The Investment Memo – How VCs Evaluate Your Business
Raising venture capital is an exhausting and time-consuming process on which a huge amount of literature has been written. We have a number of articles breaking down the fundraising process ourselves. But what is it like on the other side of the table, and how do VCs deal with these pitches?
Most VC firms like to keep the exact nature of how they evaluate pitches behind closed doors to protect their competitive advantage, manage reputations and avoid disputes with founders. However, there is still some information out there, from historical memos for businesses that made the big time, to a range of templates, articles and interviews.
So we’ve done the research to bring you the ultimate insider’s view on how VC firms evaluate investment opportunities.
The Basics
First, some background. Venture capital firms work on probabilities. Betting on start-ups is a risky business – nine out of ten start-ups will fail. This means that VCs have to play a number game and spread their investments out over a diverse portfolio to guarantee returns to their investors so that if nine are a complete loss, they will still have that tenth business to pay for the rest.
Of course, VCs cherry-pick the businesses they think are most likely to succeed, increasing the probability of success in their portfolios. As a rough rule of thumb, a VC with ten companies in its portfolio is hoping to find
🦄 1 unicorn (which will return them 100x the capital they invested)
⭐ 2-3 stars (businesses which will eventually be acquired and overall the VC maybe 5x their investment)
🗑️ only 6-7 duds (investments which return nothing or fail)
Of course a VC might discover they haven’t managed to pick a single unicorn, in which case it may find it difficult to raise capital from investors and experience reputational damage. A VC might also beat the odds, and succeed in investing in multiple unicorns and thus generating exceptional returns.
To calculate how likely a favourable return is, the VC will work out the probability of different market outcomes, and what this would return against their investment. For example, you can see part of a memo released by Bessemer Venture Partners (BVP) here analysing the potential risk/reward of their investment in Pinterest.
You can see that they lay out the various possible outcomes and estimate how likely they are so they can make an overall calculation about whether Pinterest was likely to provide good returns. This format will be standardised within the VC firm, allowing an easy method of comparison with other investment opportunities.
The Investment Memo
The above risk analysis forms part of an investment memo. This is the document that the VC who attends a business pitch will produce if they are considering investing. An investment memo lays out all of the pertinent information about your business, market and team, so that other people in the VC firm can review the investment without also having to attend a pitch.
Most of the information contained within an investment memo will be drawn from the pitch deck and any other communications between the company and potential investor. However, the memo does also contain a section of due diligence, where the VC independently investigates the business to ensure the validity of their claims.
Every VC firm has a slightly different structure for its memos, depending on stage, area, and investing philosophy. But though they might use different names for sections, and address things in different orders and depth, their concerns remain fairly consistent across the industry.
This means that investment memos can provide a really insightful guide into what information VCs really need from pitches, and what factors are most important to them when making an investment.
There are a large range of factors that VC’s consider when making an investment decision. Some of these are qualitative, such as whether they think the team is up to scratch, but others are more straightforward (if often forgotten). For example, VC isn’t generally interested in any business addressing a market worth less than several billion pounds, because they require such high returns to balance the risk profile and cushion the cost of all the businesses in their portfolio which won’t make it.
Not every VC considers the exact same factors, and they certainly don’t all do it the same way! But we’ve selected some of the most important (and interesting) considerations from across the spectrum to talk about below. These will also differ depending on the stage of the business but we’ve organised these into a couple of broad categories:
Differentiators (qualitative factors that different VCs might judge differently)
- Product
- Competitive edge
- Team
- Finances and metrics
Givens (things that the VC just need to know you’re getting right)
- Marketing, monetization and distribution
- Competition and Total Addressable Market
- Due diligence
- Market-timing risk
- Inter-VC politics
- Timing and personal relationships
We are starting at the top of the list, with concerns which effect every investment big or small – and which are most frequently addressed in memo introductions. For example, if you look at the below snippet from Sequoia regarding their seed investment in YouTube, you can see it focuses on three key areas:
- Product – or what is the offering?
- Competitive edge – or why will consumers want to use the product?
- Team – or who are they investing in?
Given that the primary aim of an investment memo is to get the right information to the VC’s partners as quickly and clearly as possible, their biggest concerns are usually drawn out in the intro. Indeed, in the case of smaller investment decisions, such as the $500k Lightspeed Venture Partners memo for Snapchat, very little other information is provided (aside from a few brief financials). These 3 factors are generally considered the basics, (and even in the case of the Lightspeed memo will have been considered in far more depth off-paper by the individual VC) but they are a great place to start!
