Why VCs Say No

And How To Get Them To Say Yes

The famous scientist Louis Pasteur popularized the Latin phrase “Fortuna favet menti paratae”, or “fortune favors the prepared.” Nowhere is this more important than when entrepreneurs seek to raise venture capital (VC) funding.

VC funding provides entrepreneurs with critical resources to enable significant success. However, securing VC funding can be difficult, especially for unproven founders. The reasons why one company secures funding and another does not, can be difficult to discern, especially to the entrepreneurs who believe it’s “obvious” why they should be funded.

Many good articles have been written to help entrepreneurs improve their fundraising pitch from a structure, delivery, and messaging perspective. This article strives to add to the conversation by sharing a journeyman VC’s view on the reasons why VCs pass. The hope is that a deeper understanding of why VCs say “no” will help more entrepreneurs get to a “yes” and achieve their company building objectives.

The patterns of success and failure in VC fundraising presented below are grounded in my good fortune to have worked as a technology VC in Silicon Valley for the past two decades as the Founder and General Partner of Clear Ventures, and as a Partner at Sequoia Capital and USVP. Insights gleaned from participating in over 300 follow-on fundraising campaigns that raised $2B+, and over 5,000 funding pitches form the basis for the comments below. The observations presented are a distillation of a running “frequently asked questions” list I have compiled from the follow-on financing campaigns I’ve worked on.

UNDERSTAND WHO YOU ARE SELLING TO

Venture capitalists trade money for equity in speculative ventures in the hope that they can sell the equity at a significantly higher price than their investment price. No other asset class offers the potential for 100x+ returns that have been achieved by venture home runs in the past. Experienced venture investors know that making an initial investment decision is often the easy part. Living with that decision for the next 4 to 10 years to turn an idea into a market leading commercial enterprise is the hard part. Thus, many VCs approach each new investment opportunity by looking for reasons to pass before they matriculate to looking for reasons to invest.

Given relatively low matriculation rates from Seed/Series A to the next financing round and ~6–10 years to IPO, bad things tend to happen quickly, and the good stuff can take a while. Early-stage VCs make subjective decisions with incomplete data.

Most VC investment decisions are based on three essential pillars: market; team; and product/technology. The approach or “filter” for VC firms can be understood by what kind of weighting factor they place on these three pillars. Some firms are primarily market investors. Some are primarily people/team investors. Some are seeking highly disruptive technology innovations. Every situation is unique, but my firm (Clear Ventures) typically biases as 40% market, 40% team, and 20% product/technology.

Many VCs ask questions to take entrepreneurs “off script” during their fundraising pitch. Doing this helps a VC assess how deeply the entrepreneur has cogitated on the journey they are proposing. For entrepreneurs, the difference between vision and execution is dilution. The better job you do on your fundraising process, the better terms you are likely to receive.

By thinking through the questions below, you will be able to improve your odds of getting past the obvious reasons VCs say “no” and get more VCs leaning forward with genuine interest in joining your shareholder base.

MARKET

Questions VCs Are Thinking (Even If They Do Not Ask Them)

· Is this a market I want to be involved in?

· If this a large established market, who currently dominates it? How and why are they vulnerable to disruption by a new entrant?

· If the market opportunity is not large today, does it offer hyper-growth potential?

· Can this company become a market share leader in their target market? This is important because the market cap of the market leader often exceeds the combined market cap of all other players.

· Why now? Is the timing right to pursue this market opportunity? Conventional wisdom among VCs is “if you are too early, it is the same as being wrong.” If you are too late, then the customer need may already be satisfied by others.

· Will the end customers in this market buy a product or service from a venture-backed emerging technology company? If the answer is no, the market is a “no-fly zone” for VCs.

· Does the team that is seeking funding understand the customers they aspire to serve? Can the team reach the target customer to validate the need for their product or service? This is a significant issue to prove.

Reasons VCs Say No

· Small market. The conventional wisdom is “small markets yield small outcomes.”

· Well served market with strong incumbent vendors. (e.g. server CPUs and Intel, SQL databases and Oracle, graphics processors and NVidia, public cloud and AWS/Azure/GCP).

· Crowded and/or over-funded market. Is there a glut of VC-backed companies pursuing the same idea, or variations of the same theme? (e.g. IoT, autonomous vehicles, cybersecurity, drones, fintech, and storage).

· Late to market. Is the company a second or third wave innovator that is emboldened by yesterday’s large win? For example, Facebook spawned a wave of copy-cat companies.

· Market with customers who have a history of not being willing to buy from VC-backed companies (e.g. telecom service providers/carriers, utility companies, hospitals, etc.)

· Slow growing market

· Commodity market with many undifferentiated suppliers, resulting in margins

What VCs Seek

· Startups that understand the needs of the market and customers they want to serve

· A big enough market to achieve revenues of >$100M per year 4–5 years after first customer shipment

· Customer proof points. Not only about the product–market fit, but also of the viability of the business model. Are people going to buy the product or service at a healthy gross margin for the company?

