5 Criteria VCs Look For Before Considering Investing
I spent the past week reviewing 200 early-stage startup business plans. My brain hurts.
The businesses were for all kinds of products and services. But the plans were painfully similar: give us money, we’ll develop the product, and then we’ll get more money to expand the business. It’s no different than all the other plans and releases I see every day.
The vast majority of those 200 plans seemed to have the potential to become viable businesses. But perhaps 10% of them seemed suitable for venture investing. The other 90% need to consider alternatives to venture capital to finance their startup.
With the huge success of VC-backed startups over the past decade and the explosive growth of venture funds, the misconception has taken hold that VCs will pour money into any good business idea. So getting funding is simply a matter of finding the right investors who believe in the company and the founders.
Unfortunately, that is not true. The venture capital financing model requires investing in a very specific type of business. If your startup doesn’t fit the model, and most early-stage startups don’t, you can either change your business plan to fit the business model, or you can find a funding source that’s a better fit for the business.
Before you waste half a year launching angels and venture funds, make sure your startup meets the following criteria to be eligible for venture funding.
The first thing I do when I look at a pitch deck is look at the revenue projections. If it doesn’t show that the startup reaches at least $100 million, there’s no point in looking any further.
That’s not to say that a smaller company isn’t a great opportunity, but the math doesn’t work for venture investing.
Let’s say a fund invests $1 million in a startup with a valuation of $5 million that is acquired at $20 million a few years later. That’s the kind of victory everyone should be jumping up and down for. But for most venture capitalists, it doesn’t move the needle.
Imagine a fund with $100 million to invest. With a target return of at least 20%, they have to grow the fund to $360 million over 7 years. They only have enough bandwidth to make 20 or 30 investments. Since 90% of those investments will fail, that requires the 2-3 hits to return $100 million – $200 million each. A return of $15 million is not worth the effort.
Although angel investors and small funds work on the same principles as hedge funds (and I’ll lump them together as venture capital), their smaller scale means the math is slightly different. If the company can finance its growth to get away with less than $2 million in angel investment, the minimum is $25 million in revenue, which is the point at which large companies will begin to consider acquiring a business.
It is not enough for a startup to grow. has to grow big quickly.
Many great businesses take a long time to develop. There may be complex technology that needs to be built and tested, a nationwide expansion that takes time to develop, or production processes that need to move from lab to pilot to factory building. These can become big, world-changing businesses, but they are hard to fit into the business financing model.
The standard risk fund has a fixed life of 10 years. Investments are made during the first 3 or 4 years. From the moment of investment to the closing of the fund, it takes between 6 and 10 years. Add a margin of safety so the fund doesn’t get stuck with investments that need to be liquidated in a panic at the end, the funds need their investments out within 5 years, 7 at the most.
Also, the longer the exit time, the lower the ROI. A 2x return on an investment in one year is a great success. A 2x return in 7 years is considered a loss.
Lastly, VCs need to show a track record of success to raise their next fund and the next. The second fund is raised based on increases in the portfolio valuation of the first fund. The third fund is raised based on the cash performance of the first fund. Fund managers need big, quick hits to keep their jobs by raising new funds.
No big company will acquire a startup at a huge multiple if they can build a competitive product themselves at a fraction of the cost. They have huge development teams, an existing customer base, and strong sales and marketing channels. Why do they need you?
There are only 3 answers to that critical question: patents, specialized knowledge or brand. This is what an acquirer buys, not the product itself.
I have been approached by many new ventures that could become wonderful and profitable businesses. But if there is no viable exit strategy, it is not a good investment.
One example is a construction company that specializes in installing electric vehicle charging stations for apartments and shopping malls. This has the potential to be profitable, repeatable, and huge. In other words, great business. But not a risky business.
There is nothing proprietary about this construction business or its operations. There’s no technology to protect, no special knowledge that competitors can’t figure out, no branding as a go-to provider. Despite the sheer scale of the opportunity, there is no reason a large construction company would acquire the business at a huge premium rather than create its own.
The corollary is that almost all venture firms build products rather than services. Services may be big business, but they are nearly impossible to protect.
For software products, it’s usually easy to find a buyer once the company has proven its worth. In the life sciences, pharmaceutical and medtech giants have essentially given up on their own research and instead acquire startups once they’ve cleared regulatory approval. But this is the Achilles heel of many startups, especially in specialized industries.
That’s not to say there won’t be buyers for any profitable business that reaches at least $25 million in revenue. But the risk model requires an exit at a large premium that in many industries is unlikely.
Imagine a startup that invents a great new sticker. They would be an obvious buying target for 3M, BASF, Henkel and others. But adding another sticker to those companies’ catalogs won’t transform your business. It is unlikely that they will enter into a bidding war with each other to buy the business. They will only acquire the startup at a valuation that will quickly turn a profit. In other words, the acquisition price will be a moderate multiple of EBITDA.
With revenue of $100 million, the company is probably generating around $10 million in profit (assuming they have reached profitability). An acquisition is likely to be in the $30 million to $50 million range. Not bad, but not the kind of return venture investors are aiming for, especially if they invest $25 million to build the factory and scale the business.
Similarly, private equity buys profitable businesses based on a moderate multiple of earnings. It may be a successful exit for founders, but not a great finish for investors aiming for returns 10 times or more than PE companies typically pay. If a startup pitches private equity as its potential exit, that’s usually the end of the conversation.
The ultimate goal of the startup is to reach a successful exit at a high multiple. Unless the company is targeting $1B in revenue and doing an IPO, exit means acquisition by a large company.
An important question for founders to ask is whether they are building the business for the acquisition or for themselves.
If the goal is to build a business that will continue to run indefinitely, I salute you. We need more founders looking to build strong long-term value. And most successful businesses are built with customer needs in mind rather than the venture capital requirement to grow quickly and get out. But that’s not the venture financing model.