Pandas were taken off the endangered species list earlier this year, but unicorns seem to have been added to it lately. VC-backed billion-dollar companies have exited more than new ones have been funded this year. This suggests investors are a lot more cautious about investing in startups than they used to be, preferring to get their older investments sold or sent public.
That means new startups courting investors may face even more scrutiny and skepticism than they would have even a year ago. These seven venture capitalists explain what their due-dilligence tests consist of right now, and what it takes to pass them.
1. Show That Customers Are Breaking Down Your Doors
“The number-one indication of the company being successful or not is its customers. That’s where I start with due diligence,” says Sonja Perkins, founder of the all-women angel/VC powerhouse group Broadway Angels. “I’ll directly talk or meet with customers and ask them the following three questions: First, ‘What is your problem?’ Second, ‘How are you solving this problem today?’ and lastly, ‘How would this new solution solve this problem for you?'” There better be a lot of customers to interview, she says, even potential ones.
Perkins continues, “I don’t ask two or three customers, I interview several. My favorite company is the one that’s doing well despite itself. Maybe the company’s founder isn’t too polished or the infrastructure is a bit weak, but if customers are dying to have the solution, I know I have a winning investment.”
Laurent Grill, an investor at Luma Launch in Los Angeles, goes even further when companies are young. “Likely, early adopters of a product (e.g., Kickstarter) will skew into a smaller demographic than the eventual larger market,” he points out. “We need to know an extended demographic that could adopt the company’s product at scale.” Grill continues:
Therefore, asking current customers of early companies about their experience can be misleading due to their intrinsic [knack] for risk-taking on companies or early products. Instead, I do a scalability risk analysis and reach out to the potential demographic for the company. This is an effective way to make educated assumptions on the ability for a company to bring their product to larger mass market.
2. Let Investors In On Your Product Evolution
Beyond adoring current or potential customers, a product’s evolution is a key mark of how well founders can adapt. But Kevin Zhang, principal at Upfront Ventures, says most startups today don’t have the robust financial models or expensive research reports he got used to seeing as a management consultant with the Boston Consulting Group. So as an investor, he’s had to turn to other metrics.
“That’s why I’m so focused on the product demo process,” Zhang says. “In the absence of significant quantitative data, the early product evolution is a mirror for a founder’s innate grasp of customers’ needs, and how they will iterate to solve them.” Before Upfront decided to fund entrepreneur Todd Hooper’s live-streaming VR platform VREAL, Zhang recalls, “I saw multiple versions of the product over six months of meetings. Each time, features were refined and stability improved with careful, user-centric reasoning behind every change.”