I’m sure you’ve heard of VCs doing ‘due diligence’ before making an investment, but what does it actually mean? I get asked a lot from founders who want to raise from VCs, but also from people who are or aspiring to be angel investors.

This topic could go on for many essays, or even a book, so this post focuses mostly on pre-seed/seed (vs growth/beyond) and just scratches the surface. Subscribe below if you want to be updated when I publish the future parts including a) how angels should apply this - i.e. things they should follow vs things they should evaluate differently, and b) how Series A + beyond startups are diligenced.

I’m also ✨trying something new✨. For anyone who shares a link to this post or my beehiiv on social media or in a relevant Discord/Slack/relevant group chat, reply back with a screenshot and I’ll randomly select one person at the end of the month who I’ll do a free deck/pitch/investment review for. You can be a founder who wants a second pair of eyes on your deck/to practice pitch and get feedback, or if you’re an investor evaluating a deal, I’ll evaluate the prospective investments’ materials with you. Shares will count as separate entries (i.e. if you post on Twitter and also share it in your founder group chat, you’ll get 2 entries). Thank you to everyone who’s already been sharing!

Here’s how VC’s invest:

OK kidding, here they are from rough order of most to least important:

Founder pedigree / founder-market fit

This is by far the most important thing VCs look at, especially at the pre-seed/seed stage. Some firms go so far to say that it’s the only thing they look at (since it’s more than likely the company will pivot, so why bother evaluating anything else?).

What does this actually mean?

• Superficially, pedigree can matter. Where did the founder go to school, but weighted more (usually), where did they previously work? Signaling is powerful

• Digging a level deeper, VCs are trying to figure out:

  • Does this person have the drive, skill, and intelligence to build a unicorn? Is this person a high caliber performer? Does this person know how to run a successful company and hire a good team? If a company is reputable, prestigious, and/or known for good talent, these feel more likely

  • How insightful/unique is this person’s insight? How well suited is this person to execute on this idea? If the person was at a high-growth startup in a relevant/reputable industry that’s continuing to grow rapidly, that person is more likely to be an expert/have first hand experience with whatever it is they’re building

Size of the opportunity - aka is this company able to be a unicorn?

Even if a company and founder are amazing, VCs may pass if they don’t think the opportunity is big enough. VCs’ success depends on investing in companies that have huge returns because of the power law:

I’m sure you’ve heard people asking about the TAM (aka total addressable market) of a business, or hearing people refer to their company as the “Uber of X.” This is because these are two things that help VCs get comfortable with the idea that a company could be a unicorn. (Data + ~pattern recognition~ = compelling to VCs)

Speaking of Uber, the company was famously underestimated when it came to market size (some VCs looked at Uber’s potential as being the size of the black car market, but had missed the bigger picture of what Uber could become in its most ambitious dreams). Some VCs therefore dismiss market size, and instead evaluate a founders’ ambition and desire to build a unicorn (vs specifically measuring the literal company TAM as it exists today).

Solving a real problem / early signs of traction

Related to the size of the opportunity, VCs want to see that a product is solving a ‘real problem’ and the most common way they evaluate it is through early signs of traction.

For consumer, people are looking at a variety of things including:

• number of waitlist sign-ups or app downloads

• retention and frequency of use by active users

  • there’s a common VC perspective that huge ideas start off ‘looking like toys’ or are avidly used by a small community, so retention/frequency of use can be commonly evaluated even more heavily than overall absolute user numbers (especially when at pre-seed/seed, these numbers are likely to be relatively small anyway)

• are users paying? if so, how much? what could a LTV/CAC look like?

• user testimonials and NPS (aka, do people LOVE it?)

For enterprise, it can be things like: