How to Evaluate a Startup
This guide is suitable from Pre-Seed to Seed. Series A onwards becomes far more about financials and strategy, expansion amongst other things.
This is a guide on how we evaluate startups at RS. It is not definitive and is always improving / moving. There are factors which are constant variables: Timing in the market, competition, regulation, the economy and like any investment. It’s up to you to make the decision. Here’s our high-level take.
Never forget the first rule:
Always ask yourself ‘how will this company make me a return on my investment?‘
Financials
Are they making money already? If so, how much. Pre-seed investments will often have little or no revenue.
Depending on the service this could be a subscription in which case it’s calculated as Monthly Recurring Revenue (MRR) or Annual Recurring Revenue (ARR). If it’s a service how many times do they sell that service in a given month or how many products (units) are they selling.
When reviewing revenue numbers, it’s important to calculate the growth rate. This is calculated by the following: Current period MRR / previous period MRR multiplied by 100.
For example:
MRR Month 2 (MRR-M2) / MRR Month 1 (MRR-M1) * 100
2,000 / 1,000 * 100 = 200% Growth. In SaaS a good benchmark is 7-8% Month-on-Month (MoM) Growth. At Pre-Seed / Seed, you’d expect this number to be around 10-30%.
Step 1: Profit (How do they plan to make money?)
The gross burn rate is just the total amount of money spent each month. The net burn rate is the amount of money lost each month and takes into account any possible company revenue.
It is calculated using the following formula: (Monthly Revenue - Cost of Goods Sold) - Gross Burn Rate = Net Burn Rate.
It’s critical to keep an eye on this number to make sure money isn’t being waster or overspent or invested badly. Particularly in early-stage start-ups that aren’t making much or any revenue.
This could be down to people being paid too much, technical costs that are out of control. It’s worth digging into these numbers properly.
Likewise, losing money is bad. Losing customers is worse. SaaS benchmarks for churn is 5-7% annually. If it’s any higher especially in the beginning (or even in the first year of operations) - this is extremely worrying.
How to read a P&L, hiring plans, COGS, how the company aims to spend money and their financial strategy:
The forecasted metrics in the P&L are also interesting, are they realistic? Do they seem achievable? Look at their pipeline, customer base, product and strategy over the year. P&L’s are often forecast over 5 years. No investor thinks they’ll hit the absurd numbers at Year 5 of £50,000,000 ARR. At Pre-Seed/Seed, you’re looking for logic, reason and if they Founders know how to make a business plan and justify it with numbers.
Depending on the model, it’s also worth looking at number of customers, number of users and number of accounts. For example if I see 10,000 users in the first year and they’re on 20 paying £50 each and a forecast of £5,000,000 - Red Flag. They’d need to increase prices to £500 per user and get 10,000 users. In one year.
What’s the period of time that the company will become cashflow positive (roughly)? Gross Profit is calculated by net sales revenue - COGS. Net Sales Revenue is what you get by taking your business’ total sales and deducting any returns, discounts, allowances, damaged goods and bad debt.
Step 2: Gross Profit
Scary acronym time. This stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.
You can find the operating income by subtracting the operating expenses from the gross margin for businesses with COGS. Without COGS, subtract operating expenses from revenue.
A companies EBITDA is typically believed to be the most effective way of looking at how a company is doing. If they have that data. In Pre-Seed/Seed this will be very limited. Again, you’re looking for consistency and realism.
Step 3: Operating Expenses (EBITDA)
Runway refers to the amount of time a company has left before it runs out of money. Typically expressed in a number of months. When a Founder raises money, you expect them to raise enough for anywhere between 12-18 months of runway. Anymore and they are potentially asking for too much money (deep-tech platforms like AI etc typically break this trend). Any less, they run the risk of having to do another fundraising round quickly (6 months is not a long time considering it can take 3 months to raise!)
To calculate runway: Existing Capital / Burn = No. Months. For example: £100,000 (money in bank) / £10,000 (Burn) = 10 Months until they run out of money
Founder salaries and employee salaries are usually 90% of the COGS in the beginning. It’s important to keep an eye out on how much they’re paying themselves. You want them to be comfortable and not have to worry about rent but in the early days - you’re not paying for them to be able to afford a new car.
