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In our previous post, we took a look at venture fund portfolio construction and the tradeoffs fund managers have to consider when building out their investment strategy. This blog post will explore the diligence process at the seed stage and will again use Tactyc to illustrate dynamics around the quantitative side of diligence, specifically return the fund analysis.
Diligence at the seed stage of venture capital involves a mix of qualitative and quantitative factors. There is no one way to run a diligence process, and often it comes down to the individual feel, style and preference of the investor. The following Tactyc model enables you to quickly run scenario analysis for your own fund to answer the “what we need to believe” question in order to hit your fund’s return thresholds. If you are interested in customizing this model for your fund, sign up at Tactyc today or drop us a note at firstname.lastname@example.org
Qualitative Diligence Factors
While this list is not exhaustive, qualitative diligence involves the following factors:
- Macro Theme or Thesis: Many firms are guided by one or more theses into which they place a potential investment opportunity. These theses help focus where they look for opportunities. At MaC, we employ a cultural investing thesis whereby we look at macro trends in human behavior that drive cultural changes that present opportunities for new companies. Examples include the conscious consumer, gaming takeover and the UNperfect parent.
- Founder and Team: Getting to know the team and why they are exceptional to solve the problem at hand is possibly the most important consideration at the seed stage. Understanding the “founder-market fit” or the “earned secret” are key in this analysis. Have the founders demonstrated grit, have they had prior exits, do they have prior experience working with their team, what is the level of their technical expertise, how strong is their network, how well can they sell and recruit, are they data-driven and do they have a compulsive, “messianic” attitude are all important questions to answer.
- Product/Service and Business Model: One must understand how unique and differentiated the product or service the company is building, and how well this product or service will solve the key problem the company is addressing. How will the company price this product or service and what is their target demo’s willingness/ability to pay. What will be the other ways in which the company makes money. It is often important here to undertake technical diligence to understand the feasibility of the product.
- Customer Demographics: Who is the company selling to? Are they individual users or enterprises? If enterprises are they large or small? Is the market they are selling to concentrated or fragmented? The answers to these questions should inform the company’s go to market and sales strategies.
- Go to Market Strategy and Sales Cycle: How will the company take this product or service to market and how will they acquire users and at what cost? What sales channels does the team feel will work best to reach and acquire new users? How long is the anticipated sales cycle?
- Product-Market Fit and Retention: Product-market fit (PMF) is when a company’s products or services are being demanded faster than they can deliver it. While it is rare for a company at the seed stage to have PMF, it is important to understand the factors that will contribute to it and how the company will measure it. Related to this is retention, or how well a company keeps its customers. Even if a company is acquiring many users, there will be reason for concern if they are losing too many of them due to lack of stickiness of their product or service.
- Competition: Who are the competitors a company will face and how are those competitors addressing the problem to be solved? How well capitalized are the competitors? How differentiated is the company’s product or service from its competitors?
- Moats: What moats will protect the company from existing and new competition? Moats can be technical, or involve patents, but they can also be first to market, network-driven, speed, unique team capabilities and capital.
- Traction: What traction, if any, does the company have? How fast are sales growing month over month? How well is the company retaining customers? Are the companies entering into pilots with prospective customers and are they converting those pilots into paid commercial contracts? Are the value of those contracts getting larger? Is the company earning more over time from each customer or user?
- Deal Dynamics: It is important to consider how much the company is raising in the round and the economic factors in the round. Typically, companies raise enough capital to fund operations for around 18 months. It is important to know the company’s gross and net current and ramped burn rates to ensure that the amount being raised will be enough to get them to the next fundraising round. The valuation should not be too low to overly dilute the founders, and not be too high to make the next round’s valuation a challenge. If raising on SAFEs or notes,a founder must understand how they could be diluted in the following priced round.
- Risk Analysis: Every deal has risks and pinpointing the key risks facing the company over both the short and long terms is key. Risks can fall into several categories that include technology, legal, market timing, scale, execution, platform, capital intensity, incumbent and personnel.
Quantitative Diligence Factors
Quantitative diligence also takes many forms. The factors below are some of the key ones MaC focuses on at the seed stage:
- Market Sizing: A company can succeed in two ways: either take market share in their market, or increase the size of their market. Calculating the size of the total addressable (TAM) market, the serviceable available market (SAM), or the segment of the TAM targeted by the company’s products and services which is within their geographical reach, and the serviceable obtainable market (SOM), or the portion of the SAM the company can capture are all key.
- Customer Acquisition Cost and Lifetime Value: One of the most important considerations when determining the long-term viability of a company is to ensure they can earn more from a customer over that customer’s life with the company than it costs to acquire that customer. There are very specific ways to calculate customer acquisition costs and customer lifetime value.
- Unit Economics: This is related to the point above, but selling a product for $0.50 that costs $1.00 to make is not sustainable in the long run. Eventually a company must be able to profitably offer their product or service and understanding the current and future unit economics of their product or service is important to knowing the company’s long-term prospects.
- Company Pro-Forma Financials: All financial projections are only as good as the accuracy of their inputs, and at the seed stage it may be very difficult to have a firm grasp around the accuracy of the assumptions in a five or ten year financial projection. Every founder likes to project financials that are up and to the right, but the reality is that things are almost never that way. Regardless, understanding the core assumptions driving a company’s revenue and costs are key to understanding the fundamentals of their business and for this reason it is important to study their pro-forma financial model.
