Anuj Abrol is the Chief of Staff to Justin Kan . He is actively involved in operating Atrium and investing in early stage startups. As Justin Kan’s Chief of Staff, he has counseled ~100 startups, evaluated ~500+ more, and invested alongside the top names in the industry. He wrote this article to answer the #1 question early stage founders ask him: “how do investors evaluate startups?” Anuj is on Twitter @nujabrol . *** What is early stage investing? If you are familiar with early stage investing, feel free to skip to the section “Why is evaluating startups correctly important for investors?” Otherwise, let’s go on this journey together. Early stage investing is the act of an investor providing money (and help) to a startup in exchange for some of the startup’s equity. Both parties aim for the startup to grow to a large business in 5–7 years. How is early stage investing different than other types of investing? If a startup succeeds, its lifecycle can be generalized across 3 stages: — The startup is focusing on making a product that people demand, use, and pay for. Early — The startup achieved the above and is now focusing on growing the company in a repeatable and scalable manner. Growth — The company wants to bring in everyday investors to raise capital, increase brand, or exit earlier investors. These are companies you invest in on the stock market. Public Time commitments, risk levels, and expected returns The earlier one invests, the longer they wait to get money back. Early stage investors are usually locked in 5–10 years (until a company goes public, gets bought, or fails), public investors can sell their stock any time, and growth investors are in between. The earlier one invests, the higher the and the . Early stage investors expect to make most of their money on 20–30% of investments, following a distribution. Public investors expect to have much less variability, with returns following closer to a . risk reward power law normal distribution If investing were baseball, early stage investing could be considered a ‘grand slam’ approach vs the public markets as a ‘get on base’ approach. Shape of Power Law (Grand Slam) Distributions compared to Normal (Get on base) Distributions. Adapted from Jerry Neumann’s Power Laws in Venture Who is involved? There are two types of early stage investors. . They differ in two ways: ‘Angel Investors,’ who invest their own money, and ‘Venture Capitalists,’ (VCs) who invest mainly other people’s money VCs are bound by their investors to only invest in startups if they can achieve some contractual agreements. This can mean a variety of things: having a certain ownership percentage, a board seat, certain terms to protect downside, etc. Angel Investors do not have mandates. Mandates — As a founder, you’ll encounter these when negotiating your term sheet. — VCs try to stand out from other VCs to win the hottest deals. They invest in and market their brand and resources (community, recruiting help, etc.). Angel investors tend to rely more on their achievements and reputation. Branding and resources As a founder, you should probe how the investor will help you out — these resources can save you time, money, and pain. When are these investors involved? Early stage investing can take place across three stages, each with different attributes for progress, team, and investment: Why is evaluating startups correctly important to investors? When we dig deeper, the degree to which early stage investing is a grand slam business is shocking. First, . The Kauffman Foundation, an investor in many VC funds, . amongst early stage investors, the returns are disproportionately distributed found the top 20 VC firms (~3% of VC firms), generate 95% of all venture returns Second, A study found the top 29 VC firms made a profit of $64B on $21B invested, while the . outside of the top 20 VC firms, most lose money! rest of the VC universe lost $75B on $160B invested VC fund returns follow a Power Law (Source: Kauffman Foundation ) So, Is it because they 1) consistently get lucky and leverage success for better deal flow, or 2) are great at picking startups? why do top investors hit grand slams more often than the rest? Some top investors claim it’s disproportionally the latter. What mindset do top early stage investors take when evaluating startups? As early stage investing operates on a power law, (founder of Y Combinator) “You [as an investor] have to ignore the elephant in front of you, the likelihood they’ll [the startup] succeed, and ” He highlights there are 10,000x variations (!) in startup investing returns, (investor in Pinterest, Warby Parker, Stripe) found top investors embrace this mindset — they strike out (lose money) . This strikeout rate is similar to non-top investors, however, as top investors are taking bigger swings, the investments top investors hit on are more often a grand slam. Moreover, the grand slams top investors hit result in disproportionately larger returns — hitting it out of the park, not just over the fence. Paul Graham mentions focus instead on the separate and almost invisibly intangible question