Fundraising seed capital for your startup is a pain, right?
You don’t really know what investors are looking for or what chances you have to raise the money you need.
In this article, I’m going to walk you through how investors think about your investment.
Now, every investor is different, and despite what people tell you, seed investing can be very subjective. But this guide is meant to give you a general sense of what they are looking at and for, so you can be one step ahead of them (most of them).
Ready to dive in?
Let’s do it, but first, two sentences to put things in context:
Seed funding was meant to enable innovators to build and prove out their ideas in the marketplace, but with the increasing size of seed rounds (often $1.5M or more), investor’s expectations have also swelled.
What was an exceedingly difficult task in the past has only gotten more challenging, and startup founders need to work harder to distinguish their business from a multitude of other promising companies.
There are a number of tactics that founders can pursue to improve their odds, but ultimately what matters the most is being able to convince investors that your startup is the best investment vis-a-vis about a hundred other options.
Although there are numerous variations of this framework, venture capital investors will evaluate your startup company along five dimensions: team, tech, TAM (total addressable market), timing, and traction.
This might seem like a straightforward exercise, but there is a lot of complexity and many nuances in addressing these criteria. In the following article, I will go over each of the five T’s in some detail to show you how you can build a compelling case for your business. No startup team will be perfect in each of these dimensions, and the goal is to be outstanding in at least three of these and very solid in the remaining ones.
At the end of the day, the only thing that matters to investors, especially at the seed stage, is whether or not your team can create a huge, valuable business that will be acquired or will become a publicly-traded company, generating high returns on their investment.
Your team is the primary input that will determine whether your venture will fail, become a modest success, or will grow to a billion-dollar valuation. Investors evaluate both the individuals comprising your team as well as the team as a whole. You need to make a compelling case that your team does, in fact, have what it takes.
Personal investment and understanding of the problem
The startup journey is long and tough requiring exceptional fortitude and commitment. Investors greatly value teams that are solving a problem that the team members have had themselves because that increases the likelihood that they will stick with the project through the inevitable lows that will creep up during the journey. Moreover, founders that have personal and intimate knowledge of the problem that they are trying to solve, are more likely to develop a successful solution since they understand the nuances and details that their innovation has to address.
Although it’s usually ill-advised for the reason stated above, some entrepreneurs endeavor to solve problems that do not affect them personally. In this case, the innovators need to learn everything they can about the problem they are trying to solve, the context within which it exists, and the people for whom they are creating the solution. For example, when Adora Chung was creating Homejoy, an on-demand housekeeping service, she worked as a housekeeper for a number of months to understand all the nuances of the business before she and her team launched their solution. Whether through past experiences or through intense investigation, it’s critical to demonstrate outstanding familiarity with the problem and market to investors. Not only will this increase the likelihood of winning investment, but you will inevitably create a better solution and business.
Domain knowledge and expertise
If your team is working on a smart home product, but none of the founding team members have any kind of education or experience related to developing and merchandising smart home or hardware products, investors would have little confidence in your success. On the other hand, if your founding team were comprised of a seasoned hardware engineer and product leaders that are veterans of an established company making smart home products, investors would be a lot more optimistic about your chances. Your goal is to convince investors that your team does have the education, training, and experience that will be required on your journey. Even if your team does not have formal education in business or engineering, they might have acquired the necessary knowledge on the job or through other means. The key is to focus on the qualities that your team does have.
Integrity, Humility, and Coachability
Would you give $500K to someone you didn’t trust? Probably not if you are a rational person. Investors are the same and will not intentionally take that chance either. In fact, the underlying methodology of venture capital revolves around “de-risking” investments, and working with unscrupulous founders is as big of a risk as they come. Nonetheless, some founders still engage in egregious behavior hoping to gain a bit of an advantage over their competitors. This strategy almost never works because the venture capital community, although large, is still very tight-knit and bad actors are quickly identified and exposed.
It should go without saying that founders should adhere to utmost integrity. Of course, claiming that the team members are honest would be awkward in a pitch deck, but engaging in unethical behavior will likely kill your chances of getting funding from anyone.
