Analyze
When a company passes our screen, we begin to analyze it. We have a multi-hour kickoff meeting with the CEO and other founders to dig in and understand in detail the drivers of risk and value for the company.
We have a template with dozens of questions, but they are arranged into four main categories:
Product/Technical
Market
Team
Economics
For product, we are asking, “will it work?” and “what are the technical hurdles or risks?” An enterprise software company usually has low technical risk. An AI or diagnostic technology to predict Y given X has a risk that it may not predict Y with sufficient accuracy to make it salable. A therapy or medical device needs to be safe and efficacious. Just because it worked in mice does not mean it will work in humans. We want to see the breadth and quality of the available data. We will read through published papers on the technology and delineate the extent of what is known and unknown.
For market, we are asking, “assuming the product works technically as hoped, will people care enough to buy it?” If the product is a cure for pancreatic cancer, the market is quite clear (large). Usually, therapies tend to have more product risk than market risk. Software and other products can be the opposite. Sure, you can make it, but will anyone care enough to buy it? How much better is this than current solutions? Is it so much better that people will overcome inertia and endure switching costs? How many customers would switch? How much would each pay? Why? How many competitors do you have now, and which will you attract if you start to succeed? Do you have a defensible moat that will protect your revenue castle if you do build it? And even in health care, awesome technologies can fail to launch due to perverse incentives. There was a company with brilliant AI technology and a small device for detecting melanoma. It was proven to be more accurate than 90% of the top dermatologists in correctly identifying melanomas. If dermatologists used it, millions of annual unneeded biopsies could be avoided. Millions of patients would be spared the pain and scarring of the biopsy. Insurance systems would save money. Who would not like that? Dermatologists. The dermatologists didn’t like it since a) they get paid more for doing a biopsy than for using this device, and b) they face potential liability for the 1 in 1,000 false negatives that lead to a worse patient outcome. Since the dermatologists were the decision-makers, this technology and the company that produced it died a slow, painful death. Market matters.
For team, we ask: Can the CEO (especially) and the rest of the team execute? What are the strengths, and where are the holes? Are the co-founders all technical, and if so, how will they build a sales team? Does the CEO recognize team weaknesses, and if so, what is their plan to overcome those weaknesses? Does the team function effectively together? Do the CEO and team show extreme intelligence, passion, and integrity? How do the “advisors” actually interact with the team? Who is on the board, and what accountability is in place? In the Verify stage, we will often play advisor for an hour or two and work through a challenge or dilemma the team is grappling with. That interaction can provide great insight into the team’s strengths and weaknesses.
For economics, we look at three different levels: unit, company, and deal. Unit economics start with product pricing. How much will customers pay per unit of product (widget, seat of software, dose of medicine, etc.)? How has that price been determined and validated? What is the cost to make and sell the widget? Does the price and value of the software lend itself to a direct enterprise sales model? If not, what are customer acquisition costs? How long do customers stay around? I met a company with a delivery service in a large niche. They were growing very well on the revenue side. However, each delivery they made brought them $6 in revenue but cost $7 in labor. Company economic factors determine burn rate and how quickly the company will run out of money and need to raise more capital at the cost of more dilution. Unit profit and unit sales costs are an important starting point, but so are management salaries (are they excessive?) and other fixed costs, including rent and total payroll expense. Deal economics have to do with the projected return on this investment we are considering. The company's post-deal valuation is key. A $100m exit on a $10m post-investment value would be a 10x multiple. On a $5m post-investment value that would be 20x. Those two simplified scenarios assume no further dilution. Company economics will drive the need for future capital, and that will affect future dilution. If you invest at a $10m post-money valuation, the company later sells 33% of the company in future financings and then exits for $100m, your return drops from 10x to 6.7x. At this Analyze stage, we gather the economic factors (deal terms, burn rate, runway, future dilution, etc.) to serve as inputs to the next stage, Quantify, where we quantify a risk-adjusted return.
(To learn about the next stage in our process, click on “Quantify” at the bottom right of this page.)