of whether they’ll succeed really big. meaning top investors must have the mindset of willing to strike out in order to hit grand slams. Chris Dixon on half their investments Top investors invest in Grand Slams at a higher rate than non-top investors (Source: Chris Dixon’s The Babe Ruth Effect in Venture Capital ) The Grand Slams top investors invest in are on average much larger than those of non-top investors (Source: Chris Dixon’s The Babe Ruth Effect in Venture Capital ) It’s important to note that not all companies should raise funds from VCs and Angels. Technology startups are a sweet spot for these investors as there is grand slam factor in the business. A small business (e.g. pizza parlors, laundromats, cafes), by contrast, does not have ambitions of world domination — they are usually geared towards a particular geographical area or limited market where it has some degree of monopoly through virtue of sheer physical presence. (early investor in Lyft, TaskRabbit) told me, “You don’t raise money from venture capital because you need scale. There are other financing vehicles to do that. It’s one of the most misunderstood parts of startups.” Ann Miura-Ko What characteristics do top early stage investors look for? We know top investors return way more than everyone else, and they do so by trying to hit grand slams. What gives these investors conviction to swing? To find out, I first defined grand slam early stage investors as those who of . Second, I scoured 100+ relevant interviews, articles, and tweets to identify the main characteristics these investors look for. Third, I bucketed my findings across three main categories: Market, Product, and Team. Below is context on each characteristic and a summarized have invested in the seed and series A rounds at least two $1B+ exits you can use to test your ideas against grand slam criteria. “founder tip” Market — ( ) “When a great team meets a lousy market, market wins. When a lousy team meets a great market, market wins. When a great team meets a great market, something special happens.” Andy Rachleff co-founder of Benchmark, co-founder of Wealthfront When evaluating for potential grand slams, top early stage investors look for one thing in markets: Market Size .” — “Data tells us the ultimate size of market addressed is the single greatest determinant of outcome Andy Rachleff Founder Tip: Frame your problem in the biggest way possible, including the adjacent products you can eventually build once your core product is at scale. If the market is not at least a ten billion dollar opportunity, you may want to work on a bigger problem. This one is straightforward. Investors love backing startups operating in great markets for the following reasons: Companies with huge returns are in huge markets A rising tide lifts all boats (a great market is good to everyone competing) Even if the startup doesn’t win the market, there can still be good outcomes (e.g. in the self-driving car market, . there have been multiple, billion dollar exits) There are three important points to remember when evaluating your market size: First — market size today matters little: what matters is the market’s growth rate and how big it will be in ten years. “The #1 mistake investors make when they miss out on a really great opportunity is they look at the size of the market today. Now, they only care about how fast the startup is growing. They don’t care about the size of the revenue today. Why they can’t make this same leap of faith for the market, I never understood.” — , Sam Altman President at Y Combinator (investor in Airbnb, Stripe, Reddit, and Pinterest) Investors need to believe your startup’s addressable market can be big. Everyone starts off with a niche initial market, but it’s very important that your vision lays a path to something much bigger. Second, if (co-founder of Cue, former YC Partner, now founder of Pioneer) told me that (early investor in Google, Yahoo!, PayPal, Zappos) takes the following approach to markets — “you should try to think how big it can be, the market size sounds too far fetched, it likely is. Daniel Gross Michael Moritz but if you have to think too hard, it’s not a good investment.” Even with these in mind, it is hard to estimate your addressable market size correctly — markets are dynamic. Uber probably by 100x. is the most robust guide on how to estimate market size. underestimated their potential This link Third, there (early investor in Airbnb, Coinbase, Gusto, Instacart, Stripe), this means i) the market is structurally set up to support multiple winners, but ii) if the market only supports one winner and customers are currently not served well — there is an opportunity to dominate the market. needs to be room for your startup to capture a large share of this market. Elad Gil explains Product “If you don’t have a winning product, it doesn’t matter how well your company is managed, you are done.” — ( ) Ben Horowitz co-founder of Andreessen Horowitz, investor in Lyft and Okta There are two characteristics investors look for in the startup’s product when evaluating grand slam potential: 