By Anuj Abrol, chief of staff to Justin Kan at Atrium – our thanks to Anuj for allowing us to reproduce his excellent blog in full below.
As Justin Kan’s Chief of Staff, I am actively involved in operating Atrium and investing in early-stage startups. Founders ask me many questions, but there’s one they ask me more often than any other: “how do investors evaluate startups?”
By working directly with over 100 early-stage companies and evaluating hundreds more, I’ve begun to identify common misconceptions about the way investors operate — and what they’re looking for in potential investments.
The following guide breaks down:
• What makes early-stage investors different from other stages
• Investor expectations for companies still in their infancy
• The three buckets you’ll be evaluated on for potential investment
If you have any questions or comments, I am 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:
• Early – The startup is focusing on making a product that people demand, use, and pay for.
• Growth – The startup achieved the above and is now focusing on growing the company in a repeatable and scalable manner.
• Public – 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.
Examples of once startups in the different stages of a company lifecycle
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 risk and the reward. Early stage investors expect to make most of their money on 20-30% of investments, following a power law distribution. Public investors expect to have much less variability, with returns following closer to a 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. ‘Angel Investors,’ who invest their own money, and ‘Venture Capitalists,’ (VCs) who invest mainly other people’s money. They differ in two ways:
1: Mandates – 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 the downside, etc. As a founder, you’ll encounter these when negotiating your term sheet. Angel Investors do not have mandates.
2: Branding and resources – 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.). As a founder, you should probe how the investor will help you out – these resources can save you time, money, and pain. Angel investors tend to rely more on their achievements and reputation.
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, amongst early stage investors, the returns are disproportionately distributed. The Kauffman Foundation, an investor in many VC funds, found the top 20 VC firms (~3% of VC firms), generate 95% of all venture returns.
Second, outside of the top 20 VC firms, most lose money! A study found the top 29 VC firms made a profit of $64B on $21B invested, while the rest of the VC universe lost $75B on $160B invested.
VC fund returns follow a Power Law (Source: Kauffman Foundation)
So, why do top investors hit grand slams more often than the rest? Is it because they 1) consistently get lucky and leverage success for better deal flow, or 2) are great at picking startups? Some top investors claim it’s disproportionally the latter.
3/ The typical VC spends most of their time doing one of three things: SOURCING companies, PICKING companies or HELPING companies.
4/ While VC’s probably spend less than 5% of their actual time on the picking, I believe the “pick” creates well over 80% of the return.
What mindset do top early-stage investors take when evaluating startups?
As early-stage investing operates on a power law, Paul Graham (founder of Y Combinator) mentions “You [as an investor] have to ignore the elephant in front of you, the likelihood they’ll [the startup] succeed, and focus instead on the separate and almost invisibly intangible question of whether they’ll succeed really big.” He highlights there are 10,000x variations (!) in startup investing returns, meaning top investors must have the mindset of willing to strike out in order to hit grand slams.
Chris Dixon (investor in Pinterest, Warby Parker, Stripe) found top investors embrace this mindset – they strike out (lose money) on half their investments. 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.
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 a 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. Ann Miura-Ko (an 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.”
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 have invested in the seed and series A rounds of at least two $1B+ exits. 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 “founder tip” you can use to test your ideas against grand slam criteria.
“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:
“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 the market size sounds too far-fetched, it likely is. Daniel Gross(co-founder of Cue, former YC Partner, now founder of Pioneer) told me that Michael Moritz (early investor in Google, Yahoo!, PayPal, Zappos) takes the following approach to markets – “you should try to think how big it can be, 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 underestimated their potential by 100x. This link is the most robust guide on how to estimate market size.
Third, there needs to be room for your startup to capture a large share of this market. Elad Gil (early investor in Airbnb, Coinbase, Gusto, Instacart, Stripe), explains 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.
“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, an 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.
Achieving Product / Market fit (PMF) should be the most prioritized objective for every early stage startup. If the startup does not achieve PMF, it will eventually run out of funding and die. PMF is when the startup has i) identified which users are desperate for the product, ii) made a product that customers can’t get enough of (demand feels exponential), and iii)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 – Marc Andreessen (co-founder of Netscape and Andreessen Horowitz, an early investor in Facebook, Twitter, Wealthfront, Slack) notes, on the inside, “you can always feel product/market fit when it’s happening. 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…”
The SpongeBob’s Hype Stand meme represents the differences in demand at pre-PMF and PMF
When investors are evaluating for PMF, Rachleff notes that the best test is to see if the product is growing exponentially with no marketing, 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 care for vanity metrics (things that don’t matter) rather than building an amazing product that people engage with (which does matter).
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 revenue, retention, or net promoter score 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 signal potential PMF even on the smallest of scales, including:
• Invitation / Referral rates
• Signed contracts / Letters of Intent
• Ad hoc internal user projects that mirror your product
After seeing that your startup has achieved PMF, or has the potential to do so, investors will want to see that your startup is the first to PMF. Rachleff notes, “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.”
“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 on your topic.
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. 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.
A good example of a crazy startup is Twitch. Twitch started as Justin.tv in 2007, allowing users to live stream their life. For 4 years, Justin.tv had mixed success and was dismissed by industry commentators 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 bought by Amazon for $970M in 2014.
