How VCs Evaluate Startups - Part 1 (Pre-Seed/Seed Stage)

Welcome to all of our new subscribers. If this is the first time you’re reading Last Money In content, we encourage you to review our previous content here, where you can read our posts on Venture Scouts, Secondary Investments, Using Syndicates to Recruit into VC, Economics of GPs, LP Strategy and more. Now onto today’s post. 

One of the most common questions we get is how do VCs due diligence and evaluate st­artups. This varies drastically across stages (pre-seed to growth) and industries (b2b software to biotech, etc.), but we want to start to uncover this over a long-term Last Money In due diligence series that will address due diligence from a number of industries and stages.

We are both generalist investors with our startup portfolios including well over 100 early stage businesses and well over 100 growth stage businesses as our entry investments, so we’ve evaluated thousands of companies. For this first article, we’re going to focus on pre-seed & seed, and discuss in general terms how we think about evaluating these businesses. For those who may not be aware – let’s quickly define pre-seed and seed, which will be the focus for this article. 

Pre-seed:

• The pre-seed stage is the very earliest phase of a startup's development, often before it has a fully developed product or a substantial user base.

• At this stage, founders typically use their own funds, money from friends and family, or funds from angel investors to conduct initial research, develop a prototype, and validate their business idea.

• Pre-seed funding is relatively small compared to later stages and is used to prove the concept and attract further investment

Seed:

• The seed stage comes after the pre-seed stage and is characterized by a startup having a more developed product or service, possibly some early traction or user base, and a clearer business plan, but may still be very much running experiments to get to product market fit.

• Seed funding is aimed at helping the startup scale its operations, build out its team, and further develop its product or service for a larger market.

• Seed funding is often provided by angel investors, venture capitalists, or seed-stage venture capital firms with raises typically landing in the $1m to $3m range. 

We believe this article is relevant for LPs in SPVs so that 1) they can better evaluate investment opportunities presented and 2) have a basic framework when scouting for GP or running their own investments. Of note – this article may be helpful for founders who are looking into insights into how VCs are evaluating you. 

So what exactly do we look for in a pre-seed/seed stage investment?

1) Founder Conviction & Founder-Market Fit

Founder Market Fit is a term that gets thrown out a lot but is critical to how we think about early stage investment decisions and even more for us as I am fundamentally a founder driven investor at the earliest stages and personally prioritize this over markets (though many investors are thesis driven with a different POV).  

Founder-market fit" is a concept that emphasizes the alignment between a startup founder's background, skills, and experiences with the specific market they are targeting. It suggests that founders who intimately understand the problems and needs of a particular market are better positioned to create successful and innovative solutions.

To share one relevant example, we recently backed a founder who scaled his previous company to a Series C and which is still operating today. At this last company, one of the biggest pain points was automating the key parts of the sales process that was significantly slowing down his sales cycle e.g. filling out RFPs, answering questionnaires, sending over relevant case studies, etc. This would delay closing weeks and the CEO could not find any good 3^rd party vendor to facilitate and so he ended up leaving his startup to found “New Co”. We like founders that identify a hair on fire problem that the team is passionate about solving with the credibility to execute on it.

Keith Rabois of Founders Fund recently held an interview here on what he looks for in founders. Among others, he mentioned: “I think on founder traits, I have this expression that only disruptive people create disruptive companies. So you have to have a screw loose somewhere to create an iconic company. You have to see things that other people don’t see or you have to ignore things that other people think are laws of physics.” 

This idea is analogous to the product-market fit concept, which highlights the alignment between a product or service and the needs of a specific market. Founder-market fit extends this notion by asserting that the founders themselves, through their deep understanding and connection to the market, can significantly impact the success of a startup.

2) Early Signs of Product Market Fit

Product-market fit is a critical concept in the startup world, referring to the stage at which a company has developed a product that meets the needs and demands of a specific market. It signifies that the product resonates with customers, and there is a strong match between what the product offers and what the market desires. Achieving product-market fit is a key milestone for startups and is often considered a prerequisite for sustainable growth.

To follow on to the “New Co” example mentioned in the Founder section above, that same founder who had those unique insights that got us excited to invest in his new company (New Co) actually also had significant early validation despite raising his Seed round. He had organically (on $0 in marketing spend) driven over 500 companies to sign up for his product and had early pilots going with dozens of users with extremely strong early engagement including from some of the largest software companies globally. 

