The Three Things you Must Know to Invest in REGCF
One of the most common ways that VC firms that we work with such as Metaprop, Lerer, and Sequoia evaluate the health of deals is through three factors: Growth, Margin, and defensibility.
Growth: the revenue generating potential and scalability of the organization
Margin: the amount of profit in every unit of sale
Defensibility: the amount of technology or partnerships you create in order to create a defensible moat around the company
Let’s examine each of the three and how VCs commonly analyze deals for positive signs of each.
Growth
While margin and defensibility are important, we are going to focus on the Growth segment herein first, as it is the largest driver: how you accurately assess the growth potential of a venture business that is expected to scale exponentially.
Most businesses operate under a fundamental principle of growth: if your revenue exceeds your costs, you will be profitable, and thus a good business. As venture businesses are often not profitable due to high technology and engineering costs, it is important to look at the sales Unit Economics: how the business grows, how quickly, and what sort of scale it can achieve within a total addressable market.
If the Total Addressable Market is sufficiently large, AND there is demonstrated Product Market Fit (a number of happy users solving their problems with it), AND there is a clear path to scale, this is typically a solid venture investment.
TAM analysis also gives way to what is referred to as a Total Sales Opportunity which is the measurement of what a company can sell within a TAM. Let's assume that there is a TAM of $200B within a given market: however, there is likely only a certain Ideal Customer Profile (ICP), and an Average Order Value (AOV) for that company. Within large TAMs we often see only a small number, like10,000, companies as ideal, and most SaaS that is non-enterprise sells for between $5,000-$10,000 annually -- this often represents a TSO significantly smaller: 100M in this case!
The best way to assess sales units is by understanding the process of sales, as if it is an assembly line: revenue comes from deals, and those deals from meetings, which come from emails or cold calls traditionally. We look at how many calls to meetings to sales create the revenue, and then how they are kept.
The secret sauce for most sales organizations are in these numbers: if a salesperson costs $5000 per month, and can generate 100 calls per day, 500 per week, generating 20 meetings which result in 4 deals, with an AOV of 5K for a total of 20k, that salesperson is generating 4x their cost.
How they GET those calls/emails (what data is used, at what cost) also is part of this assembly line! Marketing analysis of how brands collect this data is critical:
What is the SOURCE of the data (zoominfo, motive, seamless.ai, etc), and how do they acquire it, through purchase or scraping
How do they SORT this data; do they simply send out a bulk of emails
How do they SELECT deals and prioritize meetings
Most companies have not devised scalable means of data and marketing: they have in some cases not created the systems to scale acquisition of data, email marketing (when there are generally restrictions on how many emails you can send), or even prioritization of deals (they are unable to service inbound deals in some cases). Be mindful of this when you look at diligence: can the company scale from marketing all the way through sales and account management?
Growth is a direct result of the processes in place along the entire production line, from marketing to sales to account management.
Margin
Margin analysis runs the gambit from understanding the actual cost of creation of revenue and your true expenses related to the product and the sale. Labor cost can tend to be a large driver of cost which can impair margins: how much work really goes into each sale? One way of analyzing this runs alongside unit economics, and an understanding of how the sale is produced: is there an increase of cost when sales scales?
Margins are typically reported by the company in their investment decks and pitches, so the task of calculation is not left to the investor. The key is attention to the sales process and margins themselves. For example, SaaS businesses are typically high margin, given the product is cost effective to produce, and then highly distributable with low cost, whereas Consumer Product Goods can be extremely expensive to produce in a competitive environment, yielding lower margins and a greater need for sales at scale. That said, the investors gut and intuition matters here: do you see a business with a product that is a need-to-have, that market forces will require everyone to use like a CPG product used daily or SaaS that drives revenue from outsized market demand, or simply a nice-to-have like a CPG supplement.
The further challenge with margin is that it is largely obfuscated by marketing dollars, cost of acquisition, and true costs of what it takes to grow sales over time. Many margins assume acquisition costs which don’t account for variable marketing costs, such as changes in paid media. Most CPG sales are not driven by organic channels, such as media, but rather by performance marketing which is a variable cost outside of the company’s control. The recent decline of major companies like All Birds is attributed to variable costs in media. It is extremely difficult to sell products at different phases of the business, past first and second adoption cycles – in many cases, that outsized cost to sell the product can and will affect the margins of the business.
You must believe that the product has room for growth in a sufficiently large enough market to make it a large enough company to return your investment, and to sustain a healthy enough margin through that process.
Defensibility
Defensibility largely comes from technology, offering a moat: your tech can do something the opposition cannot, and it takes them too long to catch up to you. In the case of a brand, defensibility comes in the form of brand recognition or brand moat – the company has developed something so visible, so outstanding, that it is easier to market, and easier to acquire the customers needed for growth because of recognition.
Further, exclusive relationships helps defensibility tremendously. Seamless originally pioneered online food ordering by building exclusive relationships with the top banks and law firm for food delivery: in exchange for a platform that reduced expense reporting in employees and saved thousands of man hours, law firms and banks agreed to only use Seamless. Seamless was then able to approach restaurants as the “corporate food account” for all of these banks and firms, offering restaurants tens of thousands of dollars in food ordering, if they agreed to use the Seamless system (with its fees).
In investing in companies, we look for a competitive advantage in technology, but we also look at brand value, and in exclusive relationships: what leverage does the company have over the consumer or the market?
Oftentimes, companies move markets towards destinations they are growing toward: some of the greatest companies usher in change that is met with resistance but ultimately offers efficiency and scale. Online food ordering, AI, and the green revolution are just a few examples. Not even 20 years ago, the idea of being sustainable was considered niche, whereas now, demand buoyed by younger generations is so massive that companies who are not transitioning to sustainability are being left behind. There are major opportunities to capitalize on these transitions to markets, and moreover, to find companies building moats around these trends: companies like Tesla are fantastic examples, as the demand for green was appended to a fantastic industry changing product, and thus major growth was achieved. Tesla developed defensibility not only in the product, but also in the network of charging stations it developed.
Conclusion
While there are many ways to evaluate these businesses, some of the best investments come for your gut and intuition. Believing strongly in a company is not a substitute for diligence, and the above factors are what the best investors in the space use to make their decisions, but you are less likely to regret a decision you believe strongly in. Diligence is the process of reinforcing a belief more than the process of removing doubt: we don’t evaluate companies that we do not believe in, and most of us make that determination rather quickly. Use these tools to help reaffirm the position taken by your intuition.
