By Paul Morin
I get a lot of questions about what venture capital (VC) investors look for when they are considering investing in a venture.
Many of the characteristics I’ll cover here are also applicable to what “angel investors” look for in prospective investments, as these days, a significant percentage of such investors have been at it a while and have reached a level of investing sophistication that is hard to differentiate from that of venture capitalists.
I won’t go into a huge amount of detail on each of these desired characteristics, but I thought it would be nice to at least have many of them covered in the same place. (I will also throw out the caveat that not all venture capital investors put the same amount of emphasis on the same set of desirable venture characteristics, but here’s a good start.)
However, in my experience and that of my client companies, the 11 venture characteristics discussed below usually play at least some role, and often a significant one, in the investment screening decisions of venture capitalists and more sophisticated angel investors.
1. Strong Management Team
Pretty much every venture capitalist I know will agree with the old saying, “I’d rather have an A team with a B idea than vice-versa.” The reason for this is that start-up ventures and even those a little further along in their development rarely go exactly as planned.
There is always “execution risk” in any venture, but the earlier the stage of the business and the more cutting-edge the technology being exploited, the greater this risk becomes. In such situations, it is very helpful to have a team that has been around the block and has a track record of success of maneuvering in such dynamic environments.
2. A Growing, Sizable Market
The target market should be sizable and growing. Venture capitalists typically are not looking for “small” opportunities. They are looking for ventures that are targeting markets which show promise of significant growth for at least five or ten years into the future and that are of a size ($1B+, minimum) that will allow their prospective investment to enjoy considerable returns.
So, if you are looking to corner the market on widgets in your small town, or if you are looking for working capital or even growth capital for your business in a mature, low-growth industry, don’t bother contacting venture capitalists. The one nuance to this is if you are doing something to “revolutionize” a low-growth industry in a segment that has reasonable size, you may then be able to stir up some interest from VCs.
Also, clearly there are VCs and angels that will look at opportunities in small, highly targeted segments, particularly for some very specialized technologies, but these are fewer and farther between.
3. Strong Margins
As I’ve pointed out elsewhere, strong gross margins allow you to make a lot of mistakes and still be around to fight another day. They also allow the potential to make tremendous net profits and investor returns if the company grows as planned.
For these reasons, venture capitalists like to see strong gross margins (60 percent-plus) in their prospective investments. That said, it is widely known that business opportunities with such high gross margins are not easy to come by, so VCs and other investors are willing to look at businesses that don’t quite reach that benchmark, particularly if there are other positive characteristics that make the venture attractive.
Sometimes, for example, while strong gross margins would be a “nice to have,” it is much more important to the venture and the investor that the business achieve critical mass (for example, a large number of subscribers) quickly to become the leader in the market and attract the interest of potential acquirers. Every situation is unique, of course, but all else being equal, strong margins currently or at least projected at some point in the future, raise the attractiveness of a potential investment.
4. Exit Potential
The potential to exit the investment is very important. There are very few VCs that want to be in an investment for “the long haul.” In fact, VCs typically raise their money from institutional investors and wealthy individuals, in order to invest it and obtain the best return they can in a certain period of time.
They are what are called “closed end” funds. So there is an investment horizon and as managers with fiduciary responsibility to their investors for the money they have raised from them, VCs do not have the luxury of not considering how they will exit from the investment.
While the situation for angel investors who are investing their own money is distinct from that of VCs investing money on the behalf of others, their “exit mentality” is usually similar. For these reasons, both VC and angel investors will typically strongly consider how they’re likely going to be able to get out of a particular investment, before they will invest a dime.
5. Proprietary Technology
The focus on proprietary, patented (or patent-pending) technology will vary depending on which industry or industries the venture capital investor is focused on. In some industries, this may be much less important and in other industries, such as biotechnology, proprietary technology and such things as FDA approval may be extremely important.
Regardless of the industry, most all VCs, knowing how competitive any new market environment is, will want to see what many refer to as your “special sauce.” What is it that you do differently or have that’s unique, that will allow your venture to excel in the marketplace? The answers to this question can vary widely.
They may relate to operational advantages, marketing strategies and tactics, or financial advantages you bring to the table. They may also come in the form of technology or business processes that you’ve patented that will give you an advantage in the marketplace. Whatever they may be, you must show up to the table with some “special sauce” elements of your business, or you are not likely to get too far in obtaining VC or sophisticated angel investment.
6. Big Upside Potential
Venture capitalists are not looking to hit “singles,” to use a baseball metaphor. They know from experience that of every ten investments they make, one, if they’re lucky, may be a “home run.” They may also have a “double” or “triple” in there as well, but the rest likely will not go anywhere too exciting.
So when they are looking at any individual investment, if they don’t think it can be that one “home run,” why would they consider it? They must believe that if all goes well, your venture can become a home run and serve that role in their portfolio.