1) evidence of product / market fit and, 2) if it’s crazy (i.e. unusual) in its approach. Product / Market fit “A lack of product / market fit is the #1 reason for startup failure.” — Andy Rachleff Founder tip: You need to obsessively focus on making a product that users deeply care about and demand more of. Identify signs of product / market fit, and proactively share any progress with investors, even at the earliest stages. . If the startup does not achieve PMF, it will eventually run out of funding and die. PMF the startup has i) , ii) , and iii) . Achieving Product / Market fit (PMF) should be the most prioritized objective for every early stage startup is when identified which users are desperate for the product made a product that customers can’t get enough of (demand feels exponential) found a business model that works At the Series A stage, investors are mainly looking to see if PMF is achieved. This evaluation can be qualitative — (co-founder of Netscape and Andreessen Horowitz, early investor in Facebook, Twitter, Wealthfront, Slack) , on the inside, . The customers are buying the product just as fast as you can make it — or usage is growing just as fast as you can add more servers. Money from customers is piling up in your company checking account. You’re hiring sales and customer support staff as fast as you can. Reporters are calling…” Marc Andreessen notes “you can always feel product/market fit when it’s happening The SpongeBob’s Hype Stand meme represents the differences in demand at pre-PMF and PMF When investors are evaluating for PMF, Rachleff that , meaning the product is so good it grows through word of mouth. Top investors often don’t want to see marketing spend because it shows a care for (things that don’t matter) rather than building an amazing product that people engage with (which does matter). notes the best test is to see if the product is growing exponentially with no marketing vanity metrics When advising or evaluating startups in my dual role, I’ve seen many early stage founders shy away from sharing PMF-related data. Concrete data such as , , or are the best to show, but often early stage startups do not have this data — some simply aren’t selling their product yet. Despite this, you can use other pieces of data to potential PMF even on the smallest of scales, including: revenue retention net promoter score signal Invitation / Referral rates Deposits Signed contracts / Letters of Intent Ad hoc internal user projects that mirror your product After seeing that your startup has achieved PMF, or has potential to do so, Rachleff , “It’s not first to market, It’s first to product / market fit…Once a company has achieved product / market fit, it is extremely difficult to dislodge it, even with a better or less expensive product.” investors will want to see that your startup is the first to PMF. notes Crazy “Most of the big breakthrough technologies/companies seem crazy at first: PCs, the internet, Bitcoin, Airbnb, Uber, 140 characters…you are investing in things that look like they are just nuts…it has to be something where, when people look at it, at first they say, ‘I don’t get it, I don’t understand it. I think it’s too weird, I think it’s too unusual.” — Marc Andreessen Founder tip: The best startup ideas are crazy and good — the world doesn’t believe it yet, but a change has just occurred in the world that switched the idea from bad to good . Discovering these ideas requires you to be a ‘tinkerer.’ Indulge your curiosity by exploring any weird idea or irrelevant question that occurs to you. Eventually you’ll become a sufficient expert in your topic. Investing in crazy opportunities leads to grand slam returns in the event of an exit because no one else is investing in them; their prices remain low and their upside potential is game changing. Top investors care about “crazy” investments because most investments that ended up being grand slams were not only right in the long term, but were initially crazy. A good example of a crazy startup is Twitch. Twitch started as in 2007, allowing users to livestream their life. , Justin.tv had mixed success and was for being crazy. Justin.tv began seeing strong growth rates within users that were game streaming, and even though it was a fraction of their total usage, in 2011, Justin.tv launched Twitch to focus on gaming streaming. Twitch grew meteorically and was for $970M in 2014. Justin.tv For 4 years dismissed by industry commentators bought by Amazon He “ Unfortunately human nature is not comfortable taking risk; so most venture capital firms want high returns without risk, which doesn’t exist. As a result they often sit on the sideline while other people make the big money from things that most people initially think are crazy.” Despite crazy being very important, Andy Rachleff believes top investors are more likely to take this jump than non-top investors. elaborates being willing to intelligently take this leap of faith is one of the main differences between the venture firms who consistently generate high returns — and everyone else. For founders going for grand