Product
Identifying the core service offering of the business, and summarising it for the benefit of the reader, is the first job of any memo.
With more technical products this often manifests in elevator-style pitch analogies, rather than detailed product specs, as the memo will be written at the general technical level the rest of the firm is comfortable with. A good example of this is BVP’s explanation of PagerDuty as an ‘9-1-1 dispatch system for IT operations teams’, followed by a more technical rundown of how the product works.
This makes it vitally important that pitching businesses are clear about exactly what their product is, and get the level of detail right, so that whoever they have talked to can properly communicate the product to the rest of their firm.
The relative maturity of the product, and which elements will need to be developed next will also be discussed. Particularly when dealing with scale, it’s not unusual for businesses to cushion product development with a more service heavy approach, but the offering still needs to be scalable – with a clear explanation of how the business will be able to move away from such a high-cost approach.
The depth into which VCs will go into unit economics in order to ascertain scalability are evident in the Sequoia Youtube memo, which explains everything from server costs per video to time-saving code. This sort of information is often redacted and removed from published memos, which are generally still trying to protect the reputations and proprietary information of the VCs and their businesses, but the Youtube memo, which was released in full for a court case, is not subject to the same editing.
Which brings us to the next vital consideration, what differentiates this business from the rest of the market.
Competitive Edge
Every successful scaleup has a competitive advantage, something which allows it to out-manoeuvre the competition. This tends to fall across several categories of consideration, from team to product.
For example in the Sequoia YouTube memo, they highlight the ability to embed videos as the biggest factor for differentiation, and the reason they expect mass adoption. But they also discuss the code that is allowing them to do this very cheaply, while providing a barrier to entry for any other businesses, as well as the particular expertise and qualities of the team which are unique to that venture.
Barriers to entry are particularly important, whether to keep out new startups or discourage larger businesses from shifting into the same space. Sometimes memos actually note that they have other businesses in their portfolio which will be in competition with the proposed opportunity. John Doerr, chairman of Kleiner Perkins, revealed in an interview that at the time of his investment into Google, they had already invested in another search engine. In this case his familiarity with the industry encouraged Doerr to invest, but in different circumstances VCs might be reluctant to invest in a business which might cannibalise their portfolio unless they think they are looking at a sure thing.
Competitive edge also encompasses the reason that consumers will want to engage with this product, and crucially, create an appetite to pay for it. Particularly at early-stage funding, before there is financial data to prove consumer interest, there is a massive focus on any way a business can prove interest.
A great example of this is BVP’s memo for LifeLock. BVP draw out five key threads as evidence for both market interest and the business’s ability to fulfil that interest: the founder’s personal experience with identity theft; the annual cost of identity theft; current products meeting that need; how Lifelock’s product better meets this need; and how initial marketing efforts have been landing. Between all of these elements, they are able to draw a reasonably accurate picture of whether this product can be a success.
This becomes less necessary to explicitly draw-out at later stages of funding, when the commercial information generally starts doing the talking for the business. However, where there is some question about total addressable market (TAM) or a competitor’s offering, memos can still go into significant depth. For example, BVP’s memo for Twitch’s Series B takes great pains over its attempts to work out consumer appetite, as there was very little available data about how big the market could grow.
Founders and Team
All memos contain a section about the founders and other significant team members. Rob Go at seed investors NextView lists his first five questions on listening to a pitch here, four of which relate to the experience and capabilities of the founder:
At seed and series A, where the VC is buying into the team’s ability to do something as much as a product itself, this is generally the most important consideration and one that can foul a pitch even if the product seems promising. It doesn’t become unimportant at later stage funding either, where experience becomes even more important, but changes to encompass the shareholders increased power over hiring and firing.
Therefore every memo will establish credentials, experience, management style, positive and negative personality traits, and the depth of talent and experience outside of the founding team. The essential lens through which each person is viewed, is ‘what about this team will help give the business an unfair advantage?’ This can often favour experience, as this can help prove that the team will be able to deliver on their promises.
The level of detail can be seen from this extract of BVP’s memo on LinkedIn’s series C:
‘On the management team, Jean-Luc is thought of as a perfectionist, which means the product back end is solid, but feature development and the pace of hiring are not as rapid as they could be. He has done an adequate job by all measures, and given that he has been in the role since day one of the company, there is a lot of important technical information about the service in his head.’