Despite crazy being very important, Andy Rachleff believes top investors are more likely to take this jump than non-top investors. He 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. Unfortunately, human nature is not comfortable taking a 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.”
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 most things that sound crazy are crazy, but the ones that are good ideas have massive upside. Peter Thiel (founder of Paypal, an early investor in Facebook, LinkedIn, Yelp, Stripe, etc.), once illustrated the sweet spot for startups being the intersection of opportunities that are bad ideas (crazy) but actually a good idea.
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 expands, 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?’
So how do investors identify ideas that are crazy, but good?
Disruptive technology shift
“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. Through a combination of luck, skill, and timing, they produce huge outcomes that were just meant to be.” – Mike Maples (an 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 rode a major shift in the way we use technology. Apple (smartphones), Google (online search), Microsoft (personal computers), Facebook (social networking), Amazon (e-commerce), Netflix (online media and entertainment).
A proxy for upcoming technology shifts is buzzwords. 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.
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 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. Sam Altman expands, “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 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 of people fail to realize is that without great distribution, the product dies.” – Reid Hoffman (founder of LinkedIn, early investor in Facebook, Airbnb, and Zynga)
Founder tip: It’s never too early to think about your 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 (acquired for $1B), 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.
To believe the startup can fulfill grand slam potential, investors want to see the startup has verified their assumptions on how users find the product in a repeatable and scalable manner. This is also called a go-to-market strategy (GTM).
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.
Bill Gurley (major early investor in Uber, Stitch Fix, Zillow, etc.) called 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:
• 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 notes 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: 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 the 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 want to make sure it doesn’t get knocked off its perch. Therefore, many top investors care about a startup’s unfair competitive advantage. You might also hear this as a startup’s “moat” or “defensibility.” Bill Gurley discusses these are all synonyms for concepts of how a business will protect itself over the long term.
I’ve heard this evaluated in two ways. The first is an in-depth framework called the “Value Stack.” The Value Stack is made up of different layers of defensibility that each help a business entrench themselves from the competition. The framework was pioneered by Mike Maples and Ann Miura-Ko of Floodgate Capital, and they use it to evaluate if the businesses they invest in will be able to hold its own. Check out this post for more info.
The Value Stack (Source: Mike Maples)
Andy Rachleff has a second perspective on how startups can avoid competition. With his adaptation to Clayton Christensen’s (Harvard Business School Professor) disruption theory, startups can compete with reduced competition in either two ways. They can compete via new-market disruption – 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 low-end disruption – targeting the same set of users as incumbents, but offering a greatly reduced product at a lower price point.
New-Market Disruption and Low-End Disruption (Source: Parsa Saljoughian)
We previously read, “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.
“But very early in that discussion, they [Bill Gates and Warren Buffett] agreed that the two traits they share most in common are 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 tests if executives at the startup have a notion of insane curiosity – constantly learning new ways to win. To evaluate this, he asks questions on what information (e.g. books, podcasts) executives learn from, how they engage with it, and then probes if they are trying to use that information to majorly improve themselves or their business.
Chris Sacca (early investor in Uber, Instagram, Twitter, etc.) layers on this point, noting the founders of billion-dollar companies he’s worked with are “all incredible listeners…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.”
I find it important that this curiosity is coupled with obsession. Obsession means making this curiosity your core focus – immersing yourself, focusing on it, and never stop thinking about it.
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 idea maze – a concept by Balaji Srinivasan (CTO of Coinbase, a 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 to 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.
“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 about 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 an early stage situation, a market is going to determine the potential of the startup, but the team’s execution ability is going to determine how much potential is realized. Investors not only care your startup is on a path to a large opportunity but also your plan to seize that opportunity – 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.
If you are making your bold thinking known, you’ll benefit from magnetism. Magnetism is when others are attracted and feel naturally pulled in to the work you are doing. Startups make investors money because they succeed in approaching a problem in an entirely different, non-consensus, way. Unfortunately, we live in a society that whenever something is done outside of the norm, it is met with skepticism. Accordingto Kirsten Green (an early investor in Dollar Shave Club and Bonobos) and Bill Gurley, to get customers, talent, and investors on board, it significantly helps if the founders are ‘magnetic.’ 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.
Justin Kan (co-founder of Twitch, a former partner at Y Combinator, an investor in Cruise and Zenefits, now co-founder of Atrium) taught me startups are pitching narratives of what they want to become. Being able to clearly articulate a bold vision is a major key that differentiates startups that raise capital, attract talent, and sign up customers easily from those that do not.
“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 the problem of your own deep personal frustration and expertise. What do you know about your customers that no one else understands?
Grand Slam opportunities start with having a secret on how users are going to interact with a product. This unique insight requires an authentic founder. According to Roelof Botha, an authentic founder is someone solving a problem of their own deep personal frustration. Mike Maples and Bill Gurley note authenticity also indicate domain expertise, a deep understanding of their target customers and the space they are operating in.
An authentic team has two benefits:
First, it’s hard for anyone to legitimately copy authentically derived ideas – these ideas unique and crazy, meaning it’ll be hard for anyone else to think of and have conviction in them. To compare, non-authentic ideas are 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.
Second, authenticity leads to perseverance. 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.
“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 for 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 constantly rejected by prominent investors when raising at a $1.5M valuation. They most recently raised at a $31B valuation – over 20,000 times that initial amount.
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.