Being funded by a VC fund has been glamorized in the past 10 years—and it’s no wonder why. Venture capitalists not only provide funding for startups, young businesses, or high-risk companies; they also often come with a partnership with professionals who are experienced in business development and growth.
Because venture capitalists’ investments tend to be high-risk, with around 65% of VC-backed businesses failing to return their capital. So, what do venture capitalists look for in a business? Good ideas are dime a dozen, so it’s not necessarily the idea that matters. What’s more important is the team, the proof of concept, the size of the market, and the terms of the investment.
1. How is the leader’s capability to lead?
One of the first people the venture capitalists will come in contact with is the CEO. What is his or her presence? Is the person inspiring and a great communicator? Do they seem like a great leader? Do they seem calm and competent under pressure? Do they seem like they would be able to problem-solve and make adjustments should the business hit roadblocks? Are they passionate and knowledgeable about their product/service and industry? These indicators often signal to VCs that the team is one that will succeed in their pursuits.
2. What does the team look like?
In a recent podcast by Tatyana Gray, an angel investor and host of the Angel Investing Podcast, Gray interviewed Sam Bernards, a renown Utah venture capitalist and partner at Peak Ventures. In this interview, Bernards explained why the team is something venture capitalists look for in an investment. “It’s the team that means everything,” says Bernard, saying that 80% of the decision is wrapped up in this qualification.
Venture capitalists want to see a team that is all the way in at the very beginning (not halfway out and waiting for funding to jump on board). The idea is that if the team is passionate about their product or service and can get through the bootstraps stage of growth, then they have the capability to overcome any challenges they will face in the growth process. VCs also want to see a team that shares the vision.
3. There’s a cap table in place.
Since venture capitalists are investing as much (or more) in the team than they are in the idea, they want to see a cap table that will account for the dilution that will happen in subsequent raises. They want to know that the leader in whom they invest will be able to maintain ownership and control through the dilution.
4. The product or service is innovative
Venture capitalists don’t want to see a “me too” or “also-ran;” they want to see a business that either provides a compelling reason for people to change from their current habits, or see something that is truly unique. For this reason, venture capitalists want to see a product that has strong differentiators. They’ll want to see that people don’t have a reason to buy someone else’s product or service instead. If people are already using a similar product or service, why will they want to shift to your product instead?
5. Proof of concept aka “Traction”
Even though venture capitalists are typically investing in startups or young companies, they still want to see proof that the business is a viable one. This means moving beyond just having a product idea to having proof that someone will pay for it (outside of family and friends). They want to see traction with your core market. This should be a broad segment and intentional, otherwise the VCs will be skeptical.
6. There is a broad market
If your product or service is for a very niche market, then chances are a VC fund won’t be very interested. They want to see a large market and see that people are spending (big) bucks in that market. In an article by Forbes, Kathleen Utecht, seasoned entrepreneur, investor, and current Entrepreneur in Residence at Comcast Ventures, Utecht suggest that to attract VCs your market needs to be at least $1 billion.
7. There’s conversion proof (and conversion isn’t too complicated)
Venture capitalists want to see that you can move prospects to the point of conversion. They want to know what the different customer segments are and how you can get to them. They also want to see that there aren’t too many barriers in the buying process and that there is a relatively uncomplicated process for converting clients.
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8. Your burn rate and “runway” look reasonable
Chances are, a venture capital fund is going to take a look at your cash burn. How much do you currently have and how quickly will it run out? They call this your “runway.” Your gross burn rate is the amount of operating costs incurred as expenses every month. If your company is currently earning revenues, then your burn rate will be your revenues minus operating costs and COGS. If you take your money in the bank and divide it by your monthly burn rate, then you’ll get a good idea of your “runway,” or how long you have until you’ve burned through your current cash.
9. You have a plan for what you will do with the money
This—hopefully—goes without saying, but a venture capitalist won’t want to invest in your business without knowing what, exactly, the money is going to fund. This is where a financial forecast can be incredibly helpful. A financial forecast will detail out where the money will go and when, and will use existing trends and educated predictions to show how this is expected to impact revenues, operating costs, cash flow, and the bottom line. Read more about financial forecasts in this article.
10. The terms are attractive
In a study published by the University of Chicago Booth School of Business surveying 885 institutional venture capitalists, the VCs rated the most important factors in deal structure and how flexible/inflexible they were on each feature. In this survey, the most common deal structure features included pro-rata rights, participation rights, and redemption rights. VCs also tended to be less flexible in pro-rata rights, liquidation preference, anti-dilution protection, valuation, board control, and vesting.
11. Realistic potential to 10X
Since venture capitalists are investing in companies that are higher risk, they’re usually looking for 10X exit multiples. This is because half of their investments are likely to be worth zero in five years, and others may return no more than their original investment. In order to provide a reasonable ROI to their LPs across their portfolio of investments, they need to look for businesses that will make up for the investments that don’t return as well (or at all).
When you’re proving this 10x, make sure it’s realistic. Know exactly how you’re going to make those numbers happen (and that they’re comparable with industry standards and similar organizations).
12. It seems like the “right fit”
VCs are looking for companies that fit their investment philosophy and the compliment their portfolio and brand. This isn’t because their snooty; it’s because due to the mentorship nature of venture capital funding, they’re looking for a business to which they can best add strategic value.
About the Author
Troy Skabelund has over 20 years experience as a CFO and Systems Expert for organizations of all sizes and industries, including 12 years at the Walt Disney Company. He specializes in analyzing and designing financial systems with experience in both proprietary and 3rd party solutions.
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