This discussion of the VP of engineering addresses advantages and shortcomings, as well as implicit problems that might arise in trying to replace him, for example, the difficulty of finding anyone else with such a comprehensive understanding of the product.
In the same memo they discuss the process of replacing the current CEO, and the risks this might cause. Succession planning is a fairly common concern, usually undertaken with the cooperation of current business leadership (as with this particular memo), but sometimes boards will oust founders or CEOs they don’t like to replace them with a more experienced hand.
Given that VC firms can expect to spend a lot of time working with the CEO, and might well sit on the board of any significant investments, they are also identifying people they’d like to work with. The importance of the founders and the VC-founder relationship can be particularly seen in interviews, such as that of Chris Fralic on 20VC, where the VC will typically lay the success of the business at the founder’s feet.
BVP also boasts a tongue-in-cheek anti-portfolio, where they highlight businesses they failed to invest in that went on to become very successful anyway. They keep it brief and light, but one of the most common reasons they highlight for passing on an investment, besides chance and stiff competition, is inexperience in the team.
Finances and Metrics
There is a fourth basic consideration that will make the introduction section, though not so much in early-stage opportunities such as the Youtube memo – and that is the business’s financial information.
Financial data is often missing entirely from seed decks and consequent investment memos, and can be slightly more detailed at series A. However by series B it has gone from an area with limited data to one of the VCs biggest concerns. These memos concentrate very heavily on ARR, gross revenue, monthly burn rates and any other metrics relevant to the business model.
BVP’s memo for Toast’s series B is introduced with no analysis of product or team, but instead with a rundown of all the numbers:
Though they go on to consider all the usual suspects in-depth, the headline information is about the figures, and whether they will make sense against a $17.5m investment.
Marketing, Monetization and Distribution
Investment memos frequently focus on marketing efforts and distribution channels. The only time this is really missed is with seed and early-stage investment into deeptech solutions, which can expect to be in development for a long time before going to market.
They will also typically place a lot of attention on plans for monetization of services. This is particularly significant with many tech and SaaS products, which often don’t start charging for services until quite late in the growth journey. Exploring potential methods for extracting revenue is therefore important for making sure they don’t invest a lot of money into a great product no-one will ever pay for.
Monetization can take various guises, from tiered subscription models to paid advertising and data, and many memos will consider several possible revenue channels. If the business is already taking on revenue, it is likely that the investment memo will still contain information about new revenue streams identified by the pitch, whether that is partnership opportunities or plans to expand into international markets.
Competition and the Total Addressable Market (TAM)
Competition analysis is a vital part of an investment memo for several reasons. The first is obvious – no VC will invest in a business that isn’t prepared to beat its competition. But given scaleups are frequently trying to address new markets or disrupt established ones, competition is also a vital data point for establishing how big these markets actually are.
Many businesses, when pitching to VC, will actually lead with the idea that their business has no direct competition – that it is creating a whole new market. However, investment memos reveal the degree of discomfort VC firms have with this idea. While new markets can be incredibly profitable (see: Youtube) they also might not be a market at all (see any number of failed start-ups). That makes identifying any businesses operating in that area, or comparable areas, vital to securing VC support.
The investment memos show that, instead of sticking just to direct competition, VCs will consider businesses in comparable industries, large incumbents in similar fields which might move into the business’s territory or decide to copy the start-up’s idea, and businesses in different countries attempting similar things.
An example of the risk VCs see in developing markets with few competitors can be seen in BVP’s Twitch memo, which dedicates significant effort to analysing live esports events in Asia, Youtube categories and even US baseball viewing figures in an attempt to estimate market size in a category with no real competition. They are quite explicit in their concern, admitting that ‘there is a risk that we are overestimating the latent demand for generating and viewing this novel content type.’
In more easily calculable markets, Sequoia estimates Doordash’s TAM by doing the following maths:
‘According to Grubhub’s S-1 and the National Restaurant Association, there is over $67B restaurant takeout volume in the US. Only 15% of restaurants delivery [sic], suggesting $57B is addressable by the company. DoorDash’s TAM in revenue would be $11.4B, if the take rate is 20% or $8.6B if take rate is 15%.’
As you can see, the calculations here are much simpler, as it is addressing a market in which it is easier to gauge interest.
