How does SFC Capital select companies?

In previous articles, I covered SFC Capital’s “volume with discipline” investment strategy, and our focus on building diversified portfolios across a large number of companies and sectors. I also discussed the trends that we are targeting where the UK has strong strengths, from AI and B2B software to life sciences, fintech, climate, deeptech and consumer innovation.

This article is about the next question: if you have a broad strategy and review thousands of opportunities coming from many different sectors, how do you put in place a selection process that works consistently across so many different companies?

At SFC, we have solved this by building a scoring matrix that can be applied to any company, regardless of sector. Early-stage investing will always require judgement, and this is no substitute for it. But it gives us a consistent way to evaluate opportunities, compare companies, and most importantly, make sure that we do not get overly excited about one attractive aspect, such as a brilliant technology, a famous investor, a fashionable market etc. while overlooking all the other fundamentals that ultimately determine whether a company has a chance to succeed.

Focusing on the fundamentals

The useful thing about early-stage investing is that, although companies can look very different on the surface, many of the underlying questions are the same.

A life sciences spinout, a B2B software company, a fintech platform and a consumer brand may operate in completely different markets. But at the most basic level, a business is always a group of people getting together to bring a solution to a problem that customers are willing to pay for.

Everything else stems from that definition. Who are the people and how did they come together? How large is the opportunity? Is the solution genuinely differentiated? Is there evidence that customers care? Are the incentives aligned? Are the investment terms attractive?

Our scoring matrix is designed around these questions. It helps us assess companies across a range of dimensions, including the founding team, commercial potential, market size, technology, intellectual property, traction, company structure, funding requirements and deal terms.

Of course, the weight given to each factor can vary depending on the sector. A pre-revenue life sciences company cannot be assessed in exactly the same way as a consumer brand already selling thousands of units online. But the core idea is the same: we want to understand whether this team has what it takes to build a valuable company and ultimately deliver a return for our investors.

People first

The area where we spend the most time is the founding team. This starts with the obvious: meeting the founders, looking at their experience, track record, educational background, previous jobs, sector knowledge, and the complementarity between co-founders. We want to understand why this team is well placed to solve a particular problem.

But the CV is only the starting point. What we also need to assess is whether the founders have the right mindset to build a company. Can they test their assumptions in the real world? Can they sell? Can they listen to customers and adapt when something does not work? Can they attract talent, investors and partners? Can they stay focused and committed despite the difficulties?

In many cases, the best founders are not necessarily the ones who have the most polished CVs, but those that demonstrate vision, grit and resilience from a very early stage.

That mindset is not easy to uncover at all, and it takes asking difficult practical questions to get to the bottom of it. Do you accept that you will be working for a below-market-rate salary until the company can afford it? How will you make it work? What would happen if the company could not pay your salary for a period of time? What would you do if one of the founders decided to leave? How would you react if revenue took longer than expected? What if the next funding round is not raised, what would you cut first and what would you protect at all costs?

The answers to these questions matter, but we are most interested in the thought process and what it reveals about the founders. We are looking for signs of resilience, self-awareness, realism and commitment. We want to see founders who do not expect an easy ride and understand that things will go wrong and have already started thinking about how they would adapt.

That’s why previous entrepreneurial experience can be such a positive signal, whether the previous business succeeded or failed, as it shows that the founder is aware of how difficult the journey ahead will be. But we still need to get a clear sense that lessons have genuinely been learned and whether the founders can explain why this new company benefits from that experience.

We also particularly like it when co-founders have worked together before in another high-pressure environment. Founder relationships are tested intensely in the early years of a startup. Prior working history can give us confidence that the relationship is based on more than the initial enthusiasm at the point of incorporation.

And, for the record, we have nothing against husband-and-wife teams. If anything, we can usually assume that there was (at some point at least!) a strong connection between them. That is more than can be said for teams assembled more recently, as part of an accelerator programme for example. This is not necessarily a dealbreaker, but we are particularly careful when assessing team dynamics where the founders have not known each other for long.

Structure, incentives and commitment

A strong team can only perform well if the company structure is sound. We spend a lot of time looking at the cap table, founder equity split and incentive structure. The people driving the company forward need to be properly incentivised.

