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 young and innovative businesses; they also bring a partnership with seasoned professionals and experts with a proven ability to develop and grow a business.
Because venture capital investments tend to be high-risk, with around 65% of VC-backed businesses failing to return their capital, VCs tend to be very selective about where they place their money. With so many businesses seeking VC investment, competition for VC funds can be fierce.
So what do venture capitalists look for in a business? While essential, a “good idea” is not enough. A number of additional factors weigh into venture capital decisions, including the team, the proof of concept, the size of the market, and the terms of the investment.
1. Leadership Ability
One of the first people the venture capitalists will come in contact with is the Founder/CEO. What is his or her presence? Is the person inspiring and a great communicator? Do they seem fully committed? Are they willing to listen and take advice? 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 Founder has the potential to succeed. If a Founder feels they are lacking in this regard, adding a strong CEO can beneficial.
2. A Strong Team
In a recent Angel Investing Podcast, host and angel investor Tatyana Gray interviewed Sam Bernards, a renown Utah venture capitalist and partner at Peak Ventures. In this interview, Bernards explained that the team is a top factor venture capitalists look for in an investment. “It’s the team that means everything,” says Bernard, stating that 80% of the decision is anchored in how they feel about the team. The bottom line is: VCs invest in people, not just businesses.
Venture capitalists want to see a team that is “all in” from the beginning (not waiting in the wings for funding to arrive before they 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 determination to overcome any hurdles they will face in the growth process. VCs also want to see the team shares the founder’s vision and offers the relevant skills and experience to face future challenges the business will face as it expands. Smart founders are very strategic as they build their core team, making it a source of value that VCs find attractive.
3. A Clean Cap Table
As a general rule, when venture capitalists look at a company, they tend to prefer to see a limited number of investors and they like to see accredited investors (over $1 million of assets not including their home or making a high income multiple years in a row). This means a VC will want to see the capitalization table (list of shareholders, how much of the company they own, and the amount they have invested). Early-stage businesses often require multiple rounds of investment and the cooperation of existing investors. Carrying a large number of small investors—especially family—can be a real challenge, making it hard for smaller investors to keep up with larger ones in later rounds. A “messy” cap table is a turn-off and increases the risk of conflict in the future. Most entrepreneurs walk a fine line to secure much-needed capital early on without adding baggage to their cap table.
4. Innovative Product
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. Broad SOM (Serviceable Obtainable 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. Reasonable Cash Burn Rate
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. A Detailed Plan for How the Capital Will Be Put to Work
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. Favorable Terms or Downside Protection
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. 10x Potential
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. Investment Thesis 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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