Evaluating VC Deals: A Comprehensive Guide for RIAs
Our most recent posts explored the diversification and appreciation benefits of adding venture capital to client investment portfolios. However, private investments can be challenging to assess and act upon for those unfamiliar with them. While this post is not personalized advice, it aims to provide some insights into a practical framework that RIAs could leverage in advising their clients looking to add individual venture capital investments to their investment mix.
Consistency Is the Key
Having a consistent approach to evaluating and approving venture capital investments is the key to long-term success. Waves of innovation characterize the field of venture capital, and often, a great deal of enthusiasm accompanies those waves when they crest and pessimism when they crash. Maintaining consistency in your decision-making process and perspective, regardless of outside factors, is paramount.
At Alumni Ventures, we have created an investment “scorecard” that ensures a consistent approach to reviewing and evaluating opportunities. Two critical elements of that evaluation are the company’s unique characteristics and the quality of the team leading it. Please join us for our upcoming webinar, in which we will discuss AV’s disciplined approach to evaluating venture opportunities and how RIAs can apply a similar concept to their clients’ portfolios.
The attractiveness of a company for investment purposes can be broadly divided into several different categories:
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Customer Demand
Is the target market large and growing? Does the company address a significant unmet need or pain point? - Home
Business Model
Does the company have a clear path to profitability and revenue generation? Is the model scalable and adaptable to market changes? - Home
Company Momentum
Has the company achieved early successes, such as early adopters, customer acquisition, or pilot projects? Does it have evidence of product-market fit? - Home
Capital Efficiency
How well has the management team used the capital that they have previously raised? Are they a scrappy team that's making every dollar last? Alternatively, is this a business that, by its nature, needs a lot of money to grow? - Home
Barriers to Entry
What differentiates the company today, and how will it protect its position as it grows? Can competitors easily enter a market, or are there inherent advantages, such as intellectual property or network effects, that provide meaningful protection?
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As for the founding team, AV places significant emphasis on their expertise, track record, and ability to execute the business plan. A strong founder-market fit is considered essential, ensuring that the team possesses the necessary skills and understanding to navigate the challenges of the specific industry. While the ability of the existing team is paramount, it is also essential to understand the company’s near-term hiring plans to add talent as they grow. The absence of a CFO or VP of Sales may not be a concern during the early stages of a company’s existence. However, their addition becomes crucial as the company looks to expand and scale its operations.
As a company passes through different stages of development, the balance between the importance of the founding team and demonstrated company performance, as it relates to valuation, shifts dramatically.
Here’s a breakdown of the fundamental changes:
Early Stages
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Focus on Idea and Team
At the seed and Series A stages, investors primarily focus on the quality of the business idea and the capabilities of the founding team. This includes evaluating the market opportunity, the competitive landscape, the uniqueness of the solution, and the team's track record, expertise, and passion. Hard data is scarce, so judgment relies heavily on qualitative assessments and gut feeling. - Home
Limited Validation
Due to the early stage, concrete metrics like revenue or user traction are often limited. Instead, investors look for indicators of potential, such as early adopter feedback, prototype demonstrations, evidence of product market fit, and the team's ability to demonstrate execution capability and iterate quickly.
Later Stages
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Shift to Traction, Execution, and Scaling
As companies progress through Series B and C, the focus shifts from potential to demonstrated traction. Investors want to see evidence of product-market fit, validated by metrics like user growth, revenue generation, customer engagement, and market share gains. At this stage, investors are looking to put gas on the fire…providing capital for the business to scale. The quality of the team still matters, but their ability to execute the plan and deliver results becomes paramount. The company needs to demonstrate that it has moved beyond a dependence on founder-led sales to a more repeatable sales process. - Home
Data-Driven Insights
Hard data becomes increasingly available, allowing for data-driven analysis of key metrics and performance indicators. This new information enables investors to make more informed decisions based on objective benchmarks and compare the company's performance with industry peers.
These are general trends, and the specific criteria used to judge a startup will vary depending on the industry, stage of development, and individual investor preferences. However, understanding the shift in focus from idea and team to execution, growth, and financial performance as the company develops is crucial for investors as they consider the merits of specific investment opportunities.
A good company does not always make a good investment.