slams, you need to actively get connected to investors who are seeking out founders taking crazy swings. The problem for investors is that . Peter Thiel (founder of Paypal, early investor in Facebook, LinkedIn, Yelp, Stripe, etc.), the sweet spot for startups being the intersection of opportunities that are bad ideas (crazy) but actually a good idea. most things that sound crazy are crazy, but the ones that are good ideas have massive upside once illustrated The ideas that are crazy, but good, have massive upside potential. Adapted from Peter Thiel’s Venn Diagram in Paul Graham’s Black Swan Farming Sam Altman , noting a proxy for crazy ideas are those that big companies will say no to — big companies make decisions rationally. He often asks startups, ‘tell me why this idea sounds bad to the big companies but actually is good?’ expands So how do investors identify ideas that are crazy, but good? Disruptive technology shift . Through a combination of luck, skill, and timing, they produce huge outcomes that were just meant to be.” — ( ) “There are very disruptive technology shifts that occur from time to time and a small number of companies ride the wave created by these shifts Mike Maples early investor in Twitter, Okta, and Twitch Founder tip: Evaluate where the world is at in adopting the technology you are leveraging. You need to be selling to users when the adoption rates are quickly growing. The top VC backed companies of today Apple (smartphones), Google (online search), Microsoft (personal computers), Facebook (social networking), Amazon (e-commerce), Netflix (online media and entertainment). rode a major shift in the way we use technology. A Buzzwords are used to describe completely new and different types of technology people can use. Previously common buzzwords were terms like e-commerce, search, and social media, and my favorite ‘the cloud.’ Today, common buzzwords include virtual reality / augmented reality, machine learning / artificial intelligence, and blockchain / crypto. proxy for upcoming technology shifts is buzzwords. When I moved to SIlicon Valley, I despised buzzwords. Buzzwords are thrown around recklessly here and the ecosystem as a whole is rightly mocked for it. But I’ve come to learn there is a reason why people use buzzwords: if they work as claimed, they have grand slam potential. Not all buzzwords will fulfill their potential and result in a disruptive technology shift though. As a founder you can reduce this risk Sam Altman , “It’s very hard to differentiate between fake trends and real trends…If you think hard and you really pay attention, sometimes you can. The metric I use to ” by avoid starting a startup on that shift until the technology adoption is growing quickly and reaches a multi-hour per day level of usage. expands differentiate between a real trend and a fake trend is similar to loving a product. It’s when there is a new platform that people are using many hours every day. Unique go-to-market strategy “Having a great product is important, but having great product distribution is more important…What a lot people fail to realize is that without great distribution, the product dies.” — ( Reid Hoffman founder of LinkedIn, early investor in Facebook, Airbnb, and Zynga) go-to-market strategy_. For seed companies in large, mature markets, when pitching, highlighting a unique go-to-market strategy is a way to stand out from the crowd. For example, Dollar Shave Club ( ), was competing in the crowded market of shaving razors, but stood out to investors by uniquely focusing on online only sales and viral marketing campaigns._ Founder tip: It’s never too early to think about your acquired for $1B To believe the startup can fulfill grand slam potential, investors want to see the startup has . This is also called a go-to-market strategy (GTM). verified their assumptions on how users find the product in a repeatable and scalable manner For early stage founders, you barely have enough time to grow, let alone build a product. Investors understand this and don’t expect you to have a fleshed out GTM. As you near your Series A, it’s important to test your assumptions about how the startup will grow and then share your preliminary findings. For later stage founders (post Series A), investors need to know your GTM works. They need to have confidence you won’t recklessly burn through cash as you hit the gas and attempt to significantly grow your user base. (major early investor in Uber, Stitch Fix, Zillow, etc.) a unique GTM the most under appreciated part about startups. It’s not about who did it first, but who did it right. Gurley looks to see if the startup has two things: Bill Gurley called An interesting way to get into the market A way to establish themselves once in the market The word ‘unique’ is important here. Replicating existing GTM strategies is often too costly because incumbents have already dried up the channel(s) to market and sell to customers. As a founder, you need to find a unique GTM that is repeatable and scalable. The good news here is that if you succeed, you’ll be able to keep out competitors by saturating