Step 4: Runway
Step 5: Cost of Goods Sold (COGS)
How much does it cost to deliver the solution or service? This doesn’t include operating expenses (salary, subscriptions etc). This is JUST how much it costs to deliver the service. Think Cloud Computing costs, any paid APIs, necessary items to provide the product and the salaries of the people delivering the service.
To use an easy example, if I build and sell houses. My COGS would be the cost of the timber, cement, plumbing materials, electronics and the people building it.
In SaaS, it’s so attractive because the COGS is around the 20% mark. It’s a very profitable business model and it can be delivered globally with just a laptop.
Remember, we invest at such an early-stage that much of this data won’t be reliable and shouldn’t impact your decisions TOO much. They should still be taken into consideration somewhat but don’t go hell for leather diving into the financial models and forecasts.
Ultimately the questions to ask: “When will this company be profitable? How will it get there? Is it realistic? Will they run out of money before they get there?”
Highlighted red flags: Early churn, silly salaries, high COGS, bad profit margins, poor forecasting, unrealistic goals.
Step 6: Burn & Churn
Product
We do not mean a screenshot or a prototype in Figma. Can a user login, register, use the product (even at its Minimum Viable Product Stage).
If the answer is NO, do they have the technical capabilities to build the product? For example, if someone wants to build an AI bot that’ll solve any mathematical problem ever and the technical team consists of someone who built a shopify store. You best steer clear.
A good rule of thumb when a product doesn’t exist yet is, who are they going to get to build it? Who has built it before? How much research have they done with their Ideal Customer Profile (ICP). Maybe they have design partners (companies who agreed to co-develop it or provide feedback during its building process), if so, who are they? Why do they want to help build that product?
Potentially their advisory board has some technical experts who can support the MVP development phase.
Product is a difficult one to evaluate. First things first.
DO THEY HAVE A WORKING PRODUCT?
No Product
Product (MVP or later)
Yippee!- As an investor I have something more tangible.
Questions you can ask: Number of Daily Active Users (DAU), Monthly Active Users (MAU), Features used, how frequently?
Are people paying for features? If they are which ones?
What’s the development cycle? Knowing how fast a team can push out new features and get feedback is a great tell-tale sign of a fast moving company. If a launch goes badly, can they fix it quickly and not lose any customers.
Speaking to their customer base is the best way to get a good understanding about a start-ups product. Hear from the users about why they’ve bought something. Is it because they actually love/like the product? or is it because they are doing their mate a favour?
What’s everyone in their customer base ranting and raving about? Can they expand on that? What’s the long term-vision?
We find the best way to benchmark start-ups at this stage with the following: Are they capable? Who are they building it for? Potentially you have that pain point or you know the customer base they’re selling in to. This is more gut feeling and high-risk however, it’s crucial the founders are communicating regularly with their ICP. Maybe ask to see some of the data they’re collecting or collected for validation.
Y-Combinator: Build stuff people want.
The only way you get their is by frequently being in touch with your customers or potential customers.
MVP +
The best way we like to think about this is via process.
Can they justify why they’re building a new feature, how do they run customer interviews and what’s the feedback cycle. Are they posting about the product on social channels? The faster moving the product is the better.
The team is learning quickly, even if they break stuff during the process.
GTM (Sales & Marketing)
Sales
Pipeline
Pipeline, pipeline, pipeline.
We look at how many customers are actively in the pipeline. The engagement the team has with those customers. Where do they come from?
Founder-led sales can typically get a company to £10K MRR but can they sell beyond their network. Can they even get to £10K MRR.
The way a company acquires customers either network, events, cold-calling, marketing is under a magnifying glass. How many deals does it take to get to £10K MRR?
If the Average Contract Value (ACV) is £60,000 ARR, they only need 2 deals to make to to £10K MRR. Exciting stuff!
This is where looking at financials is important if the ACV is low, they might need hundreds if not; thousands to get to the next revenue milestone.
A good litmus test is seeing how many cold/outbound leads beyond a founders network are in the pipeline. This can be an early indicator that it’s the problem the company is solving is wide spread.
Sales cycle, top of funnel (leads coming in) and pretty much every GTM metric you can think of are also pretty key here.
The biggest thing is to be considering is that is the GTM motion scalable.
