Many founders wonder how VCs analyze companies and decide which ones we want to look closer at and which ones we pass on.
While there are a number of great blog posts explaining the theory behind VC investments, this post will focus on some tips & tricks for first-time founders gathered from the outcomes of meetings with entrepreneurs in all types of stages and industries.
1. Know your sector and who invests in it. Whenever we are introduced to something new, we try to classify it. That’s how our brains work and VCs’ brains are no different. We will instantly try to place the company in a sector to be able to evaluate its performance and potential. Is it an e-commerce company? Enterprise SaaS? AI? Whatever the sector, it is important to figure out who to contact. Most VCs have some type of focus area. Sometimes broad, such as B2B, sometimes extremely narrow. Typically, it is harder to find extremely niched investors in Europe compared to the US, simply due to the amount of possible investments. However, it is important to understand who is most relevant for you to talk to, as you will otherwise have a much harder time getting interest, understanding and ultimately an investment.
2. Know your metrics and why they matter. When you have chosen your sector and business model, measure, analyze and present the most important metrics for your company so that you and investors can track your progress. For example, an e-commerce company will need to focus heavily on KPIs like return rates and customer acquisition costs while a SaaS company typically will focus more on churn and various growth metrics. The most important part here is that you should never bring out the metrics just to send them over to investors. If you choose the right metrics you should be able to gain insights and act on them on a daily basis. They will help you understand what’s going on in all parts of your business and how you can perform better.
3. Be fundable. Regardless of potential, some companies have a low probability of scoring a VC investment before even entering a meeting. One common reason is cap table mismanagement. There are several different types of cap table mismanagement and I’ll address three common types here; i) inactive owners, ii) very diluted founders at early stages and iii) ‘bad’ investors.
i) A common issue is inactive owners. If five people start a company and each co-founder owns 1/5 of the company, it will be very problematic if two or three founders leave the company after a year or two and hold on to their shares. That means that all of a sudden a big part of the shareholders are inactive, which is a negative signal. Therefore, it is important to always have a founders’ or shareholders’ agreement with a vesting clause (three to six years is pretty standard). Another way to see this is that the current owners should be an active part of the company’s future. The only ones who matter then are active founders, active team members and investors who can help fund the company going forward. Everyone else is just tagging along for the ride and investors don’t want to pour money in to help inactive founders get rich.
ii) Even if all founders stay on, all companies experience bumps on the road in one form or another. This can force the company to raise one or several funding rounds at unfavorable terms which will let the company survive, but in a damaged state. The founders will then be heavily diluted, sometimes even below ten percent, before the company has raised any venture capital from institutional investors. This is problematic for an early-stage VC as the business model is investing in entrepreneurs who needs to be committed to the company for the long haul. If a VC invests in a seed or Series A round, he or she expects at least one more (often several more) funding rounds before an exit. If the founders are already diluted below ten percent or so before the round, it is easy to figure out that there will not be much left at the time for an exit. What a VC sees here is an elevated risk that the founders will leave the company as they lack financial incentive to stay.
Good angel investors know this and will help the founders avoid this trap if they believe that the company should raise capital from VCs in the future. However, inexperienced angel investors may not always be aware of the consequences and may therefore be shortsighted in negotiations on terms, which founders must look out for.
Please note that this does not mean avoiding any dilution at any price, which many founders are afraid of. Getting the right investors on-board is much more important than pushing the valuation up as much as possible (and thereby decreasing dilution). Getting a sky high valuation at the seed stage can actually hurt more than it helps, but that’s another discussion.
iii) It is obvious to most that getting ‘good’ investors on-board is positive, but not everyone understands that ‘bad’ investors can actually hurt your chances. Money is money, right? Well, no, because investors do not only commit capital. For a startup, it is important to find investors who can help develop the company. That typically means having a list of fifty inactive angel investors will be considered negative, as it is a hassle to communicate with everyone and get decisions executed swiftly — which is crucial for a startup.
Another type of investor can be either good or bad for the company, depending on type of investment and phase. I’m talking about corporations or corporate VCs, known in the VC world as strategic investors. These investors are not called so because they are going to help you with strategy more than other investors but rather because they invest for strategic reasons rather than pure financial reasons. Some corporations invest in startups because they want to learn more. Some because they believe that the startup energy will kickstart their own organization (especially if they do so through a corporate accelerator). Some invest to get an inside look and hope that they can later acquire the company cheaper. Regardless, VCs are often careful when it comes to investing alongside corporations or corporate VCs if they have too big of a stake in the company. If a corporation owns 40% of a startup, there is not only a risk that they treat it as a subsidiary but also a risk that they don’t have a clear look on corporate governance from the startup’s perspective as an independent company. They could potentially block a pivot if it means abandoning the industry that the strategic investor works in.
Not only that, a strategic investor can be a chain around the ankle, a limitation, in an exit process. The strategic investor’s peers and competitors can refrain from trying to acquire the startup because they might wonder either why the strategic investor doesn’t acquire the startup themselves or if the strategic investor will already know everything there is to know about the company, which would dramatically decrease the strategic value for a competitor.
With that being said, this does not apply to all types of strategic investors in all situations. A strategic investor can be a great partner to launch in a new market for example and some corporate VCs are virtually independent from the corporation that owns them or have a large extent of autonomy. If you are insecure, see the next point and just ask!
4. Meet us early. Most VCs want to invest in lines, not dots. Connect with VCs early on and let them know that you are not raising money at the moment but rather take the opportunity to have an open discussion. If you make a good impression you will have less of a ramp-up period when you actually want to raise a larger round as you know from the start what they look for and what their investment process looks like. Ask the VC if it is okay that you add them to a bi-monthly or quarterly investor update e-mail with a high-level progress report (keep it short!) on what’s going on in the company, so that the VC can backtrack your journey quickly.
5. Understand the VC math. If you ask a VC to invest $1 million in a $5 million equity funding round with a $15 million pre-money valuation, you will have a hard time getting an investment. The reason is that the VC would only get 5% of the company ($1 m divided by $20 m post-money valuation). Unless the company is a total outlier with successful serial entrepreneurs at the helm and top tier co-investors, the deal is not meaningful for most VC firms. Early stage VCs typically expect around 10–35% of the company when they invest, as a share smaller than that means that the VC cannot motivate allocating time and resources to the company.
6. Design matters. The design and copywriting of your pitch deck tells a lot about how you think — probably more than you think. For an R&D heavy B2B company, sleek design is obviously less important — and sometimes even harmful — compared to a B2C company. But regardless of industry, the design needs to be coherent and aligned with the company’s overall position and brand. A well-designed, easy-to-understand and engaging pitch deck will immediately get you more attention.
7. Show your product. All VCs are different so even if you follow all the steps above you may not be funded and conversely you may get funding even if you’ve missed out on some parts. The one thing that truly unites VCs is the desire to understand what your company is doing and the value it creates. In the end, this is the most important parameter so even if it’s not finished, show us a demo and send over a beta invite or prototype. That’s the best way to engage in a meaningful conversation about your vision, what you think about the future and how your company will need to evolve going forward.
N.B. This post was originally published as a guest post at The Nordic Web.