What venture capitalists look for: 6 things VCs want to see before they invest
Published 2017-01-13, updated 2023-03-21
Summary - This is the third in a series of postings on the venture capital investment process, and what startups need to know about VCs from a founder perspective.
As I’ve been saying in recent posts, too many entrepreneurs looking for funding from venture capitalists don’t know enough about how the venture capital investment process actually works.
This isn’t a glitzy, larger-than-life process. It’s slow and requires lots of time and trust. Taking on VC investment is taking on a partner – a partner who will want an active say in how you run things.
Before they give you a cent, VCs will do due diligence and ask you some hard questions. You will need to be ready and have the answers. The founders of some of Canada's fastest-growing startups share tangible advice on VC investment in season one of the Metric Stack podcast.
Although you need to showcase your passion and commitment when sharing your vision and the opportunity before you, this is not a time for selling the sizzle. This is a potential partner you’re talking to. The best approach is to be truthful and authentic.
Here are the six things VCs will want to know before they invest in your company:
1. VCs want you to demonstrate that there’s a big market for what you’re selling, and big bucks being spent in that market.
VCs will want to know about the market for the product or service you’re selling. More than that, they will want to know that it’s a big market.
Why? VCs are in it to help you grow, and big markets support growth.
Not only are big markets more stable and less inclined to volatility, they are also able to support the operations of multiple growing companies. And if the market is growing, even better. That will give you a tail wind.
On the flip side, if the market you work in is too small, there may not be room for enough growth for the investor to get a return on his or her investment.
What is a big market?
There’s no firm definition, but generally speaking we’re talking about $1 billion globally.
Within that, it may make sense to look at what’s called the ‘addressable market’ – the part of the market you serve.
For example, when we talk about our market, we point to 50 million small and mid-sized businesses globally, of which we consider 10 million to be addressable. These are businesses that have a need for what we sell and match our target company size, profile, and geography. They currently spend $10B annually, and are growing at a cumulative annual rate of 8%. Once we can show VCs that, they listen.
2. VCs want you to show how your product is different from what’s out there. What makes it unique?
A unique product or service will be attractive. A product or service that is not somehow different – that becomes a commodity – will not attract. ‘Unique’ means not only different and new, but also hard for a competitor to replicate. Your product or service needs to include a ‘secret sauce’ that will prevent a competitor from taking you out.
There are several ways to stand out.
- Product differentiation: You’ve got something completely different (and hard to replicate).
- Process differentiation: You are selling a new, more efficient way of doing things.
- Price point differentiation: You have found a way to sell a product or service for less or for more (i.e. premium pricing).
- Super niche differentiation: You’ve found a market that’s a particularly good fit for you.
If you’ve got several differentiators, all the better.
Klipfolio, for example, stands out because of our process and price point – we have an incredibly efficient business model – and the niche (small and medium-sized businesses) we are targeting.
Differentiators change over time. In the past, for example, holding a patent was a good differentiator. But today patents are less effective because technology moves so quickly and it is often quite easy to get around them.
The important thing is to have and keep developing strong differentiators.
3. VCs want you to prove that you have a solid management team in place.
A VC about to invest in your company will want to know that the money will be well-managed. So having a top-notch management team – a team with experience – is crucial.
Don’t try to hide a weak link. The VC will ask for details about everyone on the management team, and will want to meet the players.
In fact, if there are any weak players on your management team, I would recommend holding off on the search for VC financing until your A team is on the ice. If you have a weak player, coach them to improve their abilities – and if that does not work, replace them.
It’s actually better to be missing a key player on the team than to have the wrong player. That’s because it’s perfectly acceptable to tell a VC that some of their money will be used to hire a solid A-level player.
So be aware, and be up-front.
In addition to vetting your management team, the VC will also want to understand your company’s culture and your management’s philosophy – how the management team handles problems and challenges.
The VCs will spend time in your office, and they may test your management team by throwing some difficult questions their way or organizing whiteboard sessions – asking how your team would handle such and such a problem. If your team has a dysfunctional approach, it will disqualify you. Your team should be used to working together – and work well together.
The VCs will also put a lot of value on the CEO – to the point that I’ve sometimes heard it said that VCs don’t invest in a company, they invest in a CEO.
The VCs will put a lot of effort into understanding how the CEO operates – how he or she deals with issues, motivates and listens, and inspires and drives the business forward.
4. VCs want you to show how your company is a good fit for their investment philosophy.
Every venture capitalist has a philosophy that underlies their approach to investing.
Some VCs are strictly in it for the return. Others take a strategic approach, looking to support startups that will benefit their parent companies.
For example, Intel Capital is the investment arm of Intel. Intel is a major maker of semiconductor chips. Intel Capital invests in developers and providers of hardware, software, and services in areas and industries that (as a general rule) use semiconductor chips. In other words, they help create future markets. This is a strategic approach.
