VCs ideally like to see revenues growing rapidly as well as a business model that is sustainable, unique and has lucrative profit potential. One softer aspect of the evaluation is the quality of the team and how good a working relationship the VC can have with the team.
A VC evaluates the following in a company that the VC is considering investing in.
1. Credible numbers that show that the market opportunity is large
2. There are not many competitors (ideally, very few) who are trying to address the same problem as the current entrepreneur. Even if there are quite a few competitors, then the VC would like to see if the company being evaluated is among the largest or has a unique differentiator as compared to the other competitors.
3. Unique intellectual property – this could include technology, patents or brands
4. A logical, ethical, and driven team that is committed to corporate governance and is willing to work with the VC
5. The existing unit economics indicate that a lucrative business can be built
This is one of the most important factors that VCs focus on after all the proof of the pudding is in the pudding.
Unit economic analysis seeks to establish two main things:
a. that there has been rapid growth historically and this rapid growth can continue
VCs would ideally like to see that revenues are growing rapidly (greater than 50%) in the last few months or years. If revenues are still not being generated then there has to be some other revenue related metric that is growing rapidly, e.g. volumes or subscribers.
b. what the profitability profile for each unit of product/service sold.
As an example, consider an ecommerce company that sells books. If the existing financials, show an average revenue of USD 5 per book, direct costs of USD 3 per book thereby indicating a Gross Profit of USD 2 per book. Now other costs such as marketing, corporate expenses, are not as much directly related to revenues. So even if the company is currently unprofitable at a PAT level, as long as revenues grow, profitability will be obtained because of economies of scale.
Assume that in its first 12 months of operations, the company had the following numbers
| Currency: USD | Actual historical numbers | Projected future financials | |||||
| Year 1 | Year 2 | Year 5 | |||||
| Books sold | 10,000 | 25,000 | 300,000 | ||||
| Average price per book sold | 10 | 10 | 10 | ||||
| Revenues | 100,000 | 250,000 | 3,000,000 | ||||
| Average direct costs per book sold | 6 | 6 | 6 | ||||
| So direct profit per book sold | 4 | 4 | 4 | ||||
| Total Gross Profit | 40,000 | 100,000 | 1,200,000 | ||||
| total marketing costs | 50,000 | 80,000 | 900,000 | ||||
| marketing cost per book | 5 | 3.2 | 3 | ||||
| corporate expenses | 20,000 | 24,000 | 150,000 | ||||
| Corporate expenses/book | 2 | 1.0 | 0.5 | ||||
| Total net profit | -30,000 | -4,000 | 150,000 | ||||
In the company above, one can see that the direct profit per book of USD 4 has been maintained in the two years of operations. Additionally, there has been high growth of 2.5x (in volumes).
A key takeaway is that indirect costs such a marketing and corporate expenses are reducing per unit as volumes increase. This is because of economies of scale and because of ‘operating leverage’ on these cost items. If an investor can develop comfort around volume growth, and if the unit revenues/cost sustain at the existing levels/trends then there could be significant trends as the company reaches a certain threshold value then profits should be generated. This can be shown above in the projection for Year 5, where assuming that if the company can sell 300,000 books, maintain gross profit margins make some improvements in marketing/corporate costs per book, then profitability can be achieved.
VCs want to see some form of above outcomes in order to develop comfort around the financial profile of the company. Independent of any discussion with the VC, an entrepreneur should track the above dynamics in order to ensure that the business is progressing in the right direction.
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