Venture Capitalists (VCs) take on a huge risk when they invest in a new business.
In which case, if you are an up-and-coming entrepreneur looking for venture capital investment, you will want to understand how these firms operate. By understanding what they are looking for in business ventures (and their leaders), you can identify opportunities to position your company as the perfect suitor for investment.
Here at CFO Hub, we are quite experienced in this space, so we wanted to shed some insight on venture capital investment criteria. By the end of this article, you should understand if your business fits the bill.
VC In a Nutshell
Venture capitalism can be an ideal alternative to traditional bank loans. Because many new start-ups have a dearth of hard assets, banks are less likely to invest—that is where VC firms come in.
According to a November 2020 report from The Economist, “Venture-backed companies account for around a fifth of the market capitalisation of public companies in America and almost half their research spending.”
VCs typically work in high-growth segments, and seek out both protection and opportunity for growth. This means they are seeking out investments that they will be able to safely exit if the company goes south, and ones they will be able to invest in further if the company succeeds.
Additionally, VCs work with investment companies, wealthy individuals, and large corporations to pool funds. They then invest these funds in high-risk, young companies that they believe will produce enough ROI to mitigate any of the associated risks.
VCs are discerning by nature—just because you know you have a good idea and they agree with you does not mean they will be willing to invest their carefully curated funds in your fledgling endeavor.
A study by the Journal of Financial Economics says that the average VC firm screens 200 “targets” but will end up making only four investments.
Thus, there are five key factors venture capitalists consider when scoping out an investment opportunity:
- A strong team (even stronger leadership)
- An innovative product
- Proof of concept
- Market size
- Favorable terms
#1 A Strong Team and Stronger Leadership
Strong, reliable management is a linchpin for startups. Savvy investors look for leaders who understand the business plan and know how to execute it. The first contact a VC has will be with the company’s founder or CEO, so the success of this meeting is imperative.
Industry note: There is something to be said here about the world of venture capital. Many firms live by “we invest in the person, then the company.” This method of operating is hyper-specific to the individual leading the enterprise. Their willingness to invest often hinges upon whether they regard the leader as a visionary, and whether or not they deem them capable.
To that end, VCs will ask themselves questions like:
- Is this person fully committed to this enterprise?
- Are they inflexible, or will they be open to advice and new ideas?
- Is this person a time bomb or cool, calm, and collected?
- How well does this person communicate with others?
- Does this person feel passionately about the product or service they’re backing?
If VCs find that the founder/CEO or any other soon-to-be executives lack any of these qualities, then the business should be willing to bring on outside management. VCs are looking for a cohesive team that complements each other, not a few “Star Players” here and there.
According to the Project Management Institute, “poor communication results in project failure in one third of cases.” If they pick up on this in your initial bout of interacting with you, they will likely not want to pursue investing.
#2 An Innovative Product
While having a strong team is paramount, having a viable and innovative product or service will give you an edge over other entrepreneurs. VCs want to invest in a solution to a problem—they do not want to see a re-hashed version of an already popular, widespread idea.
Maybe your product is the best-priced in the market, yet it still retains its value. Maybe your service is one-of-a-kind, and will lead the market before any competition even exists. To catch the eye of sought-after VCs, you will need to show them that you have something that will either change the way consumers operate or will entice consumers enough to not want any product other than yours.
Are you changing a market, creating a market, or absorbing a large chunk of one? Fantastic. Focus your narrative on the utility of your product or service.
#3 Proof of Concept
Just because your company qualifies as a start-up does not mean VCs will not look for proof of concept. You will need to show them you have more than just a clever idea—you need to prove people will pay for your product or service.
If you are looking for a way to gather data from consumers, the Small Business Administration has a list of reliable sources that provide market information at no cost. Focus on gathering the following types of data to present to a VC:
- General business statistics
- Consumer stats
- Economic indicators
- Employment stats
- Income stats
- Money and interest rates
- Production and sales stats
- Trade statistics
- Statistics of your specific industry
At the touchpoint of investment, many companies are not yet profitable. In fact, some of them have not even begun to generate revenue. In which case, you need to find a way to convince a VC firm that consumers have a need or a strong desire for what you’re selling.
Another factor is beating your competitors (should they exist) to market.
#4 Market Size
VCs want to see that your product or service is part of a large market—they will not be willing to use their investors’ funds to invest in something that will only attract a negligible portion of consumers. VCs will ultimately want you to go public one day, so this means your niche rock candy store may not fit the bill.
Prolific entrepreneur and investor Kathleeen Utecht says that to attract VC firms, your market needs to be “at least $1 billion.”
Just like you gathered data for your proof of concept, you will need to gather data to outline market size, too. You will want to have an analyst or strategist prepare research reports which should include detailed market size analysis.
In a venture capitalist’s mind, the faster a business grows, the faster they can recoup their initial round of funding. VCs are often not in it for the long haul—they want to fund a great idea, watch it scale, then exit with money in hand, ready to fund their next venture.
#5 Favorable Terms/Risk Protection
When investing in your business, VCs are looking for more than just potential revenue. They are also looking at the risks involved and what potentially devastating consequences could arise from investing in a losing enterprise.
A few questions VCs will consider when investigating new businesses include:
- What if any legal issues could arise?
- What is the timeline for a potential exit?
- What is the projected ROI?
- Is this product right for today’s market, or a future market?
For its full integrity, we should oversimplify this factor—VCs are in it to make money. If the terms that you are offering do not favor (or, at the very least, entice) their firm, then even if they believe in your business’ success, they will not be inclined to invest.
Due to this factor, VC firms can have a sharkish reputation. This is not without reason, seeing as many of the companies they invest in fail, and only the few that succeed help recoup the difference of their lost funds.
Increase Your Company’s Financial Operations with CFO Hub
Maybe you’re on track to elevate your company with VC funding, or maybe you’re steadily working toward the goal of producing enough revenue to attract initial VC interest. In either case, you’ll want to have a firm grasp on your business plan. This means you might need some assistance in the fields of accounting, mergers, financial modeling, and more.
In order to gain the support of venture capitalist firms, you will need to present them with the strongest story possible. In other words, your modeling, financials, and bookkeeping need to be seamless. Given how many companies they review on a weekly basis, if your backend isn’t in order, they might pass on your company just because of this entropy.
That’s what we’re here for.
As an outsourced CFO and financial consulting firm, we provide solutions for growing businesses to outsource and increase their financial operations. With CFO Hub, you can bolster your management team and present potential investors with the most attractive “story” you can tell.
Ready to prep your company for VC funding?