the new channels. To see if you can establish yourself, Elad Gil to look for structural disadvantages or barriers that allow your GTM to succeed over competitors. For those interested in learning more about unique and successful GTMs, check out my piece: notes An Introduction to Aggregation Theory . Unfair competitive advantage “Capitalism is all about somebody coming and trying to take the castle. Now what you need is a castle that has some durable competitive advantage — some castle that has a moat around it.” — ( ) Warren Buffett chairman and CEO of Berkshire Hathaway Founder tip: Drive initial adoption by making a product so good that it is irresponsible for a user to not use over competition. To ensure long run unfair competitive advantage, understand what about the product is hard to replicate (e.g. some form of intellectual property, network effects, or scale required) and double down. Investing in grand slams is rare, so when investors do have the fortune to back one, they Therefore, You might also hear this as a startup’s “ ” or “defensibility.” Bill Gurley these are all synonyms for concepts of how a business will protect itself over the long term. want to make sure it doesn’t get knocked off its perch. many top investors care about a startup’s unfair competitive advantage. moat discusses I’ve heard this evaluated in two ways. The first is an in depth framework called the “ .” The Value Stack is made up of different layers of defensibility that each help a business entrench themselves from competition. The framework was pioneered by Mike Maples and of Floodgate Capital, and they use it to evaluate if the businesses they invest in will be able to hold its own. Check out the for more info. Value Stack Ann Miura-Ko this post (Source: ) The Value Stack Mike Maples Andy Rachleff has the second perspective on how startups can avoid competition. With his adaptation to ’s (Harvard Business School Professor) , They can compete via — targeting a new set of users and competing on different characteristics (e.g. instead of price, focus on experience) than competitors, or they can compete via — targeting the same set of users as incumbents, but offering a greatly reduced product at a lower price point. Clayton Christensen disruption theory startups can compete with reduced competition in either two ways . new-market disruption low-end disruption New-Market Disruption and Low-End Disruption (Source: Parsa Saljoughian ) Team We previously , “When a great team meets a great market, something special happens.” What makes a great team? Here are the common things, in order, I found top early stage investors look for in the founding teams when evaluating potential grand slams. read Obsessive curiosity “But very early in that discussion, they [Bill Gates and Warren Buffett] agreed that the two traits they share most in common is this insane curiosity. If you’re remarkably curious, you’re constantly learning new ways you could win, and you’re also less likely to fall into the trap of thinking that yesterday’s rules are the rules you need for tomorrow. And so that curiosity element is something we’re looking for, raw intellect.” — Bill Gurley Founder tip: Constantly seek information about your customers to serve them better. See below for examples how obsessive curiosity is evaluated and test yourself against them. Along with the above quote, Bill Gurley executives at the startup have a notion of . To evaluate this, he asks questions on , how they engage with it, and then probes if they are trying to tests if insane curiosity — constantly learning new ways to win what information (e.g. books, podcasts) executives learn from use that information to majorly improve themselves or their business. (early investor in Uber, Instagram, Twitter, etc.) layers on this point, the founders of billion dollar companies he’s worked with are “all …they go out of their way to interview other people**…these guys are learning**, they’re modeling, they’re constantly researching, they’re gathering data.” Chris Sacca noting incredible listeners I find it important that this . Obsession means making this curiosity your core focus — immersing yourself, focusing on it, and never stop thinking about it. curiosity is coupled with obsession Curious folks tinker. Obsessively curious folks solve the hardest problems that require endless tinkering. If you are obsessively curious and fail with your original plan, . odds are you will use your learnings and pivot into a big market that loves their product If a founder is obsessively curious, they can navigate the — a concept by Balaji Srinivasan (CTO of Coinbase, former partner at Andreessen Horowitz). By running a founder through the idea maze, investors evaluate if the founder understands all permutations of their idea, why their plan is superior to all other competitors, and which turns lead to treasure versus which ones lead to certain death. It’s important for a founder to thoroughly know their idea maze, it can save years by not going down the wrong path, in addition to convincing investors you know can be a grand slam. idea maze