Four VCs on Evaluating Opportunities

Four venture capitalists explain to Harvard Business School professor Mike Roberts and senior research associate Lauren Barley how they evaluate potential investments.
by Lauren Barley

What makes for the ideal entrepreneurial opportunity?

To learn about the frameworks firms use when evaluating potential venture opportunities, Mike Roberts, executive director of the Arthur Rock Center for Entrepreneurship, and HBS senior research associate Lauren Barley recently interviewed four venture capitalists from leading firms in Silicon Valley. The following are excerpts from their responses.

Russell Siegelman (hbs Mba '89)
Partner, Kleiner Perkins Caufield & Byers

The most important requirement is a large market opportunity in a fast-growing sector. We like a company to have a $100 million to $300 million revenue stream within five years. This means that the market potential has to be at least $500 million—or more, eventually—and that the company needs to achieve at least a 25 percent market share.

The second factor involves a competitive edge that is long lasting. It is usually an engineering challenge that is tough enough to give the company an edge, resulting in several years lead or longer, if we're lucky. We look for a tough problem that hasn't been solved before. The solution can't be so straightforward that someone can look at the blackboard and say, "I know how to do it."

The third thing is team. We look for engineering vision and execution, sales, and entrepreneurship in a team. Typically, it's at least two people; sometimes it's three. In the early stages, I tend to invest behind an entrepreneur, not behind a professional manager as the CEO. Entrepreneurs have to have a clear sense of the opportunity and how to build the business. But the best ones are willing to reexamine their assumptions and are willing to veer left or right or pivot all the way around when the data suggests they're headed in the wrong direction.

So overall it's a funny mix. When we review an investment opportunity, entrepreneurs have to have a pretty good story to tell about what they want to do. I think it helps to be cocky, there's no doubt about it, but if you're not sufficiently confident, you're not going to be successful in selling your idea.

Sonja L. Hoel (hbs Mba '93)
Managing Director, Menlo Ventures

I always look at the market first. By that I mean a strategic view that includes evaluating market growth, market size, competition, and customer adoption rates. If a company has a great market, it doesn't need to have a complete management team or positioning story or sizzle. The details can be filled in later.

We have a process here called SEMS, or Systematic Emerging Market Selection. We do a SEMS project for every investment we make. Twice a year at our planning meeting, we talk about new markets or problems that need to be solved.

We track four things and relate them to the success of our investments: market size, the team, unique technology, and whether the product is developed at the time we invest. We found proprietary technology is important but doesn't make much of a difference as a unique differentiator for significant returns. Market size and a developed product matter most. We have much better luck if the product is in beta or shipping, although we do invest in start-ups without a developed product. Often someone has a great new technology, but hasn't looked at the market the technology is going to serve.

In order to create a barrier, the technology has got to be hard to execute. Some companies have patents; some don't. We encourage them to have patents because it's a more litigious environment than it was ten years ago.

We also look at the management team. If we've got a founder who's in it for the lifestyle or unwilling to upgrade the team if necessary, we have a conversation about the willingness to hire new team members.

We also look at location. It is very easy to hire good people in Silicon Valley and in the Boston area. In other places, it's a lot more difficult.

Fred Wang (hbs Mba '92)
General Partner, Trinity Ventures

In no particular order, for us they are team, market opportunity, and the product/value proposition for the solution. Technology differentiation or business model differentiation is also important to sustain a competitive advantage.

One potential point of differentiation between us and some other firms relates to how we think about the CEO. A couple of years ago, we analyzed our successful companies across multiple dimensions. The one trait of all our successful companies was that the CEO we backed at funding was still the CEO at the sale of the company or IPO. So now, to fund a company, we need to believe that the existing CEO could bring the company to a successful outcome.

We found proprietary technology is important but doesn't make much of a difference as a unique differentiator for significant returns.
— Sonja L. Hoel, Menlo Ventures

As a result, we spend a lot of time focused on the CEO and the members of the management team: the quality of the people they attract, their biases, their strong points, and their overall depth.

We've also done some analysis that suggests another big determinant of success is the sector; it's a sector bet. If we're investing in the right sector—even if the team is more mediocre, or the execution isn't as good—the rising market lifted all the companies in that sector.

Our rule of thumb is we'd like the company to get to $100 million in revenue. Realistically, if we can see the company get to $50 million in revenue and the valuation is right, it could still be a good venture deal. In a decent IT market, a $50 million revenue company should be worth at least a $100 million to $200 million outcome. At that point, we're making a good venture multiple, potentially a five to ten times type of return.

Here's one that we typically won't do: It looks like a great technology, really groundbreaking, could be a huge market, but it's a technologist—sometimes a wild-eyed technologist—who's driving it. The businessperson is either weak or not there at all. The hit rate and the time it takes to constantly arm wrestle with the technologist are issues we try to avoid.

Robert Simon
Director, Alta Partners

There are two schools of thought in evaluating new opportunities. In the first, the venture capitalist says, "I invest in people first and foremost. Smart people will find great opportunities, and they will always know the sectors or technologies better than I would." In the other, the venture capitalist says, "I don't care about people; I care about markets. I look for big opportunities, big painful problems that customers have. If management doesn't work out, I can always fix management." The truth is obviously somewhere in between, but I tend to place more weight on the market opportunity versus the team. In our experience, markets trump people and trump technology.

When analyzing the market for a new product or service, we try to determine whether the product is a replacement for an existing product or whether the product is offering something new and previously unseen. The replacement product can be called the better, cheaper, faster model. With these opportunities you can estimate market size by looking at the revenues of the existing product shipments.

Conversely, a product that provides new functionality previously unseen, we call the brave new world model. Here, the market size and demand are really unknown. These often are in the consumer sector. Netscape, Yahoo!, and the Sony Walkman are examples. The brave new world model certainly has a greater market risk but not necessarily more technical risk.

Additionally, there are market timing issues. If we're too early, there's no market demand, and we have to survive until the demand reaches us. In that period of time, we have two problems: We have to keep the doors open and feed everybody, and we may be susceptible to being leapfrogged by technology. So we don't want to be too early, but we don't want to be too late.

Everyone wants the $1 billion market. We don't necessarily target market share for our companies; we target revenue. We expect north of $60 million to $80 million in revenue in three to five years. We get to market size by estimating how many customers feel the pain. We like customer pain.

We also look at the technology to see how proprietary and difficult the solution to the problem is. The ideal case is four Ph.D.s solving a problem they've been working on for two years, and somehow they've struck upon the magic solution. And it's two orders of magnitude better than whatever else is out there. Finally, we want the team to have conviction. We get a little concerned when the entrepreneur comes in and says, "I'm in this to flip it in a year." So if we get the impression they're not in it for the tough times, then it's definitely a problem.

About the Author

Mike Roberts is a professor at Harvard Business School and executive director of the Arthur Rock Center for Entrepreneurship.

Lauren Barley is a senior research associate at Harvard Business School.