How Investors Evaluate Startups

We spoke to Jacqueline van den Ende, partner at Peak Capital, to discuss how investors evaluate startups.

DISCLAIMER: This interview was recorded and introduced as a lecture for our free online 10-week program, StartupLeap. It has been edited for clarity purposes. Watch the recording for the full conversation.

What do you look for in a startup from your personal role, but also from your Peak Capital position? 
“In Peak Capital we use what we call the T-score, and the T- score gives a score on team, traction, thesis and timing, and so in the earlier stage it is more about the team. One of the absolute triggers for a great team is prior entrepreneurial experience and for me even if you were selling lemonade at the age of 14 or 15, that already means that they have some hustling, entrepreneurial, commercial skills”

How do you show that you have prior entrepreneurial experience?
“You can see it in a bit of a path in somebody being entrepreneurial from an early age or somebody trying things. And the reason why that is so important is because inevitably when you start your first company, and it goes for me exactly the same, you make a ton of mistakes. And so doing it again you get to avoid the mistakes you made in the first run and you know much better what to expect. Statistically the chances of succeeding on the second or third run are much higher than on the first run. That is the first aspect.

The second aspect we look into is a complementary team. So we look for and I think that’s a typical startup slang: the hacker, the hustler and the hipster. And so we always wanted the hacker as CTO type of person to be in the team, as we invest in tech startups, it needs to be inherently tech.”

What about outsourcing and those kinds of constructions at least at first? Not all startups can find a CTO at day 1? 
“I think that’s okay. It depends on what kind of business you have. If you are a deep tech business outsourcing is not an option, if you are more of an e-commerce player and tech is less central you can make it through with freelance developers in Hungary as long as ultimately the tech leadership, so the CTO, the architect is in your founding team and has a significant stake. So what we also don’t necessarily like is hired CTOs, people that are on the payroll, but don’t have a strong equity stake.”

What about the thesis? 
“The thesis is what you do and what is a problem that you solve and how do you solve it? How much value do you add to your customer? An example can be Slack. Slack is a hugely valuable company because you use it every single day and it’s at the core of your business. And now you can compare it to something that is more of a feature say chatbots. They can either be core to the business, but it can also just be a nice to have feature on top of your business, so the question is how central, how much value do you create and there is great test for that on product market fit. It’s called the Sean Ellis test. So the Sean Ellis test asks your customers, what would your life look like or how would you feel if we ceased to exist. So if that is a major problem to your customer you know you are creating a ton of value and it’s not a nice to have but need to have. The painkiller so to say. You should have over 40% to have product market fit.

So when we look at the value of the solutions, we look at the market size, and a third thing we obviously look at is how competitive is a space. Again for example in the field of chatbots you see that it’s getting wildly competitive or you address a very particular niche in which you can create a certain value.”

How do you influence timing? 
“Timing for us is a bit of a question of all the above mentioned, but timing is also how much money have you raised to date. If you raised say a million or 2 and you are now at 20K MRR (Monthly Recurring Revenue), one of the key KPIs for any SaaS type of business, that raises some questions. We also look at founder equity so has somebody diluted quite a lot. So if you waste too much money in an early stage then what happens is that founders dilute below a certain threshold and when founders have let’s say less than 50% equity at the phase of a seed round, that’s problematic because you are going to dilute much further down. Then the question for investors, as investors always have a risk perspective is how motivated is somebody to stay. When it gets rough and it will get rough, then people might decide to quit, and move on to their next big idea, which leaves investors hanging.”

You said you are quite an early stage investment fund. Are you usually the first investor in the company or follow up investor?
“So we are normally the seed investors and often the companies that we invest in are either bootstrapped or have angel funding. But normally we are the first institutional investor that comes on board.”

When should startups look for funding? 
“When they need money is a good point to start. But it depends on the phase and the type of investors. So when you are just off the ground, you have an idea, you are looking for product/market fit. You have no or various commercial traction, at that point you should consider an angel. And in that phase the value added is not just money, but also network. So you should look for an investor who is active in your space, who can really be a collaborator. Then you look towards a VC, and a VC like Peak Capital can come when you have some sort of early proof of product market/fit. And what gives a proof of product market fit is starting to have some commercial traction. So we invest either in very experienced entrepreneurs with a proven track record, which can be pre-revenued, or at the moment when you start to get a little traction and that can be very steep growth in a three months time frame or decent growth in a 12 months time frame.

The Venture Capital model is that you make 10x return on any investment that you do, because part of your investments will likely go bankrupt. That actually never happened with Peak Capital, but that is typically the VC model. And a couple will make it to a medium sized business and so the VC model relies on you also investing in a type of ‘unicorn’. We look for companies that have that ambition to really do something very big.”

How do you find the right investor for your company? 
“It’s very wise to do some desk research and ask people from your environment. The best is to have someone that is active in your space. So you should know very well what is the phase that a VC invests in. Is it an early stage? Do they have a minimum revenue threshold? Say 100K MRR or lower? Do they invest in your type of business and you have most of the investors define whether they are B2B or B2C. Is there any particular Business Model required? I generally recommend to really start from your own network, because a warm intro is so much more powerful than a cold intro. On average we receive 10-15 pitch decks per week (more than 500 per year), while our target is to do approximately 6 investments per year, making the funnel really narrow.”