Bold thinking “The #1 thing we look for in an entrepreneur is courage…The difference between a vision and a hallucination is that it’s called a vision when other people can see it.” — Ben Horowitz Founder tip: Visualize yourself in the future, be as specific possible. What is your bold vision? Think how you will best seize that opportunity, and let it be known to your stakeholders. What products will your startup sell? Why? How will your startup specifically be organized and run? In any early stage situation, a market is going to determine the potential of the startup, but the Investors not only care your startup is on a path to a large opportunity, but also your plan — especially around running and growing your organization and product offering**. If you believe in what you are doing, the bolder thinking on these plans, the better.** team’s execution ability is going to determine how much potential is realized. to seize that opportunity . Magnetism is when others are attracted and feel themselves naturally pulled in to the work you are doing. Startups make investors money because they succeed in . Unfortunately, we live in a society that whenever something is done outside the norm, it is met with skepticism. to (early investor in Dollar Shave Club and Bonobos) and , Startups around the globe are warring for all three of these types of stakeholders, and the best of these stakeholders are attracted to the biggest visions. If you are making your bold thinking known, you’ll benefit from magnetism approaching a problem in an entirely different, non-consensus, way According Kirsten Green Bill Gurley to get customers, talent, and investors on board, it significantly helps if the founders are ‘magnetic.’ (co-founder of Twitch, former partner at Y Combinator, investor in Cruise and Zenefits, now co-founder of Atrium) taught me startups are of what they want to become. Being able to clearly articulate a bold vision is major key that differentiates startups that raise capital, attract talent, and sign up customers easily from those that do not. Justin Kan pitching narratives Authenticity “The best entrepreneurs are the ones who are passionate about solving a problem because they’ve had it or seen others have it, love those customers, love solving that problem, or have been domain experts. Those are authentic entrepreneurs.” — ( ) Steve Blank Pioneer in customer development methodology Founder tip: Focus on solving a problem of your own deep personal frustration and expertise. What do you know about your customers that know one else understands? Grand Slam opportunities start with having on . . Roelof Botha, an . Mike Maples and Bill Gurley a deep understanding of their target customers and the space they are operating in. a secret how users are going to interact with a product This unique insight requires an authentic founder According to authentic founder is someone solving a problem of their own deep personal frustration note authenticity also indicates a domain expertise, An authentic team has two benefits: First, it’s hard for anyone to legitimately copy authentically derived ideas — these ideas To compare, non-authentic ideas are those thought of while brainstorming. If you can brainstorm ideas from the top of your head and try to derive good startups to start, odds are anyone else can too. This leads to average returns for investors. unique and crazy, meaning it’ll be hard for anyone else to think of and have conviction in them. Second, Startups are constantly challenging and to persevere, it helps if you are authentic — a missionary caring about the problem deeply. If you don’t persevere, your startup is not going to succeed. authenticity leads to perseverance. “I’m convinced that about half of what separates the successful entrepreneurs from the non-successful ones is pure perseverance. Unless you have a lot of passion about this, you’re not going to survive. You’re going to give it up. So you’ve got to have an idea, or a problem or a wrong that you want to right that you’re passionate about; otherwise, you’re not going to have the perseverance to stick it through.” — ( ) Steve Jobs co-founder of Apple - As you pressure test yourself against the above criteria, I hope you realize that if you want to succeed really big, just like the best investors, you as a founder need to be willing to fail in pursuit of the best ideas. There is no risk-reward optimization — you have to go big and swing for that grand slam. That said, if you strike out with investors, remember that they aren’t perfect. Look at Airbnb, a storybook grand slam opportunity in hindsight — they were when raising at a $1.5M valuation. They most recently raised at a — over 20,000 times that initial amount. constantly rejected by prominent investors $31B valuation Please let me know if this is helpful — feel free to direct message me on on twitter: @nujabrol . *** Thank you to Justin Kan, Rahul Raina, Sam Altman, Alexia Bonatsos, Ann Miura-Ko, Craig Cannon, Phil Opamuratawongse, Andrew Lumley, Jordan Bramble, Tyler Hogge, and Radhika Gutta for providing feedback on drafts of this post.
