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50 Questions: How does a VC evaluate a company’s product?

Fortieth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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VCs evaluate products by looking at demos and having a play themselves, by soliciting third party opinion and by looking at whether and how customers are using and paying for the product. The balance between these three methods of evaluation, lets call them ‘direct’, ‘third party’ and ‘customer’, depends on the stage of the company, the nature of the product and the experience of the VC.

Starting with ‘customer’, unsurprisingly, the more customers and revenues a company has the more a VC will look to what they are doing to tell him or her whether the product is good. If the product is great customer numbers will be increasing, per customer usage (often termed engagement) will generally be increasing, customers will be expressing their love for the company on blogs and in reference calls, analysts will be saying good things, and the price point will often by higher than for competing products. Two caveats are appropriate here. Firstly, some products are great precisely because they are cheap, often because they have simpler than the competition (e.g. Skype). And secondly, it is possible to build a profitable company with a product that people hate but buy because it is cheap (e.g. RyanAir), although in that case I would say you have a good business, and probably a strong capability elsewhere in your organisation (e.g. supply chain management, marketing), but not a good product.

With earlier stage companies investors generally don’t have the luxury of being able to rely on hard metrics and instead have to rely on gut feel – i.e. ‘direct’ evaluation. If they have relevant experience and the product is consumer focused, or a business product that can be demonstrated, then a large part of the opinion on the product will be formed based on what they see and feel when viewing or using the product. VCs without experience (which can come from either investing or operating) often struggle to differentiate between a good product and a bad one.

Finally, investors often ask ‘third party’ experts for an opinion. This is most common when the product is deeply technical and there isn’t much to be learnt from direct observation. In this situation the expert will generally be giving a view on the technology risk as well as the product. VCs often use executives in relevant portfolio companies to do this expert review. Sometimes they use third party consultants. The expert’s opinion will most likely have a big impact on whether the VC decides to invest, and it is advisable to work with the VC to ensure the person conducting the review has the right background to understand your company and give a good opinion.

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  • http://twitter.com/a_alshalabi Abdullah Al-Shalabi

    Makes sense to me. However, my team and I are currently in the stage of developing the product and will probably take 3 months to get to a product that the VC’s can play with (MVP). Should we wait until we get our product ready (after 3 months) to pitch to VC’s? Or we can start pitching while the product is under development? 

  • http://www.theequitykicker.com brisbourne

    Hi Ced – it is hard to determine what good looks like in advance, so agreeing metrics up front is generally difficult.

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  • http://www.facebook.com/people/Sharky-Rechinas/100003609817993 Sharky Rechinas

    Maybe add some “unofficial experts” which are the VCs kids – especially in Social Media and Games :-). Finished reading thank you.

    What are your thoughts about entrepreneurship life evolved in the last 100 years? Would Ford/Porsche/Ferrari/UHaul, Disney still have fun today starting a business?

    How about future – you need less and less money for infrastructure, less and less money for marketing etc.
    What do you think of crowdfunding?

    How serious is the “competition VC Threat” – someone has first mover advantage, start having traction then a competitor (new or existing) recieves 10x more cash even if they have less traction. Is this a real word threat ?

    Why do you think when Facebook received their first 500k investment we did not see a big VC throwing 20 million to a competitor “clone” or similar product – it would have been very easy to replicate and even get more initial users .

    Can a clone win the war or it is very unlikelly to catch up on invovation (they lost in Star Wars) ?

    Thank you,
    Sharky.
    We shall see.

  • http://www.theequitykicker.com brisbourne

    Hi Sharky – lots of questions! Keep reading (and commenting!) and I will try to answer them over time. Here’s one now – nobody cloned Facebook until it was too late because it was a novel model and they didn’t believe in it. This is true of many of the most successful startups. Google was the same.

  • http://www.facebook.com/people/Sharky-Rechinas/100003609817993 Sharky Rechinas

    so “better mouse trap” sindrome :-). cool. tx.