The 5 T’s: A Blu Venture Investors Guide to Raising Early-Stage Capital
From among the hundreds of prospective deals that we see and evaluate every year, we are charged with pinpointing the handful of new companies in which to invest. The screening and due diligence process is rigorous and with reason, as our criteria for investing is extensive. Ultimately, we only fund a very small percentage of companies that we screen.
We know the funding process isn’t any easier on the other side of the table as raising capital can be intimidating and challenging for entrepreneurs, particularly for first-time founders. From a lack of transparency surrounding the funding process to struggling to get a foot in the door, there’s a lot of information founders have to absorb in a short amount of time and the bulk of it is not easily accessible.
While every investment firm is different, we at Blu Venture Investors have found ourselves coming back to the same set of criteria to evaluate every deal, which we have tried to distill into an easy-to-remember paradigm called “the 5 T’s.” The following guide breaks down each of the 5 T’s in turn and aims to fill in some of the blanks for founders and potentially offer fellow investors a couple new factors to consider. It is not intended to be complete nor comprehensive, but we hope it paints a clearer picture of what we look for during the funding process.
The 5 T’s (With Relative Weights of Importance)
1. Team (30 - 50%)
2. Traction (15 - 30%)
3. Technology (product or service) (10 - 25%)
4. TAM (10 - 20%)
5. Terms of the Deal (15 - 25%)
This is by far the first and most important criterion we assess. In any new venture, the team drives everything about the business, and aside from the many external forces that may impact the fortunes of the business, the team is essentially the most critical factor for all decisions and execution of the business plan. In evaluating the team, here are the most common elements we consider:
- Is there a lone founder or a small group of founders?
- What is the previous experience and track record of the founder(s)?
- Have members of the startup previously worked together?
- Have one or more founders successfully grown a startup before?
- How well do the founder(s) make their pitch? Is it clear, compelling and credible?
- Is the management team balanced in terms of functional areas of responsibility, covering sales and marketing, operations, finance, etc.? If there are voids, are these filled by outside contractors?
- Do the founders convey a deep know-how about the market in which they compete? Do the founders have a long-term capitalization (funding) plan?
- Is there a credible plan to eventually exit, and in a timeframe that is aligned with BVI’s investment thesis?
- Do they have a good idea about actual possible acquirers?
- Do they appreciate exit multiples for their industry?
- Are the founders smart and savvy, “coachable,” eager to learn and welcoming of external ideas and expertise?
- Do they appear easy to work with? Do they want to work with our investment firm, and do they recognize and value our potential value-add in helping them grow their business?
- How timely and responsive are founders in responding to emailed questions, populating a data room, etc.?
- Are the founders “all in,” or do they have some fallback plan?
- Do the founders have real “skin in the game?”
Here we refer to the ability of the company to generate revenues from actual paying customers. It is one thing to have a great idea and to convey an exciting vision for your startup, but the proof of this is to be able to convince customers to pay the company in exchange for their product or service. In evaluating traction, here are the most common elements we consider:
- What are current and TTM revenues (or ARR), indicating the current size and scale of the business?
- How fast are revenues/ARR growing year-over-year and quarter-over-quarter? Sometimes a fast rate of growth may indicate a more valuable enterprise than one with high revenues.
- If the company is too early to have regular customers, does it have paid or unpaid pilots or proof-of-concept evaluations ongoing with prospective customers?
- What is the customer concentration associated with these revenues?
- What percentage of revenues are non-recurring service/implementation fees?
- What are the gross margins of these revenues/ARR, and do we see increasing margins with increasing scale of the business?
- If this is an enterprise SaaS business, how do we evaluate performance in terms of basic SaaS metrics, and how are these metrics trending over time?
- What did we learn from our diligence calls with customers (a key diligence item for us at BVI)? Do the customers love the company and their product/service? Would they/did they recommend them? How likely/fast will they grow their business with the company? What do they say about the quality of and interactions with the team (overlaps with team above)? Did implementation and service go well (overlap with technology below)? Is the product/service working (overlap with technology below)?
- Do they have an established sales process for tracking opportunities and moving deals logically through the sales funnel?
- Do they have an appropriate sales commission plan in place?
- Do they have the right metrics to measure sales and channel performance like CAC (Customer Acquisition Cost), close rate, selling cycle (6, 12, 18 months etc.)?
- Are they using any CRM tools, spreadsheets or other to track and forecast opportunities?
- Assuming they have an installed base of customers, what is the churn rate? What is the industry standard for churn? What churn amelioration plans have they implemented?
- Are they thinking broadly about their GTM (Go-To-Market) strategy, including, but not limited to, product fit, target audience, competitive positioning, verticals, geographies, inside sales, direct sales, indirect sales (channel sales), OEM, distribution, etc.?
