What are venture capitalists really looking for?

[Note to readers: this post is designed to promote transparency and fill in some of the gaps that I encounter on a daily basis as a venture capitalist working in Brazil. Specifically, I am trying to ameliorate the huge disconnect between venture capitalists and entrepreneurs by helping remove the mystery surrounding the way in which venture capitalists analyze projects. Hopefully, I will have the chance to revisit each of these issues, in more detail, in the future. While there are many similarities, I would caution readers against applying the information cited in this post to markets beyond Brazil as criteria often differ from market to market.]

You have written your