Evaluating Seed-Stage Startups
A Rubric for Evaluating Seed-Stage Investments 2.0
Have you ever wondered how a venture capital firm evaluates a potential investment? You’re not alone. We hope what follows will help you better prepare any documents you send us and enhance any conversations we may have.
At Ulu Ventures, we evaluate all potential investments using a standard rubric built on the following dimensions:
- Good Ulu Fit
- Big Market Opportunity
- Strong Team
- Compelling Product
- Focused Go-to-Market
- Financial Viability
- Clear and Aligned Values
We complete our evaluation across these dimensions over the course of our investment process. Our process is made up of a combination of meetings, analysis, and something we call “market mapping” (see here).
Elements of our rubric and its underlying criteria are discussed in the following sections.
Good Ulu Fit
We look at five factors when assessing basic fit: Geography, Stanford, Company Stage, Diversity, and Category. Startups need to meet at least three of the five criteria to be a good fit.
We look at five factors when assessing an investment opportunity: Geography, Stanford, Company Stage, Diversity, and Category. Startups need to meet at least three of the five criteria to be a good fit.
We make most of our investments in and around Silicon Valley. Having said that,we recognize there are other hotbeds of innovation and we have invested in companies located up and down the west coast, in the Northeastern corridor, and occasionally elsewhere in the US. We almost never invest in companies headquartered outside the US.
We have been associated with Stanford for many years, and find the ecosystem creates a rich opportunity set for early stage investments.
Stanford is a unique entrepreneurial ecosystem with 40,000 active companies founded by approximately 220,000 alumni and faculty generating $2.7 trillion in annual revenues in 2017, a staggering number that compares favorably to the sixth largest economy in the world that year according to the World Economic Forum.
Fifteen are well-known public companies with a market capitalization of $1.87 trillion in the midst of a global pandemic (Charles Schwab & Company, Cisco Systems, Dolby Laboratories, eBay, E*Trade, Electronic Arts, Google, Hewlett-Packard Enterprise & Hewlett-Packard Inc, Intuitive Surgical, Netflix, Nike, NVIDIA, Tesla Motors, and Zillow). Silicon Valley has been called a “Stanford spinoff” by former Secretary of State George Schultz.
Silicon Valley startups often cut across traditionally defined sectors, create new categories, or reposition existing categories.
Stanford’s excellence across a wide range of disciplines including top programs in computer science, engineering, medicine, business, law, education, and earth, energy and environmental sciences as well as over 200 interdisciplinary research centers and programs creates many of the best investment opportunities in Silicon Valley.
The vast majority of our investments are “Seed Stage,” which can mean pre-seed, seed, post-seed and even occasionally Series A. Ulu’s typical initial investment is around $750,000, though we have invested both more and less than that average amount.
Diversity is an essential part of Ulu’s investment thesis. It is grounded in the lived experience of our founders as well as abundant empirical evidence. To cite just one example, the authors of a Harvard Business Review article called “Why Diverse Teams are Smarter,” observe that diverse teams have a pronounced tendency to do the following:
- More actively seek information and evidence to support their decision making,
- Process information more carefully and thoroughly,
- Consider and implement more innovative ideas,
Our diversity thesis provides Ulu Ventures a meaningful advantage in sourcing and ultimately funding high performing founders and firms that other venture firms systematically overlook.
To illustrate the point, of themade 68 investments made through Ulu Ventures Fund II, 41% have diverse (women and minority including URM) CEOs and 59% have diverse founders.
For more on our views on diversity, see this page.
Our investment thesis is strongly rooted in our experience with Enterprise IT and Smart Data.
Enterprise IT: Enterprise customers are undergoing a profound demographic shift toward the preferences of digital natives, members of society who were so young when the Internet came into common usage that it’s all they’ve ever known
Members of this generation have different attitudes about access to information, transparency, privacy, collaboration, self-service, real-time, etc. They expect the ability to interact with sales, service, IT, and other groups seamlessly across email, text, chat, phone, social media and using rich media like pictures and video, just like they do in their personal lives. They expect the ability to take action and immediately see results and receive feedback.
Companies best able to catch up to these changing expectations will increasingly win the war for both talent and customers. Responding to these changing needs will require wholesale changes in business practices and the enterprise IT infrastructure that will power them.
Smart Data: At Ulu Ventures, we’re interested in founders with differentiated views on how to turn “Smart Data” into actionable information. We like startups solving the last mile problem of connecting analysis to better decisions, which is often a difficult challenge. This is where meaningful value is often created.
Big Market Opportunity
We love big market opportunities, but sheer size isn’t enough
Within the broad categories of Enterprise Software and Smart Data, competitive advantage begins with a fresh view on category definition and a strategy for establishing a previously unseen or undervalued view of either the market’s understanding of the problem or the solution set or both.