- Do they have a marketing strategy using social, networking, direct mail, or other?
Here we refer to the company’s core value proposition – its product or service. And while investors may be tempted to look at this first, we try to evaluate it after team and traction, as these two other factors are likely more important predictors of an eventual success or failure than the actual product or service that the company sells. In evaluating technology, here are the most common elements we consider:
- What, specifically is the company’s technology (i.e., value proposition)? What problem/pain point does it solve?
- How disruptive and/or innovative is this technology? Is it 10%, 100% or 1000% better, faster, cheaper, etc.? Try to quantify.
- Is this technology a “must have” or “nice to have” product or service?
- Is the technology something that we fully grasp and understand, including the market and product-market fit?
- Is there anything competitive that comes close to this technology?
- Does the product or service fit well with what we know and like to invest in?
- Is the product or service fully developed and deployed to customers, or is it still in a state of development (with some greater or lesser degree of development risk)?
- Is the technology an easy self-install/setup, or does it require complex and time-consuming customization, setup and installation?
- Is there significant inventory cost and/or supply-chain risk?
- What do reference customers think about this technology as well as the ability of the company to deliver and support it? Why did they choose it over any alternative competing solution?
- What other companies/products are out there trying to solve the same problem? How does the company compare? Why will the company win?
- Has the company built a competitive moat (IP or other) around this technology?
- Do they have a strategy to protect their intellectual property?
- Does the company have a platform for the development and addition of future products or services?
4. TAM (Total Addressable Market)
Here we evaluate the total market into which the company can sell its product(s) or service(s). The key term is “addressable.” Too often entrepreneurs will over-hype the size of the market into which they plan to sell, rather than the specific target sub-sector of the market that their product or service can actually serve.
For example, a company that is developing a new medical device for orthopedic repair of the ankle might represent TAM as (i) the total surgical market (grossly overstated), (ii) as the total of all orthopedic surgeries (also overstated), or (iii) as the market for the specific orthopedic ankle procedure for which this specific device is applicable (accurate TAM).
Assuming an accurate representation of TAM, we much prefer to invest in an enterprise that serves a very large ($1B+ or $10B+) market rather than a very small (<$100M) market. The reason is simple: If the entrepreneur can achieve a 1% penetration of the TAM, then this represents $100M in revenue for a $10B TAM, but only $1M for a $100M TAM.
The company must also discuss how they will penetrate and sell to their TAM and who the actual decision-makers and buyers are. The founders must convince us that they appreciate the likely sales cycle, which is all too often grossly underestimated. Is this believable, backed up by actual sales data, or not?
Finally, we may choose to drill down into SAM (the service addressable market within geographic reach of the company) to distinguish it from TAM, as SAM will give a more representative means of the actual size of the company’s target market.
Here we refer to the financial and non-financial terms of the investment. These are often “socialized” early in the discussion in order to ensure that the prospective investor and founder have similar expectations and can move forward into due diligence. In evaluating deal terms, here are the most common elements we consider:
- What form will the investment take? Two common approaches are (i) priced equity and (ii) convertible notes (CN). There are pros and cons to each of these approaches, and some investors and founders have a strong preference for one approach over the other. Smart founders will be flexible and willing to take money in exchange for any reasonable investment instrument, whether in the form of equity or CN. SAFE notes as well as debt coupled with equity or warrant incentives are additional, though less common approaches.
- Pricing is always a critical consideration for a priced equity financing. Is the pre-money valuation within expected market range, higher or lower? Likewise, if a CN is used, is there a cap, what is the discount and interest rate, and what is the proposed term until maturity? What are the rights of the company to convert or in the event of a default
- How much money does the company plan to raise, regardless of the form of financing? Is it too much, too little or a reasonable amount to allow the company to execute its plans and to create significant additional enterprise value before either (i) having to fundraise again or (ii) reaching a cash-flow positive status?
- What does the (detailed) cap table look like, so we can understand the relative ownership of the common shareholders, the preference stack, the identity and ownership of earlier external funders, available option pool as well as the post-investment cap table? Also, are there any special preferences, rights or side-letters that were granted to earlier investors?
- As for non-financial terms, these are too numerous to mention here. At BVI, for instance, our two highest priority non-financial terms are Board Representation and (enhanced/super) pro-rata rights. Some of the more critical terms investors often pay attention to include the following:
- Board representation (and if the company even has a functioning board)
- Board composition (number of insiders and outsiders)
- Information/Observer rights
- Pro rata rights to invest in future rounds
- QSBS qualified?
- Antidilution calculation
- Warrants (percent coverage and expiration date)
- Redemption rights
- Vesting of some or all of founder’s shares
- Investor rights to approve important corporate decisions
Please note that model investment document templates that address all of these issues can be directly downloaded from the North American Venture Capital Association’s website.