Investors simply looking for a return often develop a philosophy nonetheless – usually around their past ability to pick winners.
For example, one VC might decide to focus only on startups that sell into Fortune 500 companies, because that is where there’s big money to be made. Another VC may focus on green technology or social enterprises.
A VC who specializes in a certain area – say green technologies – will come to know that area very well, and be able to understand the playing field, competitors, trends and buying behaviours. They may also want to invest in companies that have synergies with each other.
So whether they’re in it strictly for the return, or whether they are doing it strategically, most good VCs will have a thesis or area of interest.
And if you are looking for their money, you need to know what their thesis is.
5. VCs want you to be able to back up whatever you tell them with metrics and solid evidence.
A VC who is interested in you will take the time to get to know you before investing. If you chat about your projections for growth, you can bet your bottom dollar that the VC will be taking notes. And if your growth falls short of projections the next time their analyst calls, they will ask why.
So be aware that you will need to back up everything you tell VCs with metrics and solid data. For your own firm, that means having solid evidence of progress.
What VCs look for won’t be the same for every industry. For a SaaS (software as a service) company there are many well-known metrics on which a company is evaluated. For example, you may have heard of the Five Cs of Cloud Finance. (It’s Number 5 of the 10 laws of cloud computing put out by Bessemer Venture Partners.)
The Five Cs are:
- CMRR, ARR, & ARRR – Committed monthly recurring revenue, annual recurring revenue, and annual run rate revenue;
- Cash flow – Start with gross burn rate and net burn rate, then hopefully turn to free cash flow over time;
- CAC – Customer acquisition cost payback period.
- CLTV – Customer lifetime value.
- Churn & renewal rates – Logo churn, CMRR churn and CMRR renewed.
As Bessemer Venture Partners says, “we recommend EVERY cloud business track and report on these as a starting point, plus additional metrics that are relevant to your teams and functions.”
Investors will be able to tell a lot from these metrics, but not every VC will react to them in the same way.
For example, if you’re cash positive, an investor may be OK with putting in money if you are projected to grow by 50% in a year. But if you’re not cash positive – in other words, if you’re still burning cash – the investor may demand 100% growth in a year before putting in any money.
The important thing is to have the data.
There is an interesting “Rule of 40” that Brad Feld published a year ago, where for a healthy SaaS business the sum of your annual growth rate and your EBITDA (Earnings before interest, tax, depreciation and amortization) profit margin should equate to roughly 40%.
And you’ll need evidence for things outside your business as well.
For example, earlier I mentioned how investors want you to operate in a big market. You need to be able to provide figures to show how big the market is. And if the market is growing, you need to be able to show the rate of growth.
And evidence doesn’t just come from facts and figures: It also comes from ‘soft’ sources like customer testimonials.
Our VCs have always talked to our customers before signing up with us, and chances are they will want to talk to yours.
So you want your customers to be able to say things like "I love this!" or "I’d be lost without this product/service" or "We have no qualms about paying for this product/service, and we recommend it."
6. VCs want you to be able to explain how you are going to use their money.
It sounds self-evident, but it really needs to be spelled out. A VC investor needs to know – in some detail – how you intend to use their money.
Will you invest in advertising? Will you hire new talent, either a top-flight executive or new sales staff? Will you use the funds to acquire a small firm that provides something you need so you don’t have to develop it in-house?
The investor needs to know what you plan to do with the money, and how your plans mesh with your goals.
Ready to find a VC? Get introduced.
As I’ve said many times, a VC will speed a company’s growth. Bringing in the right VC will increase the likelihood of things happening. A top-tier VC is inherently valuable, because winners deliver winners. The top five venture capitalists in the United States produce a disproportionate percentage of the capital returns in the VC market. In addition, the top VCs have better, deeper relationships with the bankers who produce the IPOs.
If you understand what VCs are, how they work, how they make their money, how they can help you grow and what they’re going to ask you – you’re ready to go out and look for one.
A few final pieces of advice: Don’t cold-call a VC.
And don’t rush to take part in those public pitchfests in which entrepreneurs get five minutes to wow a room full of VCs.
If they cold-call you, be friendly and take the time to talk. I regularly get calls from young analysts hired by VCs to search out companies that might fit their investor’s thesis.
But the best way to meet a VC is to get introduced by someone you know.
And once you have been introduced, try to find a VC whose values and objectives are a good fit with yours. After all, this could become a long-term relationship.
Allan Wille is a Co-Founder and Chief Innovation Officer of Klipfolio. He’s also a designer, a cyclist, a father and a resolute optimist.
Six things startups need to know about venture capitalists
Transparency and business: Four critical things business owners need to know