FRNTIER: VC: 3 matrices for evaluating early-stage startups

Obviousness, capital intensity, timing, market, founder-market-fit and technology.

FRNTIER does research for venture capital. You can read more about our approach here.

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This newsletter provides 3 matrices to provide intellectual clarity when evaluating early-stage companies: obviousness X capital intensity; market X timing, and founder-market-fit X technology.

1. Obviousness x Capital Intensity

This matrix comes from Chamath Palihapitiya (Social Capital; see here).

Re (non-)Obviousness: (non-)Obviousness refers to whether the startup has a secret. Chamath makes the point that it is very hard to determine ex ante and a priori which companies are non-obvious now but will be obvious in retrospect. But the following question helps: Has the company identified an opportunity that others don’t see? (The Secret Question; Zero to One, Peter Thiel and Blake Masters, p. 154). 

Re Capital Intensity: Chamath makes the point “whether [a company is] obvious or non-obvious, [it] want[s] to be in that capital light column.” The reason is because “venture excels in obvious-meets-heavy.” Why? “Because it pays-off the charade.” In short, ‘charade’ refers to the view that most VCs force startups to grow for the sake of growth in order to inflate the startups valuation in following rounds (a “Ponzi Scheme”; see Chamath’s 2018 Annual Letter). However, as Chamath makes clear, it’s better to compound at 25% per year for 25 years (i.e. Amazon) than it is to grow 400% for a year and drop to 8% growth and wondering WTF happened.

This does not mean that investors should not back capital-heavy companies. However, there are two key rules for capital-heavy companies:

  1. The founder(s) must be an extreme outlier; and

  2. It should be funded on a trial-and-error basis.

It seems that there are three types of capital-heavy companies:

  1. Those in winner-takes-all/-most markets (the blitzscaling narrative; think Uber, Airbnb);

  2. Those hard tech companies (think SpaceX); and

  3. Those encouraged to grow for the sake of growth (the ‘charade’/‘ponzi scheme’).

Perhaps 1 and 3 are the same.

You further need to understand why a company is capital intensive and how difficult it will be for the company to become cashflow positive. For example, with regards to scooter companies, you need to understand the durability, depreciation and maintenance costs.

One observation: it seems that companies are beginning to resist the urge to grow for growth’s sake (especially pre-PMF). Consider the rise of companies remaining stealth for considerable periods of time. Think Rippling and Duffel, for example.

2. Market x Timing

This matrix is inspired by an answer Marc Andreessen gave in this a16z podcast. 

Marc indicates that an investor should default into thinking that a technology will happen; they should not spend time on the question ‘Is this going to happen?’ because basically everything happens.

The two questions which you should ask are:

  1. “How high is up?” (market)

Put another way, this means whether the market is large enough. Much has been said about calculating market size so I will not explore it in great depth. Further, I am not well-placed to comment on requisite benchmarks for market size. Suffice it to say that a bottom-up approach is preferable to calculating TAM (see here and here). 

  1. “When will it happen?” (timing)

Put another way, this means whether the timing is right: why now? Is the market ready? Is the technology ready? Are regulatory bodies ready? etc.

A good question to ask here is this: Why did this company not exist before? (h/t Brian Singerman).

See this thread from Erik Torenberg about what good answers to the ‘why now?’ question may look like.

3. Founder-market-fit (FMF) x Technology

This matrix is inspired by Founders Fund’s Manifesto: “Technology matters, but so do teams.”

Re technology: “Properly understood, any new and better way of doing things is technology” (Zero to One, p. 8). There are two types of progress: 

  • Horizontal or extensive: copying things that work; and

  • Vertical or intensive: doing new things (i.e. 10x better).

Founders Fund’s perspective on the two types is summed up by this: “We believe that the shift away from backing transformational technologies and toward more cynical, incrementalist investments broke venture capital.”

Remember the cardinal rule of venture investing: only invest in those companies which have the potential to return the entire fund. It is likely that these will majorly be companies making vertical progress.

Re FMF, questions to consider here include:

  • Who is the person that has X the most decoded? 

  • How much time and effort has the person put into X? 

  • How qualified are they to pursue X? 

  • What is their personality? 

  • Can they build a company around X? (Marc Andreessen; aforementioned a16z podcast)

FINAL NOTES

First, I considered including a matrix with pre-PMF and post-PMF along the x-axis and insufficient-growth and sufficient-growth along the y-axis. However, (1) I am not well-placed to provide the benchmarks at each stage of a company’s growth, and (2) it would have run counter to the ‘charade’ discussion above. That said, it may be a useful matrix you wish to consider.

Second, in light of this discussion, there are two problems with the current state of VC:

  1. Most VCs are chasing growth for its own sake;

  2. Most VCs are investing in incremental technology/companies.

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