Another characteristic that resonates with many venture capitalists is humility. Yes, it’s true that founders usually are a little grandiose and confident, and having conviction is a good thing. However, founders must work to keep their confidence in check to make sure it doesn’t turn into haughtiness. The reason why haughtiness is a risk is that it can lead to either bad judgment or unwillingness to take advice. Investors want to make sure that founders will not rush into foolish decisions, will encourage their team to challenge the founders’ ideas, and that they will earnestly consider advice from board members, peer executives and the investors themselves.
Humility and coachability go hand-in-hand and is important for founders, particularly first-time founders. Nearly all venture capital partners either have extensive experience creating and growing businesses themselves or have made many investments and worked with teams through a myriad of challenges. It’s important to recognize that venture partners bring invaluable insights and experience which can be beneficial for the startup in solving challenges and meeting goals. Willingness to accept advice is consequently very important for venture capital partners.
Just as it would be awkward and presumptuous to state that your team is humble and coachable, it is possible to show these qualities in the tone of your pitch and in conversation with investors. One way that I have seen founders do this effectively is by admitting that they don’t have all the answers, asking a lot of questions, and listening intently to feedback and advice during investor calls. Additionally, if founders have exhibited these traits through past actions, for example by course-correcting or pivoting their business by seeking outside counsel, these are worthwhile mentioning.
Team composition and dynamic
If you’re a fan of sports you’ll know that the team with the best players does not always become the champion. Instead, it’s often those teams that have depth, breadth, and cohesion that rise to the top. Tech entrepreneurship is similar, and most savvy investors understand that even though a startup team might have all-star members, that does not guarantee success. The composition of the team and how they work together can greatly increase the startup’s chances regardless of the star-quality of the individual members. It is, therefore, not enough to convince investors of the qualities of individual team members. To make a compelling case that the team that will guarantee success, you can speak to at least the three dimensions that I mentioned above: breadth, depth, and cohesion.
The breadth of skills and how the founders’ capabilities complement each other is a factor that influences a startup’s success. Even early-stage startups are complicated businesses requiring the team to work on product design, engineering, marketing, sales, customer support, hiring, operations, finance, and so on. If the founders’ skills span all of these functions, they will probably be more successful in growing their business, particularly on limited resources. On the other hand, if the founding team is strong in just one or two areas, they will find running the whole business more challenging or will have to hire quickly to fill the gap.
Finally, there is team cohesion. As I mentioned above, the team with the best individual players doesn’t always become the champion. How well the team members work together is a critical factor in ensuring success. The challenge is that it’s difficult to demonstrate team cohesion to investors. However, there are some anecdotes that can help make the case such as the length of time that the team members have known or worked with each other or how they have overcome challenges in the past can help paint a picture of a cohesive team.
If there were an “x” factor in tech entrepreneurship, it would be the founders’ hustle. As mentioned above, the startup journey is extremely difficult, and investors want to be confident that founders will walk through walls to turn their vision into a successful company. On the other hand, some teams have all the right credentials but fail because they run for the hills as soon as things get tough. The challenge for founders is to demonstrate to investors why they have hustle. The good news is that there are many signals that you can leverage to show your commitment to the future success.
The most compelling signal that demonstrates hustle to investors is showing them that you have skin in the game. There is a reason why so many stories of successful enterprises begin with the founders quitting their jobs, selling their house, and working day and night on their venture. Once you have severed all your safety cords, you will be hell-bent on success since you’ll have no other option. Investors love to see this level of commitment.
There are also other anecdotes that entrepreneurs can provide to demonstrate a high level of commitment. Your past experience is as good an indicator as any. Experience as high-performing athletes or military service can be strong signals for hustle. Similarly, stories about overcoming adversity can help convince investors that you will stick with the business no matter how difficult things get.
Making the case for your team
The mistake that many founders (even serial entrepreneurs) make is focusing on the credentials of individual team members to prove to investors that your team has what it take to build a huge, impactful company. That is certainly an important component, but as I hope I have demonstrated above, there are many other factors that can determine a team’s success rate. Even if you or your co-founders are not award-winning, MIT-educated engineers with multiple successful companies under your belts, you can still make an exceptionally compelling case that your team is worthy of investment by articulating your strengths along all the dimensions mentioned above.
