VC Masterclass: The Art of Evaluating a Deal — Part 3

In previous parts of this series, we examined Deal Dynamics and the Lead Investor. This time, we’re focused on execution, which examines how the company plans to make money profitably, the size of the opportunity, traction points to date, future potential, and what competitive advantages it can build. These critical issues help us evaluate the odds and size of success.

To learn more, you can also watch our on-demand webinar here.

Part 3: Execution

The most heavily weighted segment of our deal evaluation framework is what we refer to as “execution,” but it’s designed to evaluate significantly more. Assessing current business traction at the time of investment is important, but we believe it’s equally important to understand a company’s economic potential over the long term.

Most of the value attributed to venture-stage assets is driven by potential future results, so our analysis needs to be forward-looking. We focus on three primary areas to assess the potential of an investment:

1. Magnitude of future revenue: addressable market and growth potential
2. Quality of future revenue: margin profile, scalability
3. Durability of future revenue: competitive moats

These inputs help us gauge sustainable earnings potential, a key driver of a company’s value creation over time. While the odds are against most companies actually realizing their full potential, we use this information to anchor our assessment of an investment’s attractiveness at any point along the journey.

To understand a company’s future revenue, we assess the dollar potential of customer demand and the evidence of momentum against that demand. Specifically, we address these questions:

The answers to these questions help quantify how large an opportunity could become over our investment horizon. Given the power law nature of VC investment returns,* it’s critical that portfolio winners have the headroom to grow sustainably for an extended period of time.

*The Power Law applied to investing asserts that a handful of investments generate the bulk of returns.

While large revenue potential is necessary to make an investment compelling, it’s not sufficient. We also analyze revenue “quality,” looking at a company’s unit level economics, long-term customer value, customer acquisition costs, business process repeatability, and other factors. We have several key performance indicators that we use to assess these variables, both in absolute terms and relative to benchmarks drawn from our portfolio and the venture markets at large.

One specific focus of diligence stems from the fact that rates of revenue growth can be manipulated in the short term by uneconomic behavior. We need to convince ourselves that a company’s revenue trajectory is the product of a sustainable business model rather than simply trading dollars.

The final leg of the stool is what we call the “durability” of future revenue. One of the most attractive elements of the innovation-driven businesses we target is that they tend to erect competitive moats around their customer relationships. These moats can be very valuable in creating highly defensible business franchises with attractive rates of return on invested capital. Such businesses are particularly important to investors like AV because we own illiquid investments with a long investment horizon. As a result, we evaluate the potential for competitive moats based on proprietary intellectual property, business processes, network effects, switching costs, etc.

*No representation is intended that the results discussed are representative of the outcomes experienced by any AV fund or investor. Past performance does not guarantee future results.

Challenges

• Evaluation of pre-revenue companies is difficult. There are different confidence levels that we can assign to certain proof points that a company has achieved. When evaluating a company’s customer pipeline, we’ll look at the level of commitment / interest these potential customers are actually expressing. Written agreements with economic terms are much more indicative of traction than “beta-testing” or limited commitment pilots.
• Guessing on opportunity size in a nascent market. When the market is new, we need to make assumptions to determine how large it could become. Instead of choosing a single winner, we often prefer to find players that provide the “picks and shovels” to the potential competitors in that market to mitigate some of the investment risk.

To learn more, please watch our on-demand webinar here. You can also read the rest of our series on The Art of Evaluating a Deal (Deal Dynamics and Lead Investor).

This communication is from Alumni Ventures, a for-profit venture capital company that is not affiliated with or endorsed by any school. It is not personalized advice, and AV only provides advice to its client 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 fund(s) concerned, and describe significant risks and other material information that should be carefully considered before investing. For additional information, please see here. Venture capital investing involves substantial risk, including risk of loss of all capital invested. This communication includes forward-looking statements, generally consisting of any statement pertaining to any issue other than historical fact, including without limitation predictions, financial projections, the anticipated results of the execution of any plan or strategy, the expectation or belief of the speaker, or other events or circumstances to exist in the future. Forward-looking statements are not representations of actual fact, depend on certain assumptions that may not be realized, and are not guaranteed to occur. Any forward-looking statements included in this communication speak only as of the date of the communication. AV and its affiliates disclaim any obligation to update, amend, or alter such forward-looking statements, whether due to subsequent events, new information, or otherwise.

This communication provides some information regarding Alumni Ventures’ investment process, but is not intended to comprehensive and functions as a summary only. This communication is not personalized advice of any nature.