Ultimately at the Pre-Seed and Seed Stage, there may be little or no product fit given by nature these businesses are just forming, but early signs of validation are still valuable in helping us to build conviction on an investment and derisk an investment. 

 Several characteristics define a state of product-market fit may include:

• Market Demand: There is a clear and growing demand for the product in the market. This demand is not just a result of marketing efforts but is an organic response to the product's ability to solve a problem or meet a need.

• Customer Satisfaction: Customers are not only using the product but are also satisfied with it. They find value in the product and are likely to become repeat users.

• User Engagement: Users are actively engaged with the product, and there is evidence of retention. Users are not just trying the product once and abandoning it; they are returning and using it consistently.

• Positive Feedback: Customers provide positive feedback about the product. This feedback may come in the form of testimonials, reviews, or other expressions of satisfaction.

• Referral and Word of Mouth: Satisfied customers become advocates and refer the product to others. Word of mouth becomes a significant driver of new customer acquisition.

• Scalability: The business is ready to scale without compromising the quality of the product or the customer experience. The infrastructure and processes can handle increased demand.

Achieving product-market fit is often an iterative process that involves refining the product based on customer feedback, monitoring user behavior, and adapting to changing market conditions. Once a startup achieves product-market fit, it is in a better position to seek additional funding, scale operations, and pursue long-term growth strategies.

3) TAM

Believe it or not I do not focus too much on TAM. Very notably when both Uber and Airbnb first started, their respective TAMs were thought to be limited and yet both today are $50BN+ Enterprise Valued companies. 

Great teams can expand the TAM!

When Uber was founded, it began as a black car service in San Francisco, targeting a relatively small market of users looking for an alternative to traditional taxi services. As Uber expanded its services to include ridesharing and entered new cities, its TAM grew. The concept of ridesharing itself opened up a larger market, attracting users who might not have used traditional taxi services. Over the years, Uber's TAM continued to increase as it expanded globally, offering various services like UberX, UberPOOL, and more, catering to different transportation needs. In Uber’s first pitch deck they projected their entire market at $4.2B annually; Uber generated $32B in Revenues in 2022, massively undervaluing their TAM.

Similarly when Airbnb launched it was focused on providing a platform for people to rent out spare rooms to travelers. Its TAM was likely limited to a niche market of individuals seeking unique and local lodging experiences, as well as hosts interested in renting out their properties. As Airbnb gained traction and expanded its services globally, its TAM grew significantly to something much larger than believed initially with the company introducing various accommodation options, including entire homes, apartments, other hotels and unique properties, among others. 

As you can see from Airbnb’s initial pitch deck it believed its market size was 10.6M trips. In total, the number of Airbnb nights and experiences booked worldwide reached 393.7 million in 2022, 30+ times its target market size it pitched.

The reason I’m bringing this up is that if you’re going to weigh TAM highly in your pre-seed/seed evaluation criteria, I would think hard about if your assessment is correct. We are not TAM driven investors; we are personally founder driven investors at the earliest stages.

4) Credibility of the Team

The team is considered one of the most crucial factors when evaluating seed stage investments. Ultimately we prefer to back teams that not only have strong founder market fit but that have credible backgrounds in other ways e.g. have scaled and/or taken other businesses to ten figures or more in annualized revenues, were critical members of teams that have achieved multi billion dollar outcomes, have relevant PhDs, among others. These founder backgrounds are critical for several reasons including:

• Execution Ability: At the seed stage, a startup is often in the early stages of development and faces numerous uncertainties. The ability of the founding team to execute on the business plan is vital. Investors want to see that the team has the skills, experience, and commitment needed to turn the idea into a viable and successful business.

• Adaptability: Startups frequently encounter unexpected challenges and opportunities. A strong founding team is adaptable and capable of navigating uncertainties, adjusting strategies when necessary, and seizing new opportunities that arise.

• Vision and Mission Alignment: Investors look for alignment between the vision and mission of the startup and the capabilities and values of the founding team. A team that is passionate about and committed to the problem they are solving is more likely to persevere through challenges and remain dedicated to the long-term success of the business.

• Expertise and Experience: The expertise and industry experience of the founding team are critical. Investors assess whether the team has the necessary knowledge and skills to understand the market, develop a competitive product or service, and effectively navigate the challenges specific to the industry.

