What Venture Capitalists Look For When Investing In A Startup
The business pages seem to be full of startups finding fortune through venture capital. In fact, just a couple of days ago the airfare deal-finding app Hopper announced it had secured CAD82 million in funding.
But the appearance of these stories can be deceptive.
Because securing venture capital is actually something that very few entrepreneurs successfully achieve. Estimates vary, but the Harvard Business Review puts the number of US startups funded by venture capital at below 1%.
I can't say this figure comes as a surprise.
VC-ready startups are few and far between, and investors are looking for much more than a nice idea and a few early sales. They want to know every detail about you and your business– warts and all.
And so they should: the marriage between startup and venture capitalist is not necessarily a fast-track to success. In fact, an in-depth study in business funding (by venture capital firm Correlation) recently revealed that some 65% of VC-backed businesses fail to return their capital. So it only stands to reason then that VCs want to be absolutely sure what they are investing in.
Okay, so what do you need to know if and when the time comes to start looking for investors? Because while venture capitalists undertake their due diligence with military precision -asking hundreds of questions and pouring through every intimate detail of your business- what they are looking for essentially comes down to two things: the make-up of your leadership team and the earning potential of your business.
Ideas are a dime a dozen. Even if an idea is unique and revolutionary at its inception, without graft and application it counts for nothing- plus, copycats are always around the corner. That's why the backbone of any successful business is not its idea but the team putting that idea into practice.
According to legendary Silicon Valley venture capitalist Ron Conway, this starts with you as the boss: "When you're talking to me in the first minute, I'm thinking- is this person a leader?" And Conway extends this notion when bringing others on board as well: "When you start a company, you have to go find somebody as good or better than you to be the co-founder."
But it's not just about hiring impressive individuals. Venture capitalists want to see a cohesive, engaged and passionate team in action. Essentially you and your management team have to tick several boxes. Firstly, you must be talented. Next, venture capitalists want to see open and transparent lines of communication. As recently reported by Project Management Institute, poor communication results in project failure in one third of cases. Communication doesn't just occur, it must be worked at. In an article in Management Decision titled Transmitting the entrepreneurial spirit to the work team it was noted that, "A leadership based on relationships shows a positive impact, with an intensity of more than double that of participative leadership. A task-oriented leadership style reduces the chances of transmitting the entrepreneurial spirit to the work team."
Finally, and this is the big one, venture capitalists must see evidence that your team is flexible enough to adapt. The ability to pivot is one of the most vital traits in any business and there aren't too many organisations that end up the way they started. Think about it: Google didn't set out to make phones and operating systems, nor was conquering the world of cloud services in the business plan of online bookstore Amazon.
While the market will dictate these changes to a great extent, VCs are looking for teams that can read and adapt to these changes rather than sticking steadfastly to their original yet failing plan- just consider the fall of Nokia.
This may seem incredibly obvious, but you would be surprised at how often it is overlooked. Against the backdrop of the phenomenal success of businesses like Facebook, Twitter and Pinterest being valued at hundreds of millions of dollars without a revenue stream in sight, many entrepreneurs are now being dangerously lulled into believing that this is the norm.
It is not.
These companies are very much the exception that proves the rule. And there also appears to be a school of thought gaining traction that the earlier you monetise an idea, the sooner you allow it to be judged by its revenue, rather than just the potential worth of the concept itself. If your idea has the potential to be the next Facebook, an eagle-eyed investor will spot it- revenue stream or not.
Regardless of how long the companies mentioned above took to generate a revenue, we all know they are making up for lost time now. And they have to be: revenue is, after all, the lifeblood of any successful organisation. No matter how good you and your team believe your idea to be, your potential VC has seen many similar offerings- if yours is the only one bringing in money, however, that's a different story.
But how much revenue is enough? Of course, there is no hard and fast rule. However, investor (and founder of hosted service provider WP Engine) Jason Cohen speaking to Fortune Magazine laid it out like this: Businesses can expect to net between US$1-2 million in a seed round if they demonstrate a working idea, strong growth and at least $50,000 per month revenue.
Of course, revenues of this level are out of reach to many entrepreneurs during their early stages. That's not to say potential venture capital is impossible- Cohen goes on to say that the time to start discussions with potential investors is when revenues hit $10,000 per month per founder. At this point your business is already demonstrating serious earning potential– and providing your model can be scaled, most VCs will be happy to hear from you.
Catching the eye of the venture capitalist
Venture capital success stories only come about when the deal is right for both parties. For some businesses, VC-funding is never going to be the right fit. Not every startup can grow large enough, quickly enough to warrant a huge investment of time and money. That's not to say those businesses can never be successful, just that they are unlikely to find it through venture capital.
As we established from the start, securing venture capital is incredibly difficult. Simply having an impressive concept and a tight elevator pitch -while both important- is not enough.
Many entrepreneurs fall into the trap of window dressing their businesses to catch the eye of VCs rather than spending that time nurturing and building their business. So focus on creating a strong and capable team and maximising your revenue streams.
Ultimately, this is what will benefit your business.