“Week 4 of VC School: Quantitative Due Diligence” is part of a ten-week series from the interns at Bowery Capital. The series will cover lessons learned and concepts covered during the weekly “VC School” meeting, a program taught by the Bowery Capital team designed to teach interns the fundamentals of the venture capital space. This summer, we want to open our doors and share these lessons with the broader community.
Last week, we did a broad overview of the due diligence process focusing on qualitative factors to consider while reviewing a deal. This week, we did a deep dive into the quantitative components of the due diligence process. To reiterate, there are many categories to consider when reviewing a company during due diligence including: market size, team, deal terms, product, competition, valuation and financials. When thinking about quantitative due diligence we typically focus on market size, company financials, and valuation. Some main things to consider when conducting quantitative due diligence are below.
1. Market Sizing. Market sizing exercises help uncover the size of the market that the company is operating in. There are typically two ways to think about market sizing: bottom-up and top-down. Bottom-up is the more quantitative approach and is done by focusing on a company’s unit economics. For example, a company sells a product for $X to Y number of potential clients for a total addressable market (TAM) of Z. Top-down market sizing often relies on analyst reports to estimate the largest possible market and then using assumptions to narrow down to a company’s TAM. Bottom-up analysis tends to be the most accurate approach for estimating how large an opportunity, while top down is useful to provide high level analysis. When conducting a market sizing its okay to sometimes use the sources that a company provides, but make sure to do your own research and verify them.
2. Company Financials. Evaluating a company’s financials such as their profit and loss statement helps us understand the company’s revenue and cost structure. The analysis will vary based on the size of the company – analysis of a seed stage company’s financials will be higher level than a series B company. Since there will likely be less historical data for seed stage companies, the most important part of this analysis is looking at the underlying assumptions used in their projections. Test the assumptions in their model based on market comparables and academic research. It’s usually more important to focus on cost assumptions than revenue since costs tend to be the main driver of financial instability and can show when a company will run out of money. Understanding the underlying assumptions will help provide insight into how much a founder has actually thought about the business.
3. Market Comparables and Valuation. Understanding a company’s market comparables and valuation will provide insight into what a liquidity event could potentially look like. To develop market comparables, put together a list of acquisitions of similar companies and revenue multiples of similar public companies. The qualitative due diligence that you have already done on competition can help drive this analysis. Using the average revenue multiple of the similar companies and the financial projections from the company financial section will provide an estimate of what the company would be worth at liquidation. Tying in the capitalization table allows you to estimate your firms projected ownership percentage and the estimated cash on cash return for the investment.
1. Calculating TAM. This article breaks down the different ways to calculate total addressable market include top down and bottoms up analysis. If you are looking for an actual market sizing example this article provides a deeper dive into TAM and walks through the market sizing of WeWork.
2. Why TAM doesn’t matter. This contrarian point of view from TechCrunch argues that only focusing on TAM caused some VCs to miss some of the biggest companies that successfully expanded their market size such as Amazon, eBay, and Airbnb.
3. Building comparable tables. This article provides a step by step tutorial on how to build an effective comparable analysis.
4. Quantitative guide to startups. This article from TechCrunch provides a complete overview of all quantitative metrics used to analyse startups including financial metrics, user metrics, acquisition and marketing metrics, and sales metrics.
5. Capitalization tables. The Corporate Finance Institute provides a great explanation of capitalization tables and also provides a free template to download.
Check in next week for our lesson on execution!
If you liked “Week 4 of VC School: Quantitative Due Diligence” and want to read more content from the Bowery Capital Team, check out other relevant posts on the Bowery Capital Blog.