Is the warm introduction the best way to get to you or one of your partners?
“Yes. Though, people are absolutely free to message me on Linkedin and I will always try to reply and to take it seriously, but if you can find someone in your network to introduce you, you will have an advantage. “

What are the key triggers, both positive and negative, when you see a pitch deck for the first time? 
“When you evaluate a proposition it’s often a combination of factors. The triggers on a personal level are confidence and big ambition. There are a lot of people who would like to build a mid-sized business, but a big vision is great. Again, experience and that somebody has a drive, that they will make it on their own even if they don’t get the investment, is very strong. It’s good to have eye level conversation,  not like ‘oh I pray they invest in my startup”. There is definitely a difference in the level of experience that you have, but I encourage startups to not be afraid. You have great ideas, and you would make it on your own. You should not have any kind of dependency on VCs. And if VCs want to join you, that’s great.

On a thesis level I’d like to know what’s different. There are a lot of people pursuing the same idea, that’s any idea other 20 people are working on as well.”

How different should the idea be, since it can also affect the adoption rate?
“You need to have a clear story on why your solution is better than what exists, and also how you will execute. We look at both.”

When you think something is becoming interesting, what are the next steps?
“Certainly, a process of several meetings with me and other startups.

First thing to establish is do we really connect with the team. It’s about building a relationship on a personal level. You don’t know after one date if you will marry your future husband or wife. So you need to build that relationship and get to know who you will be working with. The other aspect of the meetings is understanding the business. You should expect 3-4 meetings on a partner level and you will have to share everything about your business, your deck, your financials. There will be a lot of digging and generally it should take around 3-4 months. Every time you get to the next meeting, that’s a positive sign. If you manage to reach the 4th meeting, it’s likely you will be getting a term sheet. And that’s where you negotiate diligence.”

Do you usually set the terms? 
“We will issue the term sheet. The terms are not really complicated, they are generally straightforward at the seed stage. But founders should push back on certain terms. Never accept the valuation directly.”

Did you ever walk out of a deal because you could not reach an agreement?
“Yes actually just this morning. Very tough negotiations.

But there are also points where you have to walk away from a certain deal.”

What are the basic pitfalls around the term sheet? 
“I would say, get some advice, from someone who has done it before. Make sure you understand the terms. Also not all terms are critical, and a common mistake is that startups make a big deal of things that are not that big. You should see the VC thing as a very long term play. You enter a 10-year relationship and getting stuck in the nitty gritty is not a good idea. Focus on the terms that are really important. Examples are valuation terms, also lockup and leave terms are probably important for startups. Lock up and leave terms are basically defined as: as a founder you cannot sell your shares before a certain term. Vesting terms are always important. As the founder you hold all the equity, but a VC will make you agree that if you leave before a certain term then you don’t get part of your equity.”

How should founders without a particular network approach investors? 
“There is always Linkedin. If you do your research well, you can find the right VCs and connect with a VC partner on Linkedin, I think that’s okay. I get that and that’s okay with me. Never ever send a cold email. Sending a mass email to a whole bunch of investors in the bcc saying ‘hi that’s my great idea’ that’s an instant no. So I would go through the Linkedin route. But make sure that the VC is actually in your space.”

What would be your advice to an early stage startup looking for investment?
“I think you need to realise that the VC investment is playing a long game. I think it’s quite okay to already start connecting with VCs even before you are ready to raise funds. Maybe you can say ‘could we have a coffee’ ‘I’d love to get your inputs on my idea’ so you already start building that relationship very early on.”

When is a VC interested in starting to build that relationship?
“Again it helps if you have a personal relationship, or you know ‘I see you are very active in that space would you like to go for a coffee’.  Spending money to take investors to lunch is too much for a startup. Don’t try to bribe investors. I had a person who bought me presents and I did not yet invest in this person so that’s not the best idea.

I would say playing the long game and accepting that you will get rejected. It’s inevitable. If you are a startup you will pitch to several VCs and you will get rejected and it is important to handle this, because if you never respond again or you respond in a negative way and we’ve had that, then you are not getting it. A VC may not want invest now, but it may invest in 3 months, 6 months,  the next round, or they might discuss you with other VCs in the VC world (it’s a very small world) so you really need to play the long game and build a long term healthy relationship, no matter what disappointments you meet on your journey.”

Do you know any stories from your partners that decided not to invest and later on regretted it?
“It’s part of the VC model that you will win some you will lose some and you will also make some wrong judgement calls. An example is Tiqets, which recently raised 50 million from Airbnb, I think. We were in the term sheet phase with that company and then the Paris attacks happened, so business kind of collapsed. There were some things with the communication around that, so we decided not to invest. But things for that company went very well, but we missed it. Still, it’s part of the VC model.”