Ulu looks at a combination of short-term and long-term considerations when assessing market opportunity.
Compelling Customer Problem
The entrepreneur’s solution must address a top three problem for a customer with a budget. In most cases, we’re looking for either 1) a unique solution to a known problem, or a 2) compelling case for seeing the problem in a new way (a doable solution to a previously unknown problem). Solving the problem needs to move the needle on a metric the buyer cares about.
Total Addressable Market
Total Addressable Market (TAM) represents the total revenue potential from a group of customers available to anyone competing in the category. We start to get interested when the TAM is $3bn or higher.
Many founders take a top down approach to estimating market size. For example, the total size of the business lending market or the total domestic spending on adult education.
We find this kind of macro approach does little to illuminate the true market potential.
In contrast, we take a bottom-up approach, starting with the idea of a “sweet spot” or ideal customer. It can be useful to think about this target customer geographically, by customer type, by revenue, etc. The more precise and focused you can be, the better.
From the idea of a “sweet spot” customer, you should be able to describe and estimate the following characteristics:
- How many of those customers exist in your initial market.
- How much a typical customer will pay. This gets to the idea of your business model. For example, do they sign license agreements, and if so, is it by the seat, business unit, enterprise, or by usage? Or do they pay per transaction? Or something else?
- How much of the market is addressable, meaning what percentage of those target customers are likely buyers from you or any similar competitor. (Note: This is a different question than your likely market share at any point in time.)
When we do our own math, we focus on numbers five years from now using “low/base/high” estimates.
Multiplying those estimates together gets us a “sweet spot TAM.”
To the idea of a “sweet spot” TAM we add the “adjacent” TAM. We expect your adjacent markets to be significantly larger than the initial sweet spot (remember, we’re looking for focus in the seed stage). For some founders, that adjacency might be the same offer to new markets or customer types, new offers to the same markets, or some combination of those ideas.
Although you can do the same type of bottom-up analysis for the adjacent markets, we’re usually happy with a multiple of your sweet spot along with a descriptive justification.
Your full TAM is the sum of both initial and adjacent markets.
Are the team’s capabilities a good fit for accomplishing their key fundable milestones for Series A funding? We consider the following factors when answering this question.
In the enterprise, there are often good reasons for seemingly outmoded behaviors. A successful new solution usually must address, even respect, these underlying reasons. This subtlety makes it difficult for outsiders to empathize with their target market, especially when insiders can’t articulate why things are done a certain way. Hence entrepreneurs with domain expertise are often more likely to develop new solutions with a high chance of adoption.
Launching a startup takes a huge amount of effort. We favor entrepreneurs who are 100% committed to launching their startup with no significant outside commitments. Founder vesting is a strong signal that the entrepreneurs are committed to the long term and willing to align interests with investors.
Fit for Early Challenges
A key milestone for Series A funding is often an ARR run rate of $2m – $3m. This requires not just sales skills, but the ability to move from pilot projects to full blown enterprise implementations.
While the milestone is pretty specific, “team fit” is often context-dependent. For example, if the product is a “pain killer”or has few competitors or potential substitutes, the team may not need stellar sales skills. If customers are not aware they have a problem, or there are excellent or incumbent competitors, then demonstrated marketing and sales skills are usually crucial in the early team.
For most startups, technology is not a sustainable differentiator
Technology moves quickly and can be easily replicated, especially by big companies with bottomless resources: they are expert at breaching moats. So, we’re interested in an insight, a big idea, that does more than just surf a hot technology trend. Specifically, Ulu looks at the following factors.
This usually means customer traction (engaged users and paying customers), but it can also come in other forms. Traction is not required for us to invest, but it is a big plus. Even a small amount of traction means the product works, you’ve figured out how to sell to an enterprise customer, and you’re solving someone’s problem. We also assess how challenging it will be to build market traction that is credible to series A investors.
The Whole Product
By this, we mean the core product plus everything needed to create a compelling reason for customers to buy and enjoy using the product. Said another way…the full experience is the product.
Building a whole product is crucial for moving from selling to early adopters to the mass market. Early adopters are willing to accept significant headaches in order to be the first to adopt cool new technology. Mass market customers, however, are not willing to accept these headaches. They want things to work and value to be proven.
UIu values entrepreneurs who are sensitive to whole product issues such as the psychology of end users, the culture and context in which the solution will be deployed, and a disciplined process to observe what users do as opposed to what users say they do or will do.
Focused Go-to-Market Strategy
Ulu likes entrepreneurs who know how to efficiently disqualify sales prospects and prioritize their sales effort
From seed stage onward, entrepreneurs are most challenged to build an effective go-to-market that first delivers proof of product-market fit and later develops the ability to acquire customers, drive utilization, and generate attractive lifetime value at an acceptable cost of acquisition.