- Company Cap Table: At the seed stage, it is important that the founders own the vast majority of the business. Modeling out the cap table post the seed round is important not only to see the ownership percentage your fund will get in the round, but also what the founders will own going into the next round. Typically, series A investors like to see founders owning between 50% and 75% of a company going into an A round. If there are many outstanding SAFEs or convertible notes it is also critical to understand their effect on dilution when they convert to equity.
The final portion of quantitative diligence involves return the fund analysis. At MaC, a key part of our diligence is a firm understanding of core explicit and implicit assumptions around what needs to happen for a company to both return our fund and also return a multiple of our fund. Venture capital returns follow a power-law distribution meaning that outlier companies will deliver the vast majority of a fund’s returns. To be a top-quartile fund it is almost necessary to invest in a company that can return a fund and more.
To perform this analysis we start at the top with our fund size and gross return target. Typically, to be in the top 25% of all venture funds, a 3x net return is required or a 25%+ IRR. A 3x net return means that a fund will return three dollars after all fees and carry for every dollar invested into the fund (for simplicity’s sake we are using a targeted gross return in this analysis). This gives us the gross dollar amounts that our share in a single company has to be worth to achieve our objectives.
Company Ownership and Dilution
From there we calculate our anticipated initial ownership in a company which is determined by the size of our investment and the post-money valuation of the company. If we are investing through a SAFE or a convertible note we estimate our ownership based on the valuation cap and a pro-forma analysis of the cap table where we look at what our ownership stake would be should all the existing SAFE and note holders convert to equity.
We then consider the future fundraising rounds the company will undergo, typically looking at series A through D rounds. We will model out the estimated size and pre/post money valuations of those rounds and what our dilution in those rounds would be. We also consider if we will take some or all of our pro-rata share in those rounds to reduce dilution. Typically, to maximize returns, a fund needs to consistently participate in future rounds through its pro-rata rights.
Finally, we may factor in additional dilution that may occur in rounds past the series D round. The net result of this process is our estimated ownership in the company at the time of exit.
Implied Company Valuation
Dividing this percentage by both our fund size and our targeted gross return will tell us at what value a company has to exit at for our share of the company to be at a level to reach our fund-return and gross-return objectives.
Implied Company Revenues
Next we apply an industry-average revenue valuation exit multiple to those valuations to determine the level of revenue needed for a company to reach those valuations. Dividing the valuation numbers by the revenue multiple gives us these figures.
ARPU and Paying Customer Targets
We then take the analysis into one of two directions: we either take an assumed average revenue per user (ARPU) figure informed by the company’s business model, or an assumed number of paying customers/users based on company projections or anticipated share of the market. Using an assumed ARPU, we can divide the targeted revenue numbers by the ARPU to get an implied number of paying customers needed to hit those sales targets. Using an assumed number of paying customers and dividing that number by the sales targets would give us an implied ARPU to hit the same targets.
We then compare the ARPU and paying customer numbers to what we see in the market to help us gauge our confidence of the likelihood that this company can return our fund and also allow us to hit our targeted gross return figure. For example, if the end result of this analysis is that a company would need 1M paying customers paying an industry-average ARPU and the current market for this product or service is 2M, then the company would need to achieve 50% market share, or dramatically increase the size of the market to hit our objectives. That might make us think twice about investing. Alternatively, if the company can earn at or below an industry-average ARPU and still only need a volume of customers that makes up less than 1% of a market, there is reason to be bullish about making an investment.
Sensitivity Analysis on Revenue Multiple and Exit Revenue
In this section we evaluate implied exit values, the value to fund (after taking into account the fund’s ownership in the company) and the MoIC on the investment
Obviously, all the quantitative analysis mentioned above are just approximations. At the seed stage this is far from an exact science. But doing this diligence is important, and can often provide a worthy gut-check during the process. And equally important is understanding how changing the various inputs in the process from fund size and targeted gross return to initial ownership stake, to future round details and the taking of pro-rata, to assumptions around valuation, ARPU and paying users all affect the dynamics of return the fund analysis. Using Tactyc to explore how all these factors relate to each other is a fun and simple way to better understand this process.
By Michael Palank (MaC Venture Capital) and Anubhav Srivastava (Tactyc)
We hope you enjoyed this quick primer. This interactive analysis was built on Tactyc, a platform to build and work with interactive models for smarter scenario analysis. If you are interested in transforming your firm’s model templates into re-usable dashboards such as these for fast scenario analysis, please drop us a note at email@example.com
For any questions about the underlying model or analysis please reach out firstname.lastname@example.org or email@example.com
About MaC Venture Capital
MaC Venture Capital is a seed-stage venture capital firm that invests in technology startups leveraging shifts in cultural trends and behaviors. Our diverse backgrounds in technology, business, government, entertainment, and finance allow us to accelerate entrepreneurs on the verge of their breakthrough moment. We provide hands-on support crucial for building and scaling category-leading companies, including operations strategy, brand building, recruiting, and mission-critical introductions.
Tactyc is a no-code platform that transforms spreadsheet models into interactive web apps that enable smarter scenario analysis. Powered by the Tactyc Spreadsheet Engine that translates spreadsheet logic automatically into code, Tactyc enables users to create interactive presentations with narratives, extract model insights and build embeddable calculators in seconds. Tactyc was founded in 2020 by Anubhav Srivastava and is based in Los Angeles, CA.