My experience from a variety of Investor pitches and VC due diligence (sample size 40+), in addition to my own experience of interviewing Startups for the DMZ (sample size 120+), suggests that Investors are implicitly looking to validate a series of key criteria when assessing a Startup
I found myself asking the same few questions during the recent DMZ interviews, and realised that my mind was working up this set of criteria as I watched the pitch and asked questions. On reflection, I believe that there are 5 core criteria (or Needs) that VCs and Investors are looking to answer when considering a Startup, and that failure to address or validate each Need in order invalidates all Needs above that. This theory and set of Needs is outlined below.
Startup Hierarchy of Funding Needs
Maslow's Hierarchy of Needs is a motivational theory in psychology that outlines the various needs that a human must fulfill in order to be satisfied. The fundamental concept is: it's great to be able to view fine art, but that's meaningless if you're starving and in a war-zone.
Humans need to fulfill needs further down the pyramid (for example, satisfying hunger, being safe and secure) before they can progress to the higher levels of esteem, prestige and self-actualization. I believe that this model is applicable to startups, and posit the "Startup Hierachy of Funding Needs": -
My first belief here is that a Startup must address the lower levels of this pyramid before it can succesfully progress on to the level above. Failing to do so will render all stages above this void. Specifically, the Needs to be addressed in this order are: -
- LARGE PROBLEM - Is this a large problem, with a significant TAM?
- TEAM THAT CAN SOLVE PROBLEM - Is this team or individual likely to be able to solve this problem?
- GROWTH - Is this startup getting some form of traction?
- PRODUCT-MARKET FIT - Do they have Product-Market Fit?
- GOOD UNIT ECONOMICS - Do Unit Economics check out? Can they scale efficiently?
My second belief is that this hierarchy matches the thinking process of most early stage VCs and Investors - and therefore that Founders must understand this pyramid and how their company is progressing up it in order to be successful at fundraising
Fundamentally, it does not matter if you have great growth if your TAM is minimal, or that you have great unit economics if your team can't solve the problem
If your Startup is in any of these situations, then I recommend that you use this structure to prioritise a response. Specifically, for the two examples above, understanding how the Product or Strategy can evolve to yield a larger TAM, and recruiting talent that can solve the problem, respectively
These Needs are outlined in the sections below: -
A Startup is fundamentally not investable if it is not solving a large problem
The best measure of a "large problem" is to estimate a Bottoms-Up TAM by considering how many Customers might use your Product, how much you will charge per year, and what is a reasonable adoption rate. For example, there are 30mln SMBs in the US, each needs accounting software and might pay $300 per year, and given that this is a crowded market, you may be able to take 5% market share. A bottoms-up TAM is 30mln * $300 * 0.05 = $450mln.
You need to be able to identify for a Bottoms-Up TAM of at least $100mln in annual revenue
There are a few mistakes that Founders make at this stage: -
- Using a vague industry-wide TAM - e.g. saying that global SMB software spend is $676bln, and that's your TAM
- Over- or Under-estimating market share - e.g. estimating 50% market-share when competition is numerous and fragmented
- TAM versus SAM versus SOM - e.g. Choosing a too-specific niche that is initially addressable
A Startup that is not addressing a large problem with a path to earning at least $100mln in revenue is not going to be able to grow large / valuable enough to seek VC investment. This Need must be addressed first.
TEAM THAT CAN SOLVE PROBLEM
Cancer is a large problem. People would pay a lot of money for a cure for cancer. I'm not a doctor and it would be a waste of my time to try and cure cancer
Don't try to solve a problem in an area that you're not an expert in
There are many examples of non-experts succeeding in industries that they were initially unfamilar with, for example, Herb Kelleher was a lawyer before he started Southwest Airlines, but in my opinion these are the exception to the rule, made prominent by confirmation bias / availability heuristic.
The process of building a Startup is tricky and challenging enough without trying to learn a new industry / business / skill at the same time. You will be significantly more likely to succeed if you have the skills and capabilities required. For this reason, the Startup's team needs to be able to solve the problem, because a VC is extremely unlikely to invest in a company in which there is a combination of both Product risk AND Expertise risk
This is why DMZ interviews start by asking the Founder(s) to talk about themselves and their backgrounds
Startups, by definition, are inventing new Products, Services or Business Models, and therefore there is risk associated with whether that new model works. Indications of Growth or Traction help to de-risk this
The best measure of growth is continuous upwards Revenue or User growth - ideally with consideration of Lost Revenue or Users, i.e. by calculating a Quick Ratio. This may be difficult for earlier stage Startups that are still building or developing their Product, in which case LOIs, or other indications of intent to purchase are invaluable
In my opinion, there should be no scenario in which a Startup cannot indicate some form of Growth - even if that is just signals of interest or potential Customers filling out surveys
A Startup should not be attempting to scale without a good degree of Product-Market Fit. The result of scaling with low PMF is that time, money and resources that should have been dedicated to product development, user research etc. to find PMF are instead spent on Sales. With low PMF, these new Customers quickly churn, and the investment is wasted.
PMF is a relatively well-understood concept, but I find that most Founders are unaware of how to measure it clearly. My preferred method is to use cohort retention curve analysis (see Brian Balfour's "Never Ending Road to Product Market Fit"
GOOD UNIT ECONOMICS
Unit Economics, by which I'm mainly referring to CAC:LTV on a per-product or per-service level, are an indication of whether a Startup can scale without burning money
In the absence of Network Effects, Economies of Scale or Virality, a Startup should not be attempting to scale with a CAC:LTV ratio much below 3. The presence of Network Effects etc. indicates that scaling with a lower CAC:LTV ratio is potentially viable, but needs to be done carefully
Fundemantally, this measure is ensuring that cash invested in the Startup to fuel growth is used effectively and not inefficiently
Example, a Startup raises $2mln, of which it intends to spend $1mln on various sales efforts. It has a CAC:LTV ratio of 1:1.5. This indicates, ceteris paribus, that the $1mln invested in sales will generate $1.5mln in the future. Depending upon the payback period, that's a very bad use of money
Poor unit economics indicate that scaling will be inefficient, and this needs to be dealt with ideally before fundraising and certainly before trying to scale. Solutions vary depending upon the cause of poor unit economics, but typically fall into the areas of decreasing CAC (change sales channel, improve sales efficiency) or increase LTV (reduce churn, increase revenue)
Startups are fundamentally solving a progressive series of problems, in order to de-risk their Business / Service / Product and move towards an ultimate goal of size / scale with PMF
In order to do this, I believe that Startups need to prove that they have fulfilled a series of Needs, and that they cannot effectively move to the next level up without solving for the lower level Needs. This leads to the model of a "Startup Hierarchy of Funding Needs" that outlines the Needs a Startup must fulfill
Furthermore, I believe that this model of Needs is implicitly used by VCs when analysing Startups and during VC due diligence. Using this model will help Founders understand what they need to prioritise in order to be more effective at fundraising