How leading venture capitalists evaluate potential startups

Venture capital investments have been the driving force behind the success of high-growth startups globally since 1975. Initiated at Wall Street, the first VC schemes in India were introduced in the late 1980s, when the Government of India granted legal status to these schemes. However, the subsequently established VC firms primarily operated within risk capital, and were highly different from the VCs that operate in India today. At the beginning of the 90s, only 8 VC firms operated in India, which gradually rose to 20+ in the next 10 years. At the time, the startup ecosystem in India was at the nascent stage and the evaluation procedures were vastly different from what is done today. However, as the Indian startup ecosystem took off, the paradigm shift required VC firms to adapt to the changing norms — leading to the development of new guidelines and procedures to evaluate potential startups.

These procedures have been designed to enable VC companies to identify and address potentially scalable and high-growth startups. By identifying these traits, venture capitalist firms not only assist these companies with financial backing but also vast operational expertise and guidance to ensure growth. For example, 20% of all public companies in the US received VC support in 2015, which accounted for 44% of the total research and development expenses among all publicly listed companies in the country. This is proportionate to how VCs assist startups in targeted areas with their financial, operational and other relevant expertise. By considering the growing startup ecosystem in India, the significance of this evaluation procedure becomes even more critical. The subsequent discussion is designed to highlight a few common factors that VC firms look for in early-stage startups.

Critical insights on the market & founders

Startups are required to participate in a comprehensive evaluation process to become eligible for VC backing. This holistic investigation identifies all challenges of investing in a startup — from garnering a deep understanding of how much of the market can be potentially captured to the founders’ ability to guide the business towards profitability. These aspects also address the questions of business models, future outlook and critical insights of the founders that differentiate the startup from its industry peers and competitors. Clarity, robustness and flexibility of these fundamental understanding measure how founders have perceived the challenge their startups are solving and to what extent.

Furthermore, VC firms measure the resilience, grit and perseverance of founders to identify and overcome obstacles. When founders possess these skills, it helps them to remain steadfast at difficult periods, and carve a path towards success by overcoming barriers to ensure sustainability and profitability. These skills also directly translate towards the founders’ having bias for action, helping them to implement innovative ways to fulfil their objective irrespective of challenges. Also, emphasis on founders and their general nature is extended to determine their alignment with values and ethics, while also understanding their capabilities to lead, motivate and inspire their respective teams.

A crucial indicator of this measurement is achieving a deep understanding of the sector where the startup operates. Coupled with the business idea, model and operation, a sound understanding of the competitors in the sector, along with what differentiates the startup from its peers and indicators such as efficiency and cost-effectiveness help VCs to positively evaluate startups.

Evaluating fundamentals

Apart from numerical data, the fundamental stakeholders of a startup — employees, are also evaluated by VC firms in their in-depth procedure. From understanding the qualifications and relevant background of the team to their ability to solve complex challenges, everything is put under the microscope to determine the potential of the startup. This process includes the boardroom members and their decision-making skills as well, particularly their financial understanding, budgetary decisions and fund allocation strategies are examined to reach a consensus regarding long-term financial capacities and competencies. This is often considered as one of the most critical parts of the evaluation, as these individuals act as the primary stakeholders who ensure success for startups and amplifying or reducing the chance of success rests on their decisions. Startups having a clear strategy addressing all these concerns, especially fund usage, are evaluated favourably by VC firms.

Potential for scalability and growth

Venture capital investments are designed to support companies that offer scalable solutions that result in business and revenue growth. However, early-stage startups go through different stages of brainstorming, research and development to attain such status, and VC firms extend their expertise in operations, product development and other targeted areas to mitigate inefficiencies, and vulnerabilities and enhance quality or security. When a startup’s solutions attain a scalable status, it can lead to exponential business and revenue growth, leading to competitive advantage and market dominance.

Summary

As India’s startup ecosystem develops, the significance of venture capitalist firms as a critical enabler of the domain is also rising. However, little information is available to the laymen on what constitutes the evaluation process of startups by VC firms, however, that is changing quickly. Venture capitalists predominantly focus on the basic principles of different startups — from scalability, growth potential, founders & other boardroom members and employees, along with fundamental data that constitutes market & competitor understanding, critical insights, revenue projections, fund utilisation and budget allocations. While different venture capital firms approach the evaluation process in their distinct ways, the basic principle of the evaluation process remains the same and directly translates to extending critical support and value creation of the startup ecosystem.