· Strong customer validation and enthusiasm for the proposed product or service. This can be accomplished when the product or service is still just an idea.

What you can do

· Study your target market. Know it cold. The better you know the competitive landscape and can articulate your differentiation the more credible you will be.

· A venture investor should almost never know your market as well as you, as they divide their attention across multiple markets, but most are curious and smart. Be prepared to help the VCs you target quickly learn about your market.

· Don’t regurgitate top-down market forecasts from 3rd party research organizations. Instead, build bottom-up market sizing estimates.

· Demonstrate an understanding of the difference between total available market (TAM) and serviceable available market (SAM). Focus on your real SAM.

· Demonstrate that you can reach your target customer, collect information about their requirements, and show the linkage between your product and at least one referenceable lighthouse customer who shares the company’s vision.

· Think through how your company will reach the target customer. A well thought out go-to-market strategy can go a long way towards building confidence.

· VCs who get engaged enough to request and conduct customer references are sure to ask about both team and proposed product/value proposition. Build a strong customer reference list and make sure people on this list are champions for your team and your proposed product offering.

TEAM

Questions VCs Are Thinking (Even If They Do Not Ask Them)

· Is there a team, or is it just one person?

· If there is a team, do they have a shared and compelling vision?

· How relevant is the team’s experience to the mission at hand?

· Is there a member of the team that can be a primary author of the proposed product?

· To whom am I writing the investment check? Will they be good stewards of the invested capital?

· Does the team know each other? Do they have a positive shared history?

· Does this team have a track record of success or failure? Some failure is okay, but “success begets success.”

· Can this team recruit well? Is there a pipeline of credible talent identified that will join the company upon funding?

· Is this team “magnetic?” Can they attract talent, customers, follow-on financing, etc.?

Reasons VCs Say No

· The team is not “coachable” and/or are “bad listeners.” This characterization can be the kiss of death.

· The team does not have relevant experience and is entering a new field with no domain expertise

· The team is unrealistic about what it will take to build their company

· The team doesn’t appear to be well connected, doesn’t seem to have a well-formed relationship ecosystem, and is thus unlikely to be able to recruit well

· The team comes across as being disjoint and not cohesive, which often manifests itself as interrupting each other, arguing with each other, etc.

· Key roles are unclear to the team

· The team is not committed to building a strong team, as demonstrated by an unwillingness to create a consequential unallocated ISO pool to be aggressive in hiring. Remember that startups cannot compete for talent with large companies on cash compensation, so have to compete based on 1) quality of mission, 2) strength of colleagues and 3) equity upside and shareholder value potential from stock.

What VCs Seek

· Teams that are passionate, driven, have a compelling shared vision worth fighting for and have high odds of being able to execute

· Founders that know what it will take to build out a great team

· Teams that can attract resources: talent, customers, follow-on financing

· Teams that value, and will act upon, good advice if offered in a respectful and supportive manner

· Durable teams that have the stamina and drive for a sustained effort

What you can do

· Make sure that each team member understands their role and responsibility in the VC pitch and VC diligence cycle

· Think of the early team members as being the most important first deliverable for the founders

· Talk as a team about things like company culture, recruiting and screening process, leadership, etc.

· Take care of yourself. Good health and high energy leads to high productivity.

· Don’t be a jerk. Self-confidence sells, but arrogance is a turn-off.

PRODUCT/TECHNOLOGY

Questions VCs Are Thinking (Even If They Do Not Ask Them)

· Is the proposed product or service well defined?

· Is the company building something people really need? A nice-to-have is less compelling than a must-have.

· Does the team have a good handle on what they are proposing to build?

· How much better is this product than the current alternatives — including the alternative of doing nothing?

· What do (or will) the real users and buyers of this product think? How many have the team spoken with?

Reasons VCs Say No

· High scientific risk. There are exceptions, such as drug discovery, but VCs prefer to fund implementation and execution over research.

· High implementation risk. Few VCs gravitate to swing-for-the-fence “hero projects” with a large scope of work.

· High capital intensity before creating a “minimum viable product” that proves the basic thesis of the company

· Long development time before creating a “minimum viable product.” The longer the development cycle, the more likely there will be competitive surprises and market changes

· Insufficient differentiation (me-too product)

· Low defensibility (others can easily do this)

· Tricky prior art and patent or intellectual property issues

· Comparing your future product to a competitor’s current product. Be consistent on timeframes.

What VCs Seek

· A product that addresses a significant, and growing, unmet customer need

· A product that is hard, but feasible, to build

· A product that can be built with the “right” amount of resources, preferably with a small team of highly skilled practitioners

· A product that can command high gross margins. A common refrain in the VC world is “gross margin is nature’s way of telling you whether you should proceed or not.”

What You Can Do

· Be realistic about what it will take to get to a minimum viable product

· Build a demo or a basic proof-of-concept. The best product discussions always have a demo. While this can be hard for some categories of companies (e.g. fabless semi, embedded systems, etc.), the credibility boost that entrepreneurs receive who don’t wait for permission to start building their vision is huge.

