How VCs Evaluate Startups: The Investment Framework
Learn how venture capitalists analyze investment opportunities. Understand the key criteria: team, market, product, traction, and unit economics.
Understanding how VCs evaluate startups is essential for VC interviews—and useful if you're ever starting a company. Here's the framework experienced investors use.
The Evaluation Framework
The 5 Key Factors
- Team – Who's building this?
- Market – How big is the opportunity?
- Product – What are they building?
- Traction – Is it working?
- Unit Economics – Can it be profitable?
The relative importance shifts by stage. Early stage emphasizes team and market; later stage emphasizes traction and unit economics.
1. Team Evaluation
What VCs Look For in Founders
| Term | Definition | Note |
|---|---|---|
| Founder-Market Fit | Why are THEY uniquely positioned to win? | Most important |
| Domain Expertise | Deep knowledge of the problem space | From experience |
| Track Record | Previous startup experience | Not required but helpful |
| Complementary Skills | Technical + business talent | Complete team |
| Grit & Resilience | Ability to persist through setbacks | Startups are hard |
| Coachability | Open to feedback and learning | Will listen to investors |
A seed-stage startup has a great team from Google and a working MVP, but only $10K MRR and limited customer feedback. How should a VC weight their evaluation?
2. Market Evaluation
Market Assessment Criteria
| Term | Definition | Note |
|---|---|---|
| TAM Size | $1B+ market minimum for VC-scale returns | Bigger is better |
| Market Growth | Growing markets are easier than flat ones | Tailwinds help |
| Market Timing | Why now? What's changed? | Tech, regulation, behavior |
| Competitive Landscape | Who else is attacking this? | Crowded can be okay |
| Winner-Take-All | Can one company dominate? | Network effects, scale |
Why Market Matters So Much
"A great team in a bad market will lose to a good team in a great market."
Even the best execution can't overcome a market that's too small, shrinking, or structurally unprofitable. Market size sets the ceiling on returns.
Two startups pitch you: Company A has a 10x better product in a $500M market. Company B has a 2x better product in a $10B market. Which is the better VC investment?
3. Product Evaluation
Product Assessment
| Term | Definition | Note |
|---|---|---|
| 10x Better | Product must be dramatically better, not marginally | Behavior change is hard |
| Defensibility | What prevents copying? | Network effects, IP, data |
| Product-Market Fit | Do customers love it? | Retention and NPS |
| Simplicity | Is the value proposition clear? | Easy to explain = easier to sell |
Types of Defensibility (Moats)
- Network Effects: Product gets better with more users
- Switching Costs: Painful to leave (data lock-in, integrations)
- Scale Economies: Costs decrease with size
- Proprietary Technology: Patents, unique IP, data advantages
4. Traction Evaluation
Traction Metrics by Type
| Term | Definition | Note |
|---|---|---|
| Revenue/ARR | Best proof of value | Customers paying |
| Growth Rate | MoM or YoY growth | >15% MoM is strong |
| User Growth | Active users, signups | Pre-revenue signal |
| Retention/Churn | Do customers stay? | Cohort analysis |
| Engagement | How often do users engage? | DAU/MAU ratio |
Warning
Vanity metrics vs. real metrics:
- Vanity: Total signups, page views, downloads
- Real: Active users, retention, revenue, unit economics
Focus on metrics that indicate real value delivery and sustainable growth.
5. Unit Economics Evaluation
Key Unit Economics
| Term | Definition | Note |
|---|---|---|
| LTV:CAC | Lifetime Value to Customer Acquisition Cost | >3x is good |
| Payback Period | Months to recover CAC | <12 months ideal |
| Gross Margin | Revenue - COGS / Revenue | >60% for software |
| Burn Multiple | Net Burn / Net New ARR | <2x is efficient |
A startup is growing 20% month-over-month but has an LTV:CAC ratio of 0.8x. Should a VC invest?
How Evaluation Changes by Stage
Stage-Specific Focus
| Term | Definition | Note |
|---|---|---|
| Pre-Seed | Team, market, vision | Little/no product |
| Seed | Team, market, early product | Some initial traction |
| Series A | Product-market fit, repeatable sales | $1M+ ARR typically |
| Series B | Unit economics, scalable growth | Proven model |
| Series C+ | Market leadership, profitability path | Category winner |
Key Takeaways
Key Takeaway
- 5 factors: Team, Market, Product, Traction, Unit Economics
- Early stage: Team and market matter most
- Later stage: Traction and economics matter most
- Market size sets the ceiling – Great execution can't overcome a small market
- Unit economics must work – Growth without economics destroys value
Continue Learning
- TAM SAM SOM: Market Sizing — Master market sizing for VC interviews
- VC Interview Questions — Complete VC interview prep
- Top 30 VC Interview Questions — Most common VC questions