As seed investors, we’re looking for signs of a focused go-to-market strategy, one that effectively targets and cultivates early adopter customers.
Focused Sales Strategy
Most customers will never buy an early product from a startup; however, many will happily waste your time in sales calls. Ulu likes entrepreneurs who know how to efficiently disqualify sales prospects and prioritize their sales efforts. We’re especially keen to understand your ideal customer, look at your pipeline of interested prospects, and learn about your early sales success.
Access to Early Adopters
We like entrepreneurs with an unfair advantage in landing initial customers and the ability to develop coherent plans for creating a critical mass of customers in one niche of their market before expanding to other markets. (Further reading: Crossing the Chasm)
Network Effects We’re keen to see evidence of strong network effects, or mechanisms where every new connection makes a product or service more valuable to every other connection. According to NFX, network effects have accounted for approximately 70% of the value creation in tech. Examples include physical networks (landline phones), marketplaces (eBay), personal networks (Facebook), platforms (IOS, Android), data (Yelp!), and many others. (Further reading: The Network Effects Bible)
Many VCs say they want a 10x multiple. If they invest $1 in a startup, they want $10 back at the end of the day. We say the same thing, but probability weighted.
We look for companies with the potential to deliver a 10x or better probability weighted multiple on invested capital (PWMoIC). Valuation, Business Model, Dilution, and Exit Multiple are direct inputs to this analysis.
Valuation is the most important investment term for us at the seed stage. In the case of a SAFE or convertible note, the cap on conversion is roughly equivalent to a valuation.
An uncapped note almost always disqualifies a startup for us because it makes a risk/return analysis extremely difficult to perform. More importantly, the lack of a cap misaligns interests. In such cases, Ulu is “better off” as an investor if the round in which we convert has a low valuation.
A Business Model is your working theory for how your company will make money. A business model with high margins is more forgiving, potentially allowing an entrepreneur to grow their business with fewer dollars raised or to make mistakes and have the financial wherewithal to recover. Lower-margin business models are more likely to die when faced with high costs of customer acquisition, competitive pressures, or difficult economic conditions.
Dilution is the reduction in the ownership percentage of existing shareholders from subsequent equity issuances.
Ulu’s model accounts for dilution from Seed stage to exit.
Even the most successful startups experience significant dilution as they hire employees and raise additional capital. Capital-efficient businesses tend to experience lower amounts of dilution and lower chances of running out of money. This is a tendency, not a rule, as growth strategy and competitive forces may lead to a desire to raise more capital, more quickly.
Ulu’s model is to invest in startups with industry transformation potential. Historically, success has led this kind of company to file for an initial public offering. Hence, Ulu benchmarks exit multiples based on analogous publicly traded companies. Strong M&A possibilities are a bonus, but they are a smaller driver of our exit assessment.
Clear and Aligned Values
Entrepreneurship, at its best, is a spiritual endeavor
The aim of entrepreneurial work is to bring into existence something beneficial that exists only in “potential”. Our philosophy is that when we do right by others, trust emerges. When we work together while nurturing each other, community emerges.
Trust and community are the soil in which the seeds of entrepreneurial vision, capital and effort take root and flourish. Since shared values are the foundation of meaningful relating, Ulu looks for teams that care about and share values. Given how many meanings the term “value” takes, we want to clarify three aspects of values that are important for us.
Ulu looks for founders who are comfortable in their own skin; who speak unapologetically about and thoughtfully seek to behave in alignment with their stated values. This voice articulates the meaningful purpose of the venture.
Henry Ford said “Business must be run at a profit, else it will die. But when anyone tries to run a business solely for profit … then the business must die as well, for it no longer has a reason for existence.” We seek to partner with entrepreneurs we find inspiring in vision and character.
Ulu looks for founders who are intellectually honest, and work to stay self-aware. Entrepreneurs who proactively seek material information holistically and truthfully to build trust and fruitful relationships in business mean a lot to us.
We hold ourselves to the same standard, and our process is designed to be truthful and transparent When the foundation of a relationship is truthful, sincere, and respectful, more often than not it’s easier and more enjoyable. (Further Reading: Ethics for the Real World)
It is possible to be ethical and still behave badly day-to-day. So, ethics are not enough. We value character and founders who embody servant leadership or “laddership.” At Ulu, we strive to lead by example, build character by treating others well and fairly, help people grow, and improve the venture industry. We want entrepreneurs to choose to work with us because they believe we will be great partners. We don’t want entrepreneurs to work with us because unbeknownst to them we’ve taken advantage of them or merely because we’ve given them the first term sheet or the highest valuation.