Another green flag we like to see is logos, who are they signing? Have they got any enterprises or tier 1 accounts or exciting fast-paced companies on their books.
The other is, are you convinced by their pitch? If they can’t pitch you an investor, how are they going to pitch a customer.
Marketing
Social
In today’s world, social channels are a key pillar of marketing. Looking at how many followers they have, the rate of growth of their social accounts on LinkedIn, Product Hunt, Twitter. Not just of the company page but the founding teams is worth evaluating.
Many start-ups today launch communities of their users to have regular conversations with the people who help improve the product.
Is the company being tagged a lot by its users (if at all). How quickly does it respond to comments or tags? How regularly do they release posts, snippets, podcasts, blogs, content and everything else to build a presence?
Acronym time.
CAC:LTV is one of the most important metrics you can look at when reviewing a start-up.
What is a good CAC:LTV Ratio? Ideally, the LTV/CAC ratio should be 3:1, which means a company should make 3x of what it spends on acquiring a customer. If the LTV/CAC is less than 3, the company should be extremely concerned (and you should probably not invest!).
CAC is everything from having Sales Development Reps, the software they use to call, CRM subscription costs etc. Just to get that one customer. It should be trending down over time as a company gets more efficient and has a better sales process.
Lifetime Value or LTV is an estimate of the average revenue that a customer will generate throughout their lifespan as a customer.
CAC:LTV
Data, data, data
Views, clicks, visits and conversions.
A companies website is its face. It’s what’s being said about you while you’re not in the room.
Looking into website traffic, Click-Through-Rates (CTR), conversion rates from visit to sign up to attended demo are extremely telling.
Does the start-up have a good process? Is its brand and presence growing? Are they even tracking this yet?
It’s been said when we’ve worked with Founders previously “if you could’ve invested in something sooner, what would it have been?” - It’s always the same. Marketing, Website and inbound.
Team
This one is one of the hardest to gauge from a pitch and a short or series of conversations.
Have they done this before? Second-time Founders are shrewd negotiators however, you have confidence knowing they’ve done it before. What the expectations are and how to execute. We love second-time founders.
Why Them?
If the problem is so big, if the pain is so bad, why has no one done it before them?
More importantly, what makes the founding team the people to fix it. Being a subject matter expert in AI is one thing, translating that into running a business, managing a team is another.
The gap isn’t always easy to cross. As investors, it’s your job to make sure you can judge their character but you are confident in their abilities, hard and soft skills. Just because someone is charming doesn’t mean they’re a good sales person. Much-like being a good developer, coder doesn’t mean you’ll build something great, you still need to sell the idea and talk to people for feedback.
Looking at previous companies, speaking to previous employers and figuring our the relationship of the two individuals is a must.
Founding teams splitting up is the number three reason why start-ups fail. When the pressure is on, stuff is burning. Can these Founders put the business first and their own emotions aside.
Family, friend, colleague. What’s the equity breakdown between the team? Will the CTO leave after getting diluted into nothing? All these factors need considering.
Founder Break-Ups
Market & Timing
Timing
Many start-ups are wiped out because of bad timing. Too soon, for example: Their was a streaming service before Netflix, many infact, however, the internet wasn’t stable enough for it to be reliable enough for customers to adopt this new form of consuming content.
Too late and the ship has sailed, maybe a competitor has developed your product and done it better.
You need to review vital information such as industry news, government policies (GDPR wiped out quite a few start-ups back when it was announced) and what the market is doing.
Timing is everything when it comes to launching a company. Why is now the time for this start-up to succeed?
Market
A market is just supply and demand. The market opportunity is defined by how many people can use the product or service.
It’s critical to note, TAM (Total Addressable Market) aka how big is the universe, SAM (Served Available Market) aka how many can they reach with their sales channels and SOM (Serviceable Obtainable Market) aka Todays most likely buyers.
For TAM, it should be a big number, in the many £Bn’s preferably. No company will ever hold the entire TAM but if it’s a small number. The vision or problems not big enough.
SAM, if the company executed perfectly, what could mega success look-like.
SOM, what’s right in front of us and what, as an early-stage investor we should be looking at. Asking if they can capture that, how quickly and how much of it is meaningful.
