Key Factors VCs Consider in Early Stage Startups: A Guide

Venture capitalists (VCs) play a crucial role in fueling the growth of early-stage startups. However, securing VC funding is not an easy feat, as investors carefully evaluate numerous factors before making their investment decisions. In this blog post, we will explore the key elements that VCs typically look for in startups during the seed to Series-A stages.

A Strong and Committed Team

A startup’s success heavily relies on the capabilities and cohesion of its founding team. VCs seek teams comprised of 2-3 founders who possess diverse skill sets and a deep understanding of the industry they operate in and have the ability to work well together.

While solo founders with great mental fortitude and all the necessary skills can succeed, having a team helps in navigating the challenges of entrepreneurship and adds value through collaboration.

During the diligence process, it is important to involve the entire founding team to demonstrate alignment and commitment to the company’s vision. Your whole team will need to have the experience, commit to the goals, sell to anyone, have a great network, and work well together. And then your goal becomes to prove to the investor WHY your team is the best team to handle this problem.

Early Signs of Traction

Demonstrating early signs of traction is a significant factor that captures the attention of VCs. Startups should showcase an MVP (Minimum Viable Product) that generates revenue from customers, not just friends and family, and is obtaining product market fit.

Metrics such as Activation %, Daily Active Users (DAU), Customer Acquisition Cost (CAC), Long-Term Value (LTV), Monthly/Annual Recurring Revenue (MRR/ARR), Retention %, Subscriber Churn Rate, Virality, Profit percentage, and Cash balance provide valuable insights into a startup’s growth potential.

In the early stages emphasize realistic numbers and unit economics in a bottom-up financial analysis rather than relying on unrealistic projections of TAM and SAM, as investors value credibility over exaggerated revenue forecasts.

Relying solely on a top-down approach can lead to opacity due to subjective and excessively optimistic forecasts. If your startup is in the early stages there are a lot of assumptions regarding your business model and its execution so top-down is not the best approach, but it can be used for setting milestones, assuming no major changes happen in the markets.

NOTE: TAM represents the total market opportunity if there were no competitors and all potential customers in the market were accessible. SAM is the portion of the market that a company can realistically target, and takes into consideration factors such as geographical limitations, distribution channels, and the company’s ability to effectively reach potential customers, usually in $Millions or $Billions and VCs only invest in the ones in $Billions, while the ones in $Millions have all other forms of funding from Angel to Debt to Crowdfunding. SOM is the portion of the market that a company can actually capture and serve effectively considering its resources, capabilities, and competitive landscape (whether you have an economic moat or not).

Building Trust Through Validation

As a startup progresses, it becomes essential to validate the trustworthiness of the company. VCs may conduct customer interviews or request references to gain insights into customer engagement and satisfaction during the due diligence at later stages. Providing customer video testimonials or arranging visits to showcase the validation of your product or service can significantly enhance your chances of securing funding.

Clear Focus and Path to Profitability

Having a clear focus and a well-defined roadmap is crucial for startup founders in the early stages, it shows that you may not have achieved it all but have a clear vision for what your company, product, and market will look like once you get to those goals.

VCs also expect entrepreneurs to understand their funding needs for the next 16-18 months and articulate how the capital will be utilized effectively. It is important to show that you make fast decisions, avoid distractions from shiny new trends and non-priority tasks, and instead, maintain a steady focus on achieving profitability. Understanding the “why” behind your actions and being able to communicate it effectively is key.

Capital Efficiency

VCs are interested in startups that exhibit capital efficiency by achieving an attractive Customer Acquisition Cost (CAC) to Lifetime Value (LTV) ratio.

Unique Value Proposition

Startups should differentiate themselves by offering a unique value proposition (UVP) that creates a larger market instead of competing for a larger share of an existing market. Furthermore, possessing intellectual property (IP) or competitive advantage can help build a strong barrier to entry and position the startup favorably in the market. Less competition is usually found in boring markets, solving boring problems.

Competitive Advantage can be determined by asking the questions:

What do you know that others don’t? Have you done any real research? Do you have knowledge about a problem/market that isn’t obvious from your experience? How did you identify the problem?

Can you and your cofounders sell better than any competitor in the market? This is important as you will be selling yourself, the company, and your vision to VCs, potential employees/partners, and even your customers.

Do you have great partnerships that give you better data/knowledge/insights, more assets, or better relationships?

Can you execute faster, update your product or increase customers every week?

Financial Acumen and Responsible Growth

Financial questions are inevitable during VC due diligence, even at early stages. Founders need to demonstrate financial acumen and a deep understanding of their business model. VCs inquire about revenue and metrics such as churn rate, cost efficiency, burn rate, and sustainable growth plans. Having comprehensive answers to these questions signifies a strong grasp of the financial aspects of the business. It showcases that the startup understands its operations, can generate cash and profits, and is not solely reliant on VC funding for sustainability. The actual numbers matter far less than the founder’s understanding of the metrics.

Knowing Churn signifies that you understand the reason for your churn enough that you are actively trying to reduce it to zero.

Cost Efficiency shows that you can control your costs and spend ONLY on crucial things (having a cool office space and free food for the team is not crucial for a company that can run its entire operations remotely)

Burn and Sustainability showcases you know exactly what is happening with the money you are making and spending. If you cannot sustain your business for 3-5yrs WITHOUT funding it is best to look at what is going wrong in your operations and fix it, or have a plan to fix it. This shows you know your business inside out enough that you can generate cash & profits. VC funding will only accelerate the process, not fix what is broken.

If you are a HARDWARE startup, also consider these things early on to make sure you are ready for any VC questions:

And read more about how to build great hardware teams and make your hardware startup attractive to investors.

Remember, securing VC funding is not just about the money—it’s about finding the right partners who believe in your vision and can contribute to your growth and success and that can only happen if you are honest and upfront about your business.

To figure out if an idea you have is investable by VCs you can use the calculators I have created.