I started out learning about investing from Jerry Neumann, who at the time was a professional angel, before he launched NEU. Angels and VCs have different investing criteria, usually because venture capitalists need to put more money to work, tend to have a more formal process and try to stick to a thesis. One difference that I learned about in Newton is how VCs look for a fit, and it’s something that I hadn’t fully considered before I arrived at Softbank.
There is a limitless number of reasons that venture capital funds will pass on opportunities, but these are five reasons that entrepreneurs can work to mitigate:
1. Addressable market is too small: One of the first things you have to do as a VC is convince yourself that, if the planets align and everything works perfectly, your company is going to be OMG huge. That means that you are building something that can potentially be a billion dollar company, or at least worth something north of $100M. There just aren’t a lot of these types of successes, so if you’re going to swing, swing big.
2. Conflict with an existing portfolio company: This is a very avoidable mistake that entrepreneurs sometimes make. If there’s a conflict with an existing portfolio company, you’re not going to get an investment from that fund. In the early stages companies pivot. There are also companies that might be close and not compete, so this one is admittedly a grey area. With that said, look at a fund’s active investments and determine if you think there might be a conflict before you have the conversation.
3. Doesn’t fit the focus: Venture capital funds have Limited Partners who sign on to invest based on criteria that’s not unlike the method VCs use to look at companies: team, market and idea. The VC version of “idea” is a thesis, which forms a guideline on how a particular fund will invest, and the types of companies it will look to invest in. If you don’t fit in the thesis, you might be outside the scope of what a particular fund is comfortable investing in. That does not mean that you should skip a conversation if you can have one. Good VCs make introductions all the time, and if you’re not a fit for one fund it doesn’t mean that there isn’t a fund that your idea would be perfect for. Try to get an idea of what a firm’s thesis is before you reach out.
4. You scale with bodies: This is a bit of an extension on reason 1. Companies that can scale are the only companies that can hit $1 Bn. valuation. There are a lot of very profitable, very big businesses that don’t scale very well. Examples of companies that “scale with bodies” are law firms, agencies or consulting firms. If the value is 100% in the people and their relationships, then the value walks out the door with employees. That’s not the type of businesses that VCs are usually interested in.
5. Team: Saving the most important reason that VCs say yes or no: the team. In valuations class, we learned how to value companies using knowable metrics like revenue, cash flows and leverage. In early-stage investing, there are no metrics to value a company on. The real asset that venture capital firms invest in is the founding team. Do they know the business? Have they done this before? Have they considered the risks and designed ways to minimize them? If you have an idea that’s in an industry that you don’t know anything about, you are going to have a very dificult time getting funding. Typically, it’s the little things that make a an industry unique. You can learn 80% about an industry in a few days of research. The other 20% requires practical knowledge, and that usually requires experience. If you don’t have experience in the business, get someone who does on your team.