How To Raise Your First Round Of Funding
What Do VCs Look For In Startups?
Abstract: In honor of Y Combinator’s demo days, I thought it’d be a great idea to write about how your startup can entertain the potential of raising a decent round of funding. In this post I’ll break down a few determining factors as well as a generic overview of what VCs look for when deploying capital.
One of the most common responses from Venture Capitalist are that they’re looking for something with a global market. Another determining factor is if they personally believe the team is capable of executing the growth of the idea. Many entrepreneurs have told me that they’ve spent countless hours trying to understand why these (particularly #1) matter so much. After all, what should matter is profitability, right?
In the world of business, when you need to understand how someone thinks, it’s a good idea to understand that person’s business structure. In this case, that means understanding the dynamic of a venture capital (VC) fund. I’d like to share a framework on what a VC fund considers when exploring a potential investment (particularly in North America).
At its core, every VC firm also has investors of its own, typically known as LPs (limited partners). LPs ‘lend’ money to a VC firm for a specified duration (typically 5–10 years). During this time, the VC firm is expected to invest money in promising startups, which are expected to one day become valuable businesses. Once the investment matures, the VC firm is expected to sell its stake in those companies and return money back to the LPs.
Naturally, because a limited partner lends money to a VC firm, it expects a healthy return on its investment. Usually a percentage well above what they would generate from simply investing in conservative vehicles such as mutual funds or exchange traded funds (ETFs).
such a fund will lose the trust of its LPs
A VC firm has fiduciary responsibility for this money and has to put in all the effort required to return the money to LPs with substantial returns. Imagine the future of a fund that fails to return money to its LPs; such a fund will lose the trust of its LPs and the LP is unlikely to participate in any future funds developed by that particular VC.
During these 5–10 years, the VC firm is expected to return at least 3x the investment. This is not an easy task for a new VC firm that has hardly anything to offer a startup besides capital.
How the fund works across investments
For our discussion, let’s take a fictional VC firm, say “AB Capital”, which raises $30 across its LPs to invest in startups (typically a minimum of twelve startups). Let’s assume AB Capital invests this money of $30 equally across 30 startups (i.e. $1 per startup) and takes 20% ownership of each company in lieu of this investment.
As time goes by, not everything goes well in all investments. Some startups fail to raise follow-on rounds, others fail to find a product-market fit and yet others will see founders fight, disagree and separate — on average, the majority of these 30 investments will fail.
If we go by the typical industry benchmark numbers for a portfolio, 65% of investments will die; (i.e. 20 investments out of 30 will result in zero return on investment [ROI]). Another 20% will just barely return the principal;(i.e. 6 investments out of 30 will return barely the money invested or slightly more). Another 10% of startups will succeed and generate 10x returns for AB Capital; (i.e. 3 startups will return $10 each). The remaining 5% of startups, (i.e. one out of a portfolio of 30 companies), may become a unicorn and return 50x; (i.e. return $50).
Unicorn: A recently introduced term in the investment industry, and in particular the venture capital industry, which denotes a start-up company whose valuation has exceeded (the somewhat arbitrary) $1 billion dollars. The term has been popularized by Aileen Lee of Cowboy Ventures.
AB Capital’s hypothetical portfolio:
When AB Capital invests in these 30 startups, it has no way of knowing which of those 30 companies will result in 50x returns and which ones will not return any money at all. Had it known this prior to investing, the folks at AB Capital would have set up the 50x startup themselves! Overall, our hypothetical portfolio will return 2.9x the money that was invested. As you can see, this barely reaches the acceptable level of return, and hence AB Capital won’t qualify as a great VC firm.
So when AB Capital makes an investment, it needs to have complete conviction that each of those 30 investments will result in 10x gain and also hope to be lucky enough that one of those 30 investments will result in unicorn status. This is the only way to create a healthy return for the overall portfolio.
Now let’s put this in perspective from the startup’s side. A $1 investment in company for 20% ownership will mean that company is valued $4 before a sale or listing or $5 after. To generate 10x for a $1 investment, the startup needs to become a $50 company. Let’s extend this example to more realistic numbers. Let’s assume a $5 million dollar round of seed funding. This will necessitate the startup to become at least a $250 million dollar company. So every single company being invested in should have genuine potential to become a $250 million dollar company.
There is no way for a company to achieve those figures unless it operates in a fairly large market. By assuming that a successful company will capture 20% of the overall market, then the overall market size has to be at least $1.25 billion. Now you see why the large market size becomes the most important question when investing in any company. If you don’t invest in large market then you are fundamentally setting yourself up for failure as the investment won’t grow 10x irrespective of everything else going great for the startup.
Let’s assume you have done great job at pitching and AB Capital is convinced that your startup is operating in a really large market. What else would AB Capital need to know to confirm their decision to invest?
Reaching that $250 million mark will be a time-consuming process spanning across 5–8 years (please remember that recent hyper-valuation rounds where a company reaches a $250 million dollar valuation in 6 months is not the norm). Venture capitalists at AB Capital are not the guys who can manage a startup’s day-to-day operations. That is the entrepreneur’s job! And this journey of 5–8 years is going to be full of ups and downs. In such a scenario, AB Capital would like to be satisfied on three more key questions about the entrepreneur.
(A) Does this team have the skills or ability to figure common problems out? Generally it’s very difficult to hire great talent into a startup early on due to financing and stability uncertainty. Founders have to possess the skills and capability to operate a startup until it becomes a real business. They have to be able to attract talent around them. If founders fail to execute, there are very few people in the world who can rescue the startup.
(B) Is this team going to survive through the bad times? You don’t want to be left with a company where founders leave when the going gets tough. If a founder loses motivation and moves on, the whole company will become a liability for the investor. Over time, investors will end up owning a majority of the company and hence will have more to lose.
(C) Is the entrepreneur intellectually honest? This is an obvious attribute to look for whenever you are giving your money to someone. After funding, the signing authority moves to entrepreneur who can use money in many different ways. AB Capital won’t be happy if the entrepreneur mismanages the fund’s investment. Often times VC funds demand a board seat or appoint a trusted adviser to monitor the progress of the startup.
This framework provides entrepreneurs a few points to think. “Is our market really large?”, or “Do I have what it takes to execute the long term strategy?”
If the genuine answers to these questions are negative, then there is very little chance that an entrepreneur will make it big. It is probably quite easy to fool someone in AB Capital on these questions but over time, reality will catch up, and at that time the entrepreneur is the first one to lose (he or she also has the most to lose).
This is the main reason why VCs look for excellent management teams to partner with. This is also why you see the same founders raise multiple rounds at multiple startups. After you build a great relationship with notable VCs, they tend to accept your phone calls in the future.
