Where you typically invest:
You typically invest in a seed round (up to $250K in investment in up to $1M of a round). You want to see that the team has positive unit economics, even if the company isn’t yet profitable, and evidence of both revenues and costs through a couple of sales cycles.
Common questions you should consider asking in due diligence:
What’s your human capital plan?
Who are you going to hire and for what? (They are about to outgrow the founders. For example, the leadership may have a clear understanding of how the market works, but they’re about to hit the point where the founder/CEO can’t lead all the sales and customer relationships. Who is the sales team, and are you convinced they can effectively lead without requiring the CEO to be a bottleneck? Who do they want to hire? If they can’t afford them-that’s why you’re investing!)
Tell me about how your sales are mapping to your projections.
What is your sales cycle, and how does it compare to industry standard? Can you send me the projections you were working off a year ago, and how the last year performed? (The numbers will almost certainly be different. The most important signal that the company is on the right track is that EITHER reality is meeting or exceeding expectations, or the founders are self-aware about why and have a plan you believe in.)
Tell me where you fit in your industry and your value chain.
Which large strategic players view you as a helpful partner (they are a channel partner for you, or you are a partner for them?) Who might want to acquire you one day? Who could view a partnership with you as something that makes them far more profitable? (Now is not a helpful time to talk about “exit strategy,” as you don’t want to encourage the company to “Build to flip,” but if the company carves out a valuable piece in the industry they will have their choice of “exit options.”)
Blind spots you should be aware of (and might help you find better deals):
Many founders who didn’t go to great schools and aren’t well connected may not have an idea of how to build their teams. If a founder doesn’t know how to hire or add to their team you might want to consider whether the problem is the founder themselves or the networks the founder is in. If it’s a great founder who’s poorly networked, you as an investor can solve that problem.
The best founders almost always know their unit economics backwards and forwards, and know where their next dollar is coming from. The best founders often don’t have great financial models (the skill set for this is largely learned in banks, consulting firms, business schools). Over-focus on unit economics; under-focus on financial models.
- Smoke and mirrors:
Pay attention to the founder’s knowledge of the customer more than their knowledge of how to fundraise. At this stage, some founders know how to tell an impressive story about where the company is going, but has reasons why customers aren’t mapping to it. (Avoid these!) Other founders can tell you everything about their customers but don’t understand the larger market (you can help with these!)
Where you can add the most value to entrepreneurs at this stage:
Help entrepreneurs understand the caliber of team you’d expect to invest in, and have them think through who they would hire if they raised money from you. They should be spending most of your investment dollars on their team, so spend far more time helping them think through how to hire–and who to hire–than any other topic.
Difference between profitability and investor liquidity:
At this stage, investors often ask, “what’s your exit strategy?” Very often, founders don’t know what an “exit strategy” means, or what it is, because they’ve been so focused on building their company. Other founders have been so heads-down building the business that they don’t know. You likely have a better understanding of the merger, acquisition, liquidity market than they do, and you can help founders think through and navigate how to help make money for investors.
Help founders, if they don’t know how, learn how to measure customer experience (net promoter score, referral rate, feedback surveys). Ability to measure customer experience is key to understanding if a functional business model is a workable one.