Technology obviously has a lot to do with the likelihood of securing seed investment in a technology startup. However, what might not be as obvious is that technology can mean a number of different things, and it’s not necessarily about how cutting-edge your technology is that determines if your company would make a good investment. What is more important is how well does your innovation meet a need and how defensible is your technology (meaning how difficult would it be for a competitor to copy it). Taken together, these two factors largely determine the value of your technology, and the key is to help investors see the value of your technology by providing them with necessary details. Having said that, different kinds of innovations create unique value. Let’s consider two common types of technology innovations.
What is the defining technology that led to Twitter’s astronomical growth? What about the hugely popular dating app, Tinder? Neither product relied on a breakthrough algorithm to rocket it to the top of the user growth charts. Instead, the principal innovation that drove their success centered around design, and the actual functionality relied on widely-available technologies and frameworks. On the other end of the spectrum are companies such as Fraud Sciences, which developed a breakthrough technology for detecting fraudulent transactions and which was acquired by eBay in 2008. Even from this simple example, it should be clear that design innovations are fundamentally different from purely functional ones, and how they create value for a customer and are defended varies as well.
Twitter and Tinder vastly improved publication and dating respectively for a great number of people by greatly simplifying those tasks. The problem Twitter solved is that it was time-consuming and tedious to write long blog posts. Instead, the 140-character limit forced users to write pithy posts, which turned out to be a lot easier and fun. Similarly, Tinder solved the problem of creating and reading long dating profiles.
The innovation in both cases was a drastic simplification, through design, of commonly tedious tasks. Both Twitter and Tinder had created innovations that solved very acute problems to tons of people. The challenge is that it’s easy to copy product design, and thus both innovations are not very defensible. It’s important to note that the permanence of a given technology is often related to the traction that the solution gains in a market. If Twitter hadn’t rocketed to sky-high user numbers, it’s possible that a copy-cat might have overtaken it. For this reason, nowadays, convincing investors of these kinds of breakthroughs requires actual proof and gaining users who can substantiate your claims of an easier and more usable solution.
Fraud Science’s technology was vastly different, relying on a functional, algorithmic solution to a huge problem–transaction fraud. The relative value of the solution could also be established by comparing the rate at which the algorithm correctly identified fraudulent transactions from a sample data set. Moreover, it would be nearly impossible for competitors to copy the technology because their approach was so novel that no one could guess or backward engineer it.
Investors are looking at the value of your technology when they are evaluating your company, so your job is to articulate why your solution is valuable and how you plan to defend it, whether through patents, trade secrets, or simply growth. Another aspect to consider, even if you are not in the tech space, is how to build a moat using technology in your operations.
Out of all the factors that investors consider in evaluating a company, timing is probably the one that they get wrong most frequently because it’s based on imperfect information and multiple assumptions. Bill Gross, the founder and CEO of Idealab, claims that timing is the most important factor in determining which startups are likely to succeed. So what determines “good timing,” and how can founders convince venture capitalists that the timing for their innovation and company is just right?
By definition, good timing means that an event is taking place not too early nor too late. Those innovations and startups that are first to market often have a better chance of long-term success. At the same time, some innovations enter a market that isn’t quite ready for them making timing a tricky balancing act. One of the most cited examples is the Apple Newton, which was a touch-screen personal digital assistant (PDA) that came out in 1993. The device never gained large-scale market penetration largely due to the fact that the concept was way ahead of many dependent technologies available at the time, most notably handwriting recognition technology.
It’s basically very difficult to discern whether a market is ready for a technology or not, but it is possible to assess whether dependent technologies and ecosystem are sufficient to support an innovation. For example, let’s say that you were the founder of an electric car company. You might have an easier time convincing consumers to buy it in 2018 than in 1998 because there now exists a much more robust charging infrastructure than twenty years ago. On the other hand, you would have much more competition in 2018 than 1998. Moreover, it would have been much more difficult to convince consumers to invest in electric cars when the price of gasoline was $0.99 per gallon rather than almost $4.00 per gallon.
