Entrepreneurs

5 Factors VCs Look at When Investing

Any successful business needs funding. According to CB Insights, 38% of failed startups did so because they ran out of cash or failed to raise capital, making it the number 1 reason why startups fail. Most startup founders use personal savings for their initial funding. As such, VC funding is vital to a successful startup. It is a long shot for any startup to be funded by a top VC, with only a 0.7% chance according to Marc Andreessen, founding partner of VC firm Andreessen Horowitz. In order to improve a startup’s chances, it is beneficial to know what VCs are looking at when evaluating a company for potential investment.

Below are 5 factors VCs consider before investing in a company:

The Founder

The founder is the face of any startup; in the early stages, a company is often seen as a manifestation of the founder. Money is always given to an individual. VCs will look at the idea, the team, and the numbers, but they will invest in an individual.

Here are some questions VCs might ask:

  • Are they likeable? – VCs are seeking individuals who are relatable or will be well-liked by others. The founder should be likeable to customers, new investors, and colleagues and other team members.
  • What is their track record? – VCs want someone who has been consistently successful in their performance, whether it is current or previous business ventures, school, or even their personal life. Success is a habit; if a person has a history of delivering, one can expect they will deliver in the future.
  • Are they reliable? – Integrity is vital in any relationship. Nobody wants to work with somebody who is unreliable or will back out on their word.

Market Demand

Any company that a VC will invest in has to have some product, either a good or a service, to sell that solves a problem. The product may be an improvement on an existing product, it may fill a gap where there is demand but no product, or it could be anticipating a demand and providing a preemptive solution to a problem.

It may be easier if a company’s product can fill a gap where there is an existing demand for a product than creating market demand for a solution to a problem that doesn’t exist yet. Improvements on existing products can combine aspects of both, creating something better, faster, safer, etc., solving a problem that customers may not know they have, but also operating within an existing market against established competition.

Business Model

All companies need to make money, and VCs want to know how money will flow into the company. If a VC is to invest in a company, they want to know that it can be profitable and that it will scale. Recurring revenue in which customers pay invoices on a regular basis, e.g. monthly or annual payments, is more likely to be consistent than a business where customers are making one-off purchases. It is also easier to scale as customer usage and dependency grows.

VCs also want to see the per-unit profit margins. Because VCs don’t generally invest in companies with the goal of running them in perpetuity, but instead increasing their value and selling them for a big payday, marginal gross profits don’t provide as much value for their investment. Furthermore, VCs want their investment to help the company scale quickly, not continue as a slow burn.

Traction

VCs invest in a company with the intention of increasing its value to sell it for a profit, so they need to see that the company is in a position to grow. Investors are highly reluctant to invest in a pre-revenue company; they want to invest in a company where they have ample proof of concept. If a company has no revenue or customers, then VCs are likely not interested.

Investors are making long-term bets that companies will scale and give them a big payday, but they also want to hedge against companies that may not pay off. When investing, they need to see how the capital being requested stacks up to the companies’ current “run rate” or financial projections. They would rather invest $250,000 in a company with $500,000 in revenue than one with $125,000 in revenue; covering the initial investment with current annual revenue is a great way for them to hedge their bet.

Valuation and Exit Strategy

Venture capital firms are not in the business of running companies long-term. Their business model is to invest in numerous companies, double down on companies that do well, and sell them for a big payday. The only way this model works is when their portfolio companies are successful in raising capital at higher valuations in each subsequent funding round. For VCs, the valuation itself is not a significant factor; the difference between investing $200,000 for 10% or $500,000 for 50% is negligible. A better benchmark is how fast they can increase the valuation such that they can double their investment.

VCs are looking for companies that are about to take off. Sheryl Sandberg once said, “if you’re offered a seat on a rocket ship, don’t ask what seat! Just get on.” If VCs respond positively to 3 out of 5 of the factors above, they will consider investing; 4 out of 5 is attractive; 5 out of 5 is a rocket ship about to take off.

The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.

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