We do not like dead equity. We do not like overly complex structures. We do not like situations where the company is entangled with other businesses controlled by the founders, or where the ownership structure makes future funding unnecessarily difficult.

We want to see a clear driver in the business. In many cases, we like companies with two or three co-founders, because building a startup is extremely difficult and it is rare for one person to have every skill required. But a co-founder structure only works if roles are clear, incentives are fair and if there is someone who brings the energy, urgency and leadership required to push the company forward.

Solo founders can be riskier, but it is not a dealbreaker and we have seen excellent solo founders build very successful companies. The question is whether the founder understands the gaps around them and is capable of building the right support structure.

Most importantly, we want to understand whether the founders are full-time at least once investment is completed. Commitment matters and a startup cannot grow much as a side project, especially once you have raised investment.

This is one of the areas where university spinouts can become difficult. Sometimes the original inventor owns a large shareholding, but is not the person actually driving the company. That leading person can have the entire responsibility of building the company but not enough equity to reflect that role.

In these types of situations, it becomes much harder to see how the company can scale, no matter how exciting the technology. That is a lesson that we have learned over the years the hard way, and that we are particularly attentive to now.

Innovation and market evidence

Once we are comfortable on the team, we look closely at the more traditional investment criteria: innovation, intellectual property, market size and traction.

Is the company solving a real problem? Is the problem large enough to support a venture-scale outcome? Is there evidence that customers care? Can the company defend its position if it succeeds? Are there credible routes to market?

Intellectual property can be important, especially in science-based and deep tech companies. But IP in itself is not enough. A patent is only valuable if it protects something that the market wants. A technology is only exciting if it can eventually be turned into a product or service that customers will adopt.

This is why we like founders who do not stay in the lab, whether literally or figuratively. We want to see evidence of market demand. That evidence can take different forms depending on the stage and sector: customer interviews, letters of intent, pilots, paid trials, strategic partnerships, grant validation, regulatory progress etc.

Sometimes the potential impact of a technology is obvious. But even then, commercial thinking matters. Who will be the buyer? What does the customer use today? What needs to happen before adoption becomes realistic?

Founders who already have answers to those questions will usually score more strongly than those who are purely focused on the technology.

Never overlooking the terms

Finally, we look at the terms of the deal. This is where many investments fall through: we’re excited about a team and what they are building, but can’t agree a reasonable valuation that gives us a good chance of delivering our target return.

Valuation, round size, dilution, liquidation preferences, shareholder rights, use of funds and future funding requirements all add up over time. Experienced investors know that at pre-seed stage, the entry price is a major driver of their eventual returns.

The reverse is also true. A company operating in a smaller niche, or one that may not look like a classic venture capital opportunity at first glance, can still be highly attractive if the entry point is sensible and gives us the right upside if things go well.

Our recent exit from Hunter & Gather, a food and wellness brand, is a good example. The partial secondary sale generated returns of up to 33x for early investors, a return that tech investors would be delighted with. The reason it was possible was not just that the company performed incredibly well, but also because the original valuation made that upside possible.

That is why terms are not an afterthought in our process and form an integral part of the scoring of an opportunity. We are not simply trying to determine whether a company can succeed, but also whether our investment, on those terms, can offer the right risk-reward balance for our investors.

A work in progress

We are not naïve and accept that early-stage investing can never be entirely formulaic. But standardisation and repeatability matter. When you review thousands of opportunities a year and invest in more than 100 companies, you need a process that is consistent enough to create discipline, but flexible enough to recognise exceptional opportunities.

Our scoring system helps us compare companies across sectors and forces us to look at all the fundamentals in a startup. It reduces the risk of being carried away by hype, fashion or one impressive feature. It gives our investment team a common framework for discussing opportunities and to learn from our own decisions and mistakes, and feed those back into the model to constantly improve it.

Volume is what gives us the opportunity to capture outliers. But it’s the selection discipline that determines whether we can translate it into consistent returns for our investors.

Capital at risk. Past performance is not indicative of future performance.