• Network: A strong network can be a valuable asset for a startup. Investors often consider the founding team's ability to leverage their professional networks for partnerships, customer acquisition, talent recruitment, and other strategic advantages.

• Risk Mitigation: Seed stage investments are inherently risky, and many startups face high levels of uncertainty. A capable and experienced founding team is seen as a form of risk mitigation. Investors are more likely to bet on a team with a track record of success or relevant experience in the industry.

• Ability to Attract Talent: The founding team's ability to attract and retain top talent is crucial for scaling the business. A strong team can build a positive company culture and attract skilled professionals, contributing to the overall success of the startup.

5) Valuation

Oh valuation… There are dozens of articles you can write on this topic, but I’m of the mindset that valuation matters a lot, but that it shouldn’t generally be a deterrent from investing in a pre-seed/seed business within reason. Ultimately, if a company you invest in at the pre-seed/seed stage becomes the next Airbnb, it will likely lead to an incredible outcome no matter what you pay. 

Conversely if you dig deep into portfolio construction and what’s actually required to return an outlier pre-seed / seed fund, you’ll realize just how important entry valuation is, but that’s for an entirely different article.

Some of the best valuations we find are startups that haven’t made it on to VCs radars or in markets that are completely unloved (e.g. bitcoin 2014).

6) Financials, Competitive Landscape, Legal/Regulatory, References

For the sake of brevity, we won’t be digging too deeply into the rest, but we wanted to bring up other factors that are important.

Financials:

• Burn Rate: Understand the startup's burn rate, which is the rate at which it is spending capital. Evaluate how efficiently the startup is using funds.

• Operating Model & Financial Projections: Assess the reasonableness of its operating model and financial projections and the assumptions underlying them. Push founders on their statements to assess their credibility as anyone can put numbers on a spreadsheet. 

At the pre-seed/seed stage, revenues will be extremely minimal if not zero often. What I care about here is primarily determining whether burn is within reason, does burn generally allow the company sufficient time to run enough experiments to reach product market fit and will milestones enable a next financing.

"The primary reason seed/early startups fail is lack of product-market fit & growth, not running out of cash. Most companies die with lots of cash in the bank." 

Legal and Regulatory Considerations:

• Compliance: Ensure the startup is aware of and compliant with relevant legal and regulatory requirements.

• Intellectual Property: Evaluate the protection of intellectual property through patents, trademarks, or other means.

Famously Airbnb, Uber, Coinbase and others were operating in arguably legal gray areas when they first started, and all led to great outcomes, but there should be a pushback for companies working in legal gray areas to ensure founders have thought deeply about the regulations in the spaces they operate in. Ultimately great founders like Brian Armstrong of Coinbase, Brian Chesky of Airbnb and Travis Kalakanick of Uber famously knew how to win despite the regulatory hurdles - again going back to our view on investing in people at the pre-seed stages. 

References:

• References: Seek references from industry experts, mentors, or other investors.

Competitive Landscape:

• Competitors: Identify existing and potential competitors. Evaluate the startup's positioning and differentiation in the market.

• Barriers to Entry: Consider if there are significant barriers to entry that protect the business from intense competition.

A highly competitive landscape can present challenges for a new startup seeking investment. However, with the right elements in place - an exceptionally talented founder, a truly innovative business model, or advanced technology giving a clear edge - a crowded market is not necessarily a deal breaker.

As investors, we should have an open and nuanced discussion with founders about their strategy for differentiating themselves and capturing market share before writing them off due to competition. A thoughtful analysis of their unique value proposition, rather than a knee-jerk rejection, will lead to better investment decisions on both sides.

I’ll leave you with a few Pre-Seed / Seed memo’s from Bessemer Venture Partners to showcase how different investors evaluate at this stage as there is no one size fit all. The point of this post isn’t to give you the exact playbook as there isn’t one, but a framework for how to think about evaluating startups at the earliest stages.

• Bessemer’s Seed ext. investment in Twilio

• Bessemer’s Seed investment into Auth0

• Bessemer’s Seed investment into Wix

You can also back our syndicates Riverside Ventures & Calm Ventures to get a better sense of how we evaluate deals at different stages. 

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✍️ Written by Zachary and Alex