Due Diligence
All VC firms will do extensive due diligence on businesses, although a lot of them don’t include this information in their memos. If you are interested in memos that do, the Root Venture ones are particularly good for this. They reveal some of the range of calls made, to ex-bosses, competition, potential customers, and other businesses working in the space. With Root Venture specialising in deeptech, these calls also help sound out how plausible the products they are financing actually are, with experts weighing in on how possible and competitive it is likely to be.
Market-Timing Risk
Sameer Gandhi, a partner at Accel, highlighted market timing risk as a significant factor when deciding whether to invest in Crowdstrike, a cloud-based security software. With cloud computing not yet widely trusted or adopted, there were concerns that it might be several years before the market was ready to embrace the product.
Indeed market-timing risk is a concern with any product that will require a significant change in consumer behaviour or technological advancement – although as Crowdstrike and many other businesses like Hopin and Slack have proved, sometimes it can really work out in the business’s advantage. These businesses, which normally might have expected to have to spend a long time and a significant amount of marketing slowly shifting consumer behaviour, instead benefited from launching just in time to take advantage of huge market shifts. As a result, Hopin, which might have spent years slowly building a customer base for virtual events, actually launched as COVID-19 forced the whole world to switch to virtual and became the fastest growing European start-up ever.
These sudden changes can make market timing often very hard to judge, and plenty of other businesses will have experienced the negative reverse, as COVID-19 tanked entire sectors from hospitality to travel.
The important point for future pitching businesses, is that if VCs are concerned about how long it will take for the market to develop, this may affect their willingness to invest. Pitches will therefore need to address this, with shorter-term and longer-term plans depending on how the markets develop – so that if adoption takes five years, the business will still be around and in a great shape to take advantage when change comes.
Inter-VC Politics
Intel Capital’s memo for LinkedIn’s Series D and accompanying explanation highlights how relationships between VC firms can sometimes come into play. Partner Eghosa Omoigui notes that Sequoia (an incumbent investor and board member at LinkedIn) was reluctant to work with his firm Intel Capital ‘because my firm had antagonized them in 1999 and they hadn’t forgotten.’
Later stage investment memos will have a section on current board members and major shareholders to help them understand whether this will be an issue. This section can also give them an idea of the experience of the people leading strategy, just as with their analysis of the team.
Timing and Personal Relationships
Listening to VCs talk at interviews, a very common theme is that investors who passed in the first round will often come back to firms they maintained positive relationships with and become major investors at later rounds. For example, in the podcast 20VC, Chris Fralic from First Round Capital relates how he initially passed on Roblox, but kept in contact with the founder and went on to make two significant investments. It really highlights the role of timing, but also of building personal relationships between VCs and founders in the process.
Conclusion
As you can see, the range of concerns VCs consider when choosing investments is huge! (And we didn’t cover all of them) It also varies significantly by stage and the amount of capital they plan on committing.
There are some significant constants though, with product, team and financials clearly taking the largest chunk of VC preoccupations at every stage.
99% of the memos available to the public discuss successful investments, and all of the ones we have seen at least discuss investments they wanted to make, even if circumstances eventually prevented them.
It’s also worth bearing in mind that most VCs have a mandate that restricts them to invest only in certain kinds of businesses. This means it’s no use pitching to a deeptech fund unless you are a deeptech business – regardless of how great your business model is they are legally restricted from investing.
If you are interested in learning more, or checking out some of these memos yourself, we have included a list of resources below as a starting point. Alternatively, if you are preparing for your own funding round right now, you might want to check out our articles on applying from the applicant’s perspective. Or you could book a call to discuss how to get your business the right help, so that the investors end up writing investment memos that are this positive about your own business.
Further Reading and Resources
Background
How venture capital works | Alejandro Cremandes, Forbes
The investment memo | David Beisel, Nextview
Investment memo | Y combinator
Flowchart: how a seed VC makes investment decisions | Rob Go, NextView
7 common mistakes entrepreneurs make in VC pitches & how to fix them | David Beisel, NextView
Corporate founders battle boards to overturn forced exits | Nadia Damouni, Reuters
The Memos
The memos | Bessemer Venture Partners
Investment memos | Root Ventures Deals
The confidential Youtube investment memo by Sequoia you were never meant to see | Alexander Jarvis
On my mind #7 | Michael Dempsey
The investment memo | Tim Devane
The memo | 20VC
Doordash venture capital investment memo | Alfred Lin, Sequoia
Intel capital venture capital investment memo for Linkedin | Intel Capital
20VC: The Snapchat memo | Jeremy Liew, Lightspeed
The anti-portfolio | Bessemer Venture Partners