When is a company too late to the market with a solution? This question is about as impossible to answer as the first one. The most obvious concern is that the company is moving late into a market which already has a slew of close competitors.
For example, in 2018 Chiefmartec identified no fewer than 6,829 marketing technology companies.
If you are building a marketing technology company, you do have to convince investors why you are not too late to the party. The most effective way to do so is to focus on a granular problem that your solution is solving that maybe only a handful of competitors are addressing rather than putting your company in the same general group with all the more than six thousand related companies.
Another common concern is when a startup is entering a market that is dominated by huge, well-funded incumbents such as Google and Facebook. In this case, it would be difficult to convince investors that your small startup has a chance to bring down a tech giant. At the very least, if that is your intention, you should acknowledge the market dominance of your competitor and paint a very detailed and reasonable picture of how your startup plans to slay Goliath.
Great timing is easy to see in hindsight but incredibly difficult to predict. Is your technology too early for customers to try? Is your solution too far ahead of supporting technologies or infrastructure? Or is your company too late to a market? The best that your team can do is articulate why you think the timing is perfect for your solution and company to exist now and understand that investors have varying perspectives on timing. In fact, I have a friend who is a two-time successful tech entrepreneur and loves to invest in companies entering crowded markets based on the thesis that there must be a ton of money to be made in those verticals if companies can differentiate themselves.
4. Total addressable market (TAM)
The reason why the total addressable market is a key input for investors is that venture capitalists rely on grand slam home runs to make their money. It has been often said that many venture capitalists will not talk to founders whose companies do not have a clear path to at least a $100M valuation or (for some) a billion-dollar enterprise.
Making the claim that your startup could be worth at least $100M is a matter of both creating a solid market sizing as well as a reasonable approximation of how much of that market you could capture. First, your market sizing should be rigorous and supported with good data and sound assumptions. If you don’t do a thorough job with your market sizing, a savvy investor will quickly poke holes in it. Second, it’s important to make a reasonable assumption on how much of the market your startup can capture in a short timeframe. For example, given that there are over six thousand marketing tech companies, you’d probably be very fortunate to capture just one percent of the market and stating that you can capture ninety percent of it will quickly earn you an escort to the exit.
What if your startup is providing a very specialized solution for a tiny market and the total addressable market is something small like $10M? Should you make up numbers to get your TAM to at least $100M? No! Remember what I wrote above about integrity and about savvy investors picking apart your calculations. Instead, consider how you can build toward a bigger market. For instance, might there be another related product line or a series of product lines that could result in a much bigger TAM? Another thing to consider is whether you need equity funding. It is important to be honest with yourself about the type of company you are building and whether you are targeting the right funding sources. It could be that a loan or bootstrapping or another alternative might be the best option for your startup.
With the investment landscape changing, seed-stage investors are targeting companies that are already showing some user or revenue traction. Venture capitalists often require a startup to have a launched product with paying customers or at least a solid prototype if the solution is a bleeding edge technology. The good news is that there are a number of ways to show traction beyond exponential user or revenue growth curves, although those still convince investors best.
It can be easy to manufacture increasing user or revenue growth by pouring an increasing amount of money into marketing or sales. Investors know this and often look one level deeper at engagement metrics, which are much more difficult to fabricate. Often times founders become fixated on getting “hockey stick” growth curves and neglect ensuring that they are getting the right users or customer and that the product is truly valuable to them. Strong engagement metrics can be more compelling than exponential curves to savvy investors.
Consider the case where an investor is looking at two social network websites. One startup has grown to tens of thousands of users in just a few months, while the other social network only has a few thousand users. To delve a little deeper the investor asks the founders of each company about basic measures of engagement. The larger social network has a bounce rate of nearly ninety percent and each user views a little over one page per visit. The smaller social network, on the other hand, has a bounce rate below thirty percent and over six pages per visit. Which one has the better product?
