What Venture Capitalists Look for in Start-ups
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Venture Capital (VC) funding is a key element in the growth of innovative technologies and solutions. Innovations by their nature carry large risks in their development and adoption and VC funding provides the risk capital that can bring them to market.
Before we come to what a VC fund looks for in a start-up, let’s look at what the motivations for a VC fund are because this shapes what it looks for in start-ups. VC investing is primarily about exits. This class of investors typically do not look towards nurturing a start-up and earning profits from its operations over its lifetime but rather look at how easily the investment can be exited at a profit. The range of investment time horizon is typical 3-7 years. The exact time horizon differs from firm to firm and is determined by a couple of factors:
· Time the VC expects the start-up to mature: A very early or seed-stage VC will have a slightly longer time horizon, while a growth-stage VC will have a shorter time horizon.
· The second factor is the ‘vintage’ of the specific fund that the investment is coming from. For example, a fund raised in 2010 with a tenure of say 7 years and looking at an investment prospect in 2014 will not look at a time horizon longer than 2-3 years. This is because, at the end of the tenure, the investment has to be returned to the individual investors in the fund.
The other consideration in VC investing is something akin to the Pareto Principle, more commonly known as the 80:20 rule. Under this approach, it is assumed that 20per cent of the investees (or maybe even fewer) will provide 80per cent (or more) of the returns. This comes from the acknowledgement that some of the investments will fail – that is after all the nature of the game in backing early-stage start-ups.
Now, considering this time horizon and the fact that a VC wants the investment prospect to be one of the 20per cent successes and not one of the 80per cent failures or middling investments, what does the investor look for? Here are some of the considerations:
Backgrounds and experiences of co-founders and employees are important since success will be entirely dependent on their capabilities and efforts.
Pain Points Addressed
Clarity on why the solution or innovation is needed in the first place. This also covers what are the existing alternatives.
Ultimately, the innovation has to be able to make money. The business case and revenue model are paramount for the investor.
This aspect is about who is going to buy the product or use the service and how much they are willing to pay for it. This is usually looked at top-down, i.e., from total population, to addressable market, to planned reach, to market share.
What has the business achieved to date in terms of customers gained, revenue earned, prototypes created, or pilots implemented.
Who are the current and prospective competitors and what differentiates this business from them. Aspects covered could include how the business will compete on cost, on quality, or on utility.
Key financial highlights for the next 3-4 years covering revenues, operating costs, profit margins, capital expenditure, expansion costs, etc. Unit Economics is another aspect looked at carefully by VCs. This covers revenues and costs per customer/outlet/plant.
How much money is proposed to be raised and what will it be used for. This also covers how long this funding will last and what will be its consequence. Indication of further fund-raising in subsequent rounds is also looked at.
Valuation Ask and Equity Structure
What is the valuation that the founders have in mind, which in turn determines the stake the VC fund will own. Alongside this, the investor will also look into the existing equity holding (cap table) and previous investment rounds.
This, perhaps, is the most relevant part for the investor. The start-up will need to show a roadmap for the exit, which could include other investors who will buy the stake (this will need to be backed by data on other deals in the same sector) or what the IPO prospects are like.
Whether it is an entrepreneur who plans to set up a venture or a budding venture capitalist, all these considerations are important. While this article provides only an overview of the must-haves, there is a significant level of exposure through instruction that can help the journey.