Beyond evaluating the quality of the company and the founding team, an essential consideration for a VC investment is the price and terms at which it is being offered. A company with compelling fundamentals may not be a worthwhile investment if the price is too high, leaving little room for appreciation. Key factors in separating the quality of the company from the merits of an investment in it include the following:
Who is setting the price?
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An insider versus a new investor:
While insiders know the company best, they have different motives than a VC writing a check in the current round as a brand-new investor. All else equal, investing alongside a new investor is preferable as incentives are more purely aligned. However, there are certainly exceptions to this setup. Sometimes, a company is growing rapidly, and existing investors step up and offer their own term sheet to maintain their ownership and avoid dilution - a positive signal that we value. The trick is digging into the motivations of the players around the table to determine their alignment with your goals.
Are you following the smart money?
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Being in the right deals with the right lead investors:
At AV, we focus our portfolio on being in the right deals with the right lead investors. In making that determination, we closely examine the track record of the firm leading the investment. Do they have a record of success in companies that resemble the opportunity we are evaluating? Are they skilled at selecting and supporting companies in this industry or at this stage of development? - Home
Looking beyond the firm's track record:
Beyond the firm's track record, we also look at the specific partner who will be the point person on the investment to understand their level of expertise relative to the deal we're evaluating. We also try to get a sense of the partner's aptitude to be a good steward and advisor to a CEO because that very often can be a separate skill from company identification and the sort of analysis that goes into making an investment decision.
Are they leaning into the opportunity?
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The size of the lead investor’s check:
The size of the lead investor’s check relative to past commitments is the principal indicator that we look at to demonstrate that they have a high level of conviction towards a particular company — both in absolute dollar amounts and as a percentage of the amount the company is raising. We also consider the lead investor’s thesis for the deal. A thorough and well-reasoned investment decision adds further context to the conviction behind their check, regardless of size.
What is the price relative to comparable opportunities?
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How a deal is structured:
How a deal is structured, including the valuation of the company plus any other special rights like liquidation preferences or voting rights, will impact its attractiveness. - Home
The price/terms of the investment:
As one of the most active venture capital investors in the U.S., Alumni Ventures has a distinct vantage point on current market conditions. We combine this information with outside sources to develop a perspective on the price/terms of the investment relative to the market for similar deals. Companies priced meaningfully above or below the market need to be evaluated carefully. If the price is higher or lower, you must examine why that is the case and whether that enhances or detracts from its value. - Home
Lower than the market:
Are there problems with the deal? Is the market overreacting to these issues? - Home
Higher than the market:
Is there something uncommon or unique about this situation, such as a serial founder with past wins?
How soon will the company need to raise additional capital?
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Funding to reach the next milestone:
Venture-backed companies raise funding in tranches to give them the fuel they need to reach the next operational or technical milestone. - Home
The temptation to raise the minimum:
The temptation for a founding team or early investors is to raise the minimum amount they feel is needed to get to that next guidepost to minimize dilution. - Home
Is the company is raising enough capital?
As a new investor in a company, it is critical to determine if the company is raising enough capital to overcome any delays or difficulties it may experience along the way. Cash runway is an essential consideration because you want a company to achieve proof points and a step up in valuation before their next round. Companies in a cash crunch are also at the mercy of new investors.
Final Thoughts: Join Our Webinar
An RIA can improve its return profile and increase its diversification by adding venture capital to a client’s investment portfolio. However, evaluating venture capital opportunities — individual deals and funds — demands a targeted approach that recognizes the unique characteristics of the asset class.
Please join us for our upcoming webinar, in which we will discuss AV’s disciplined approach to evaluating venture opportunities and how RIAs can apply a similar concept to their clients’ portfolios.
Learn About Our Offerings for Wealth Managers
AV provides a range of solutions for wealth managers who want to maintain a competitive edge. Venture capital can bring multiple benefits to your clients’ alternative assets. Click below to discover more.
This communication is for informational purposes only and is not personalized advice regarding any matter. Alumni Ventures provides investment advice only to its affiliated investment funds. This communication is neither an offer to sell, nor a solicitation of an offer to purchase, any security. Such offers are made only pursuant to the formal offering documents for the investment funds concerned, which describe important information and risks associated with investment. Venture capital investing involves substantial risk, including risk of loss of all capital invested. Achievement of investment objectives cannot be guaranteed.