The above example is very simplistic, and there are many different measures of engagement such as daily and weekly active users that might capture engagement more accurately. The details of how to measure and convey engagement are beyond the scope of this article, but the key point is to remember to include this dimension in pitching to investors.
Revenue per customer
A related measure of traction is the revenue per customer, revenue per order, or average customer lifetime value. Once again, your business might not have a ton of customers, but what if your average customer lifetime value is twice that of your direct competitors? Apply the same thought exercise to the average revenue per order or any other related metric. Certainly, a savvy investor would take notice if your revenue metrics were substantially stronger than industry average even if your early-stage startup had fewer customers.
Pre-orders and sign-ups
Some tech products require substantial development before they can be launched in the market. This is a common chicken-or-egg problem that founders face. On one hand, the innovation requires a lot of capital to develop. On the other hand, investors rarely invest in startups without a product and traction. One of the best ways to show traction is to market the product before it is built and get customers to express their interest in paying for the product once it becomes available. Even more impressive is getting customers to commit some kind of downpayment. Showing investors that your startup can garner scores of sign-ups or pre-orders can greatly improve your chances with investors.
Another great indicator of traction is partnerships. If your startup has been able to attract a good number of high-profile partners that will be perceived as legitimate validation of your product, business model, and team. Some common types of partnerships are:
- Cross promotion to customers where one company promotes the partner company’s products to its own customers
- Bundling products or services where one company offers the partner company’s product along with its own offering
- Providing discounts to the partner company’s customers
Information and data sharing between the two partner companies
Demonstrating strong partnerships with major industry players will send a very positive signal to potential investors by demonstrating your ability to form alliances and sell. Partnerships also allow your startup to reach large pools of potential customers and strengthen your market position, making your company more attractive to investors.
Press, accolades, and awards
A story about your startup in a well-known publication like Forbes will certainly raise investors’ eyebrows. Even exposure in smaller news and media outlets is great validation that what you are working on is something that resonates with influencers and the public. A mention like that can be a source of customers for your company as well as a powerful recruiting tool. A word of caution here though, that press alone is often not enough. Startups should be careful not to measure success by this attention because, in the end, revenue and customers are the best validation for investors.
Awards and accolades provide proof points to investors that you are onto something that others find intriguing and valuable. Of course, how esteemed the competition is and how experienced the judges are affected how favorably investors perceive those awards. If your team wins MIT 100K challenge or TechCrunch Disrupt, that will carry a lot more weight than if your team wins an obscure innovation competition. Also, the nature of the competition matters as well. For example, idea pitch competitions and business model competitions are not as noteworthy because they involve a theoretical subject. It may not we worthwhile to enter every relevant competition, but it’s certainly worth highlighting wins in order to improve your chances. It is also worth reiterating that you ensure that you are building your business and not just collecting awards which do not translate to affecting your long-term bottom line.
Combining signals of traction
Most startups can check off a few boxes when it comes to traction, and it’s critical to communicate all of these signals to investors. Particularly if a startup does not have a steep customer or revenue growth curve, the founders need to highlight things like pre-orders, engagement, partnerships, press, and awards. Even if the company does have exponential growth curves, these additional proof points will only increase your odds of raising seed funding.
6. Terminal Value (Bonus)
One factor that is often missing from pitches but that is critically important for investors is your startup’s end game. Investors typically make money on investing in your startup during a liquidation event–an acquisition or initial public offering (IPO). It’s certainly possible that your startup can build a healthy business, but also fail to be acquired or grow to a sufficient size for an IPO. I have observed a number of cases where a few startups were working on a breakthrough technology that a small handful of larger companies were interested in acquiring. However, there were more startups than potential acquires, and many of the startups got left out of the acquisition rounds only to pivot to another model or close down.
If your startup takes an exceedingly long time to get acquired or IPO or fails to do so altogether, your investors will fail to make a good return. Therefore, you should make it clear for investors what is the likely exit strategy for your startup and how you’re going to achieve it. Who are the likely acquirers for your company? If you are aiming for an IPO, what does your company have to accomplish and over what timeframe? What are potential obstacles to a good exit and how will you overcome them? These are all questions that a savvy investor will have, so you should have compelling answers.