· File some basic invention disclosures to protect your idea(s)

OTHER KEY FACTORS

Questions VCs Are Thinking (Even If They Do Not Ask Them)

· How can I (the VC) help?

· Will I get hurt if I make this investment? What is my downside risk? This is especially true of VCs who are not founders or managing partners of their own practice, as there are career consequences of bad financial outcomes.

· Who do I know that can validate this idea?

· How much capital will this company require to achieve an accretive exit? Not just in the first investment round, but over the life cycle of the investment.

· Does the company have a good sense of the milestones they will achieve on the proposed financing? Are they sufficient to achieve success in subsequent financing rounds?

· Is a “fair deal” possible?

· What is the “exit strategy”? If not an IPO, who are the logical acquirers to buy this company?

Reasons VCs Say No

· The founding team is not willing to support a consequential unallocated ISO pool (i.e. >10%), and thus signal they are not committed to aggressively competing for top talent

· The cap table is “screwed up.” This means the VC doesn’t like the existing investors and views them as a risk to their investment.

· There are no logical buyers for this company, product, and/or team

· On a bridge loan (the “kiss of death”, “blood in the water”)

· The investment has been “heavily shopped” to other VCs, thus “the market has spoken”

· Unknown and/or untrusted co-investors

· Stage not a match (e.g. pitching an expansion stage opportunity to an early stage investor)

· Terms mismatch (e.g. early stage VC wants 15–25%, and the team wants to sell 5%)

· Goal mismatch (e.g. VC wants “swing for the fence” wins that “move the needle” and founders want a $20M acquisition after a $1–2M jumbo seed financing)

What VCs Seek

· A positive financial outcome. Does a reasonable set of assumptions support the belief that the distributed proceeds can exceed the invested capital?

· A fit between the company’s fundraising goals and the VC’s investment philosophy

· A company that is fundable today and can be funded at later stages

What You Can Do

· Think through the capital required to achieve profitability and be prepared to provide the VCs guidance on the reserves they should plan on over the life of their investment

· Building a great company “takes a village.” Thus, think through the company’s hiring plan and develop an estimate of the unallocated Incentive Stock Option (ISO) pool that will be required to meet the plan. Capable people have options, so be aggressive on the equity grants you plan to make during your team build.

· Don’t “name drop” other VCs you may be in discussions with, as this invites VCs to call each other to compare notes.

RECOMMENDATIONS FOR ENTREPRENEURS

In summary, here is a checklist I recommend when embarking on a VC fundraising process:

1. Treat fundraising like a sales campaign. Consider it a process, not an event

2. Start well before you need funding

3. Study potential firms, and investors within those firms, to determine who might be a good fit

4. Build relationships with advisors and potential funding sources so you can obtain qualified introductions and get to the top of the VC’s queue for consideration

5. Assume you will be rejected by most of the VCs you meet

6. Build a FAQ list from the VC meetings that you participate in

7. Address the issues that are being raised by VCs until there is nothing standing between you and a “yes”

8. Treat diligence as an opportunity, not a burden. It is a chance for you to test what it will be like to work with a VC firm.

9. Treat diligence as a two-way process. Don Valentine of Sequoia Capital once told me, “Picking your investors can be more important than picking your spouse, as you can divorce your spouse, but you are stuck with your investors.”

10. Help the VCs you engage with to build a good investment thesis

11. Translate every “no” you receive into “try harder” so you can prove the skeptics wrong

12. Ask the VCs that pass for frank feedback so you can continually improve

13. If you receive an acceptable investment proposal, do not sell past the close. Once you get the order, stop talking and put the mechanics of getting to a wire transfer into the hands of the lawyers.

14. Your first deliverable is your team as a tangible asset. Build a strong recruiting pipeline so you can hit the ground running upon funding.

15. Don’t take a penny more VC capital than you need to get to a position of strength for the next step. The more you raise, the bigger the liquidation preference hurdle to be cleared before all shareholders participate in the distribution of proceeds.

16. Clarity of purpose is paramount. Great companies are exceptional at saying no to distractions. Focus on being the best in the world at one thing. Be clear what that one thing is, and why it’s important.

17. Seek out good mentors with additive skills. These mentors should include your VCs. A VC’s ability to help you when the going gets tough, can add value well beyond the money they put in.

18. Above all, do your homework. Seek to understand before being understood.

This may sound a bit daunting, but it should not be. Ultimately the myriad tips and tricks above come down to answering two simple questions, “Why you?” and “Why now?”. Like most things in life, success in VC fundraising comes down to the effort you put into it. Your level of preparedness is a demonstration of how you will manage your company going forward. VC fundraising success is not an exact science, but cohesive teams that have clarity of purpose and combine high IQ with EQ and hustle get it done. Good luck!

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Thank you for reading. I would be delighted to hear from you if you have a passion for building a great product, and if you are ready to break out on your own.

Chris Rust — Founder and General Partner, Clear Ventures, chris@clear.ventures, www.clear.ventures