If they can’t believe that in the beginning, how can they expect to get behind it if all doesn’t go exactly as planned and your venture needs some more investment along the way? They must be able to believe and you must be able to make a strong argument that your business has the potential to be an extraordinary success.
7. Good Use of Investment
Venture capitalists are not making investments for the fun of it. They are not going to write you a check for five or ten million dollars and just hope they you have a good idea what you’ll do with the investment.
You need to meticulously plan how you intend to grow your business and how you will deploy the capital being invested.
How much will go to capital expenditures (“CAPEX”)? How much will go to marketing? How much will go to working capital? How much will go into upgrading and expanding the sales force? When will you need the next round of investment?
You need to have this all very well planned out and be able to demonstrate precisely how you expect to utilize the funds being invested. All investors know that nothing will go exactly according to plan, but by providing detailed forecasts on the expected growth and uses of capital for your venture, you can demonstrate to prospective investors that you are not “shooting from the hip.”
Put yourself in the place of the venture capital investor; which venture would you invest in — the one that had a detailed plan on how they were going to use your investment, or the one that was “winging it”?
8. Reality-Based Projections
A pet peeve of almost every professional investor I know is when a management team shows up with (or sends in) financial projections that they appear to have pulled out of thin air. Everyone is aware that it is impossible to predict the future, so pro-forma financials are inherently flawed and inaccurate.
This is not, however, an excuse to pick revenue and cost numbers arbitrarily! All financial projections will be driven by a series of assumptions. When you build your financial model, you should make sure that your assumptions are well-explained and justified.
It is also important that you project a range of possible outcomes. You can get very fancy with this and use such techniques as Monte Carlo Simulation, but usually if you are able to provide potential investors with a “worst, expected, and best-case” estimate of possible outcomes, that will suffice.
In terms of how to justify your assumptions, it can be a bit challenging, particularly if you are pioneering a new market. Even so, it’s important that your assumptions and financial ratios are consistent with industry standards in the same or similar spaces, unless you have very good reasons for projecting more optimistically.
9. Market Traction
If you are a pure start-up, in seed-funding mode, it’s likely a bit tough for you to show market traction. The reality though is that most of the venture capitalists I know these days have larger funds and are looking to deploy larger amounts of capital in each deal, so they’re not doing much, if any, seed funding.
Many angels still look at seed funding deals, of course. In any case though, most of the “risk capital” investors I know and work with would still like to see you demonstrate at least some market traction, if at all possible. Market acceptance and adoption are such a significant portion of the risk equation for any prospective start-up and investor, that if a company has managed to get a few initial customers, it may help to mitigate at least some of the concern related to this issue.
It is OK if they are non-paying “beta sites,” however, it’s even better if they are customers who have been willing to pay for what you’re offering. If they’re not paying customers, but they are larger organizations that any prospective investor knows would have done significant company and technology due diligence before even trying your product and service, that can serve as evidence of market traction as well.
Scalability refers to the ability to take your business from a one or two-person show and a small handful of customers, to a larger, efficient and even more profitable enterprise. Will what you are doing “scale” well? Will it allow you to enjoy economies of scale and/or economies of scope? Or will you be constrained by certain inputs that are hard to obtain in large quantities, like a certain type of skilled worker, for example?
Venture capitalists and sophisticated angel investors understand that in order to have “home run potential,” your venture has to be able to expand without an enormous amount of operational risk and with the possibility of taking advantage of certain “economies” that can lead to extreme profitability.
Ask yourself, is my venture scalable? If it’s not, consider how you can make it more scalable. Regardless of whether you obtain VC or angel investment, having a more scalable enterprise is likely to benefit you significantly as you grow your business.
It’s often not enough to just send your business plan in to a potential investor, or even to show up and present a prospective venture that is attractive along many or most of the dimensions covered in this article. In addition, you must have a vision, and it must be a big and clear one.
Prospective investors place strong importance on any potential investment having a founder(s) with vision and passion. It’s especially attractive when the team is trying to “change the world” in their particular industry or niche and when the strength of their belief is palpable.
This passion must of course be balanced with a solid understanding of “reality,” but a “we will not be defeated” attitude can carry a lot of weight when there may be a few other noticeable flaws in the venture and the plan. As stated elsewhere, early stage investors know that no start-up venture goes exactly according to plan, so belief, passion and a “never say die attitude” carry a great deal of importance in the assessment of the venture leadership and management team.
So there you have 11 things that venture capitalists and sophisticated angel investors look for in prospective investments. It is not meant to be an all-inclusive list, but it does cover many of the most important characteristics that VCs and angels assess when they are screening potential investments.
Paul Morin founded CompanyFounder.com. Morin has worked with various entrepreneurial companies in senior management roles and has led the development, review and selective implementation of several hundred start-up and corporate venture business plans, financial models, and feasibility analyses. You can e-mail Morin at firstname.lastname@example.org
Originally published: Sep 18, 2011