Vision & Scalability
Scalability
Scalability just takes into account pretty much everything.
Building sustainable pipeline, keeping COGS low, maintaining low churn, delivering a high-level of customer satisfaction, strategically capturing the market through efficient capital spend.
One way you can view scalability is like so, if you have a brick and mortar bakery and one car. You can hire more bakers, get more machines and refine processes to make 1000 loaves of bread a day rather than 100.
Eventually you’ll need more stores, more drivers and a great deal more dough.
We view scalability in the following order: Size of problem, Customer Feedback, Team, Product. The reason for this order is because the size matters. If it’s a really big problem and it’s untapped. It’ll take like wildfire. Customer Feedback plays into this as they are the market. If they’re not willing to act (aka purchase) or promote frequently (post on Socials), perhaps it’s not scalable. The Team comes before the product because if the team can execute quickly, learn from mistakes. They have what it takes to look at scalability, turn it into manageable fragments and tackle it one by one.
Product, we leave till last just because we typically operate in SaaS, it doesn’t have borders like a hardware or physical asset (like a baker).
Vision
A vision statement explains why a company exists, what its future goals are, and the change it's aiming to create in the world. It's the company's single dream or north star that unifies and inspires every employee—and ideally other stakeholders, too.
This aspiration should be enough to convey confidence, big enough to excite and seem like it’s going to get ROI (Return on Investment).
The vision is what’s going to move mountains, open doors and set this company apart from the rest. We like to look at this vision in stages. Today, this year and the future.
Everyone wants to make the next big thing like AirBnB, Uber etc but realistically, none of them started out like that. It was a powerful vision with focal points throughout inception.
It’s important to see Founders with their “feet on the ground” - for example, curing world hunger is impossible. Feeding a select group sustainably first and then working towards that goal is realistic.
Always take these with a pinch of salt, though they are paramount to the journey and success of the company.
Competition
Unfortunately, you are probably not looking at the first company doing this or something similar (and if you are, that could a big red flag).
Strangely enough, competitors are a good thing! They are proving their is a market for that companies services. They also mean that the companies ICP have an understanding of what it is the company is selling.
The question as an investor you need to address is: Are they going to do it? or Plan to do it? If not, why haven’t they done it?
They have more money, they are bigger, have more resources, launched before this company. You need to understand the why?
Sometimes (in a rare case) it’s because it’s too difficult but usually it’s because they’re too slow to move. Other times it’s because the way they built their solution means its on old code or the UI/UX is worse or not capable of holding this new technology.
This is an important step in the due diligence process.
Unfair Advantage & Competition
Unfair Advantage
An unfair advantage is something that a company uses to focus on an area that its competitors can't match. For instance, if a company decides to focus on an area that its competitors can't compete in, then it can create a high-calibre advantage. In laymen terms, that companies super power.
Typical examples of this are speed. Enterprises have so many department heads, processes and paperwork to get anything done. One of the main benefits of start-ups is that it can release stuff quickly.
Other examples could be a weak SEO presence vs. a paid marketing strategy or some form of technical advancement you created.
Even RS has an advantage believe it or not. Ours is that we are made up of GTM specialists, Founders would rather work with us because of you! Crazy right!?
Extra Considerations
Awards/Grants/PR
If they won an award (that’s credible), it’s probably been given by people who know more than you do. Same with PR, it means that they’re potentially worth shouting about ergo potentially worth investing in.
Exit Strategy
Not every company is going to IPO. If you think that, you shouldn’t be on here. It does matter what different options a company has to get out of the market. Less than 1% of companies get to IPO.
Other Investors
Who else is participating in the round? If Sequoia, Viking Global and YC are getting involved. They have huge networks and have been doing this a long time. They’re probably onto something.
Investing is high-risk
We want to remind you that this is a very risky game. The chances of success are slim and RS does what it can to minimise that but it’s your money. Only invest if you are 100% confident you can answer all of the above.
Acquisitions
Are larger companies looking in this space? Have they bought any of these competitors. What makes this company an acquisition target as a potential exit strategy?
Be prepared to lose
You should consider any money you put into a start-up gone. Just gone. It’s never coming back. This will help you detach emotionally if things go awry. We hope they don’t obviously however, the sooner you can detach yourself. The better decisions you’ll make.