Need Funding for Your Startup? Here’s What VCs Want to See

Mike Peña, Stanford University April 11, 2018

Matt Schwartz is helping grocery stores be more precise about how they order and stock food. His startup, Afresh Technologies, uses artificial intelligence to predict customer demand and recommend just the right amount of meat, produce and other highly perishable items to re-order.

Given the immense amount of food that U.S. grocers throw out each year – one in seven truckloads of perishables, according to a recent estimate – the need for more efficiency is clear. But how did Schwartz convince investors to give him the money he needs to launch his startup? Statistics, as compelling as they may be, don’t guarantee huge returns.

It’s a common question for first-time entrepreneurs. What do venture capitalists look for in the firms that come to them for funding? Setting aside the most important factor that VCs look for – whether the founders have what it takes to lead the company – the metrics used to determine the worthiness of a startup depend on how new it is, who its customers are and how much revenue it’s bringing in already.

Jeff Epstein, an operating partner at the firm Bessemer Venture Partners and an entrepreneurship lecturer at Stanford University, has developed a checklist of sorts for the startup-minded students in a Lean LaunchPad course he co-teaches with serial entrepreneur Steve Blank.

The more the entrepreneur can remove the risk, Epstein explains, the more investors will be interested – and the higher the valuation.

The key milestones, metrics and criteria that Epstein put together are generally how many VCs assess the health and potential of a startup early on – a most tenuous time for less experienced entrepreneurs.

“Venture capitalists see over 100 deals each year and often only invest in only one,” Epstein says. “So, what first-time entrepreneurs want to know is why did that venture capitalist choose this one?”

VCs usually specialize by stage, sector and geography. They look for insights and data that minimize their investment risk. The more the entrepreneur can remove the risk, Epstein explains, the more investors will be interested – and the higher the valuation.

Here are some key milestones, and the removal of risk each milestone represents:

Seed stage: Trying to prove product-market fit and raise approximately $2.5 million.

What entrepreneurs need to show investors:

  • A credible story that someone on the team will build the product.
  • A prototype that demonstrates the product’s key features.
  • Data from customers who have used your “minimum viable product” and given feedback
  • Actual usage metrics from customers who are using your product
  • Proof of product-market fit:
    • For business-to-business (B2B) startups, at least 10 paying customers who can serve as references
    • For consumer-facing startups with paying customers, at least 100 paying customers who can serve as references
    • For consumer-facing startups offering a free service, at least 100,000 monthly active users

Series A: Trying to prove your revenue model and raise approximately $6 million

What entrepreneurs need to show investors:

  • For a B2B startup, a proven go-to-market model when:
    • “Customer acquisition cost” payback period is less than two years
    • Three-fourths of your sales people are meeting quota
  • For a consumer-facing startup, generate at least two times the amount spent on customer acquisition on a “contribution margin basis” within 18 months (contribution margin = revenue minus cost of goods sold, minus variable operating costs)
  • Proven customer success: Existing customers are buying more, so annual revenue continues to increase year after year, before the added revenue from new customers
  • Proven scalability: Contribution margin (sales minus variable costs) is greater than 75 percent
  • Proven market demand: Annual recurring revenue is greater than $5 million
  • Proven traction: Annual recurring revenue growth is greater than 100 percent

Other criteria investors will look for:

  • A proven leadership team, where all key roles are in place for a year and have shown expertise in execution
  • A proven market size, with IPO potential of $100 million in annual gross profit in years six to eight
  • Proven diversification of customers, partners and suppliers, where none account for more than 1 percent of revenue
  • Proven founder-product fit, where the founder understands the customer deeply from first-hand experience
  • Proven technological advantage, where the startup has a unique technical expertise or insight
  • Proven competitive edge, where the startup has a unique economic model or advantage
  • Proven network effects, where the value for the startup’s customers and suppliers increase as more of each join

And, of course, investors will ask the all-important question: “Why now?” Epstein points to Uber’s perfect timing by starting soon after smartphones became widely used by both passengers and drivers.

Bob Tinker, co-founder of leading enterprise digital-security company MobileIron, describes this as alignment on the “problem wave.” Like a surfer positioned in front of a swell, ventures that are poised to meet a wave of demand with a relevant product and a repeatable sales process will find themselves riding high on the momentum of the market.

Schwartz began working on Afresh when he was in the Lean LaunchPad course last year, and so remembers the investor criteria Epstein compiled. Since incorporating in April 2017, Schwartz and his two co-founders have been working with actual grocery data and are now entering their first real-time pilots. They’ve completed their seed round of funding and are preparing to make their case for Series A funding.

Because the size of their contracts are larger than the examples used in the course — Schwartz says they’re aiming for deals in the seven-figure range — the checklist is a bit staggered when applied to Afresh. But the framework is sound.

“The milestones taught us that it’s very important to prove go-to-market components to successfully raise a Series A,” Schwartz says. “This has sharpened our focus on creating evidence around the efficacy and repeatability of all of the components of our sales cycle.”

In the end, Epstein says entrepreneurs who can demonstrate to investors they have reduced or removed key product, market and technology risks are more likely to have a successful fundraising process.