out for your business. 

Once you’ve progressed to series B and beyond, investors will focus primarily on revenues and costs. Series B is no longer about getting your business off the ground, but rather accelerating its growth. Naturally, investors are going to want to see the evidence of your path to profitability before they put their venture money toward fueling your momentum. They will likely also expect that you’ve expanded beyond the founding team and filled all key roles in the organization by this time.

What Do Investors Care About?

Let’s look closer at seven factors that have some of the biggest influences on venture funding decisions:

1. Team

In a study conducted by Harvard Business Review, 95% of surveyed VC firms named the founding team as one of the main factors that influence their decisions—no other factor was mentioned as frequently. Investors want to know why you have the best people for the job. Most importantly, they want to see that each team member has relevant domain expertise and the right skill set for the role they’re in. For example, if you’re developing a mobile app, investors are going to expect your CTO to have some experience with iOS app development. 

Investors are also looking for passion, especially in the seed stage. They want to see that you’re fully committed and driven to succeed, and just as importantly, they want to be convinced that you’re a cohesive team. If your team’s goals are misaligned or if some founders seem significantly less involved than others, investors won’t have much reason to trust that you’ll be able to weather the challenging road ahead.

2. Market size/opportunity

Investors want to invest in products that have a significant market opportunity. They’re likely going to ask about the size of your addressable market, your anticipated market share, and how you plan to capture that market share. 

You’ll have to decide if you want to approach market sizing top-down or bottom-up. Top-down market analysis calculates the total size of the market and then estimates what percentage of that market could potentially be captured. This method is simple, but usually too optimistic to be truly useful.

Bottom-up market analysis uses data from your current business and the number of potential buyers in the market to estimate potential sales and calculate how big the total market is. This is the more time-consuming method because it requires you to conduct your own research instead of relying on pre-existing assumptions about the market, but the results will be much easier to explain. 

Venture capitalists need to invest in startups with big target markets because so many of their investments don’t pan out. It’s therefore important that the ones that do become very big so they can return the whole fund. VCs usually want to see a market size of at least $1 billion.

3. Traction

Most investors won’t invest in hypotheticals alone—even if the idea is great and the team is capable and determined. Investors are going to want to see evidence of traction to convince them the startup is actually viable, especially if you’re past the seed stage. In simple terms, traction proves to investors that there are people out there who are willing to pay for your product or service, which is the strongest indicator that your startup is on to something. 

Investors want high returns, and they know that’s only going to happen if your startup grows fast. If you tell investors your startup is gaining traction at an exponential rate and you can back it up with credible data, you’ll be at a huge advantage. Don’t bother with vanity metrics like page views or social media shares—these are fine indicators for gauging potential consumer interest, but they aren’t hard data and they don’t tell you anything tangible about your startup’s performance. Instead, you should show investors meaningful benchmarks like your number of active users, monthly recurring revenue, retention, and month-over-month growth. As your customer base grows, customer acquisition cost and customer lifetime value will become increasingly relevant, as well.

However, it’s also crucial not to over-exaggerate your growth potential. An attractive growth projection is ambitious but not unrealistic. A few million dollars in valuation 10 years from now is not an exciting opportunity for investors, but you’ll also have a tough time convincing them your plan to reach a billion-dollar valuation by next year will succeed.

4. Product-market fit

Investors aren’t only looking for a sizeable market—they’re also looking for product-market fit (PMF). Product-market fit describes a product’s ability to meet a significant demand within a given market. Finding a good PMF means identifying the market that is most in need of your product and developing the best product and business model to sell to that particular market. It usually takes multiple tries to find the perfect PMF. 

The best way to get to PMF is to talk to your target customers and research your target market. The better you understand what your customers want and the way they interact with the market, the better you can position yourself to be the best solution in that market for their specific needs.  

5. Social validation

Investors talk, and if you play your cards right, they’ll be talking about your startup. There are few endorsements more appealing to an investor than one from another investor, especially if it’s someone they already know and trust. Sometimes, just getting a lead investor is enough to start a snowball effect where other investors jump on board once they see interest from someone else; investors are more likely to have faith in your startup if they see a VC firm or other experienced investor leading the round.

Validation from other investors is also a powerful tool for generating FOMO. Picking a startup to invest in is extremely risky and investors are well aware that they are likely to lose money on any given investment. If an investor is on the fence about your startup, seeing interest from other investors could nudge them toward a yes lest they be the one who missed out on a lucrative opportunity others recognized.

6. Competition

A market with high demand and absolutely no competition obviously presents the ideal business opportunity. Unfortunately, this market doesn’t really exist. If you tell an investor your startup is going to succeed because it has no significant competition, they’re almost certainly going to assume that you’ve either grossly under-researched your market or that there must be no demand for your product or service. On the other hand, if you’re entering an especially crowded market, it’s important to have clear differentiators that show investors why your product is going to have an impact.

Conducting a careful competitive analysis is the key to coming up with an accurate picture of the competition you can present to investors. Take both direct and indirect competitors into consideration. You can start by using a website like Crunchbase to identify your most relevant competitors, then dig further into their website, social media, customer reviews, online store—anything that will give you an idea of their strengths and weaknesses.

7. Fit with investment thesis

Each venture capital firm typically has an investment thesis—a unique philosophy that dictates the kinds of companies in which they are willing to invest. Operating under a set of guidelines helps them focus on the industries they know best and keeps their investments organized. If your startup doesn’t match the investor’s investment thesis, you will have little chance of closing the deal, regardless of how good you are.

What’s included in an investment thesis varies from one venture capitalist to the next. Some have very broad parameters and others are extremely specific. They usually differentiate based on factors like investment size, industry, business model (B2B, B2C, SaaS, etc.), founder demographic, market size, geographic location, and more.

You should identify and prioritize investors who typically invest in companies like yours. Not only will pitching to relevant investors give you a better chance of finding a good match, but it will also demonstrate to investors that you care enough about their investment to do your research.

Don’t Be Afraid to Seek Advice

There are a lot of different variables at play when you’re planning an investor pitch. That’s why it’s important to prepare well and come to each meeting with a clear idea of what the investor is looking for. These seven factors are generally the most important, but remember to adjust your approach based on the stage of funding you’re at. If you’re struggling to figure out what to prioritize in your pitch for raising capital, you can try asking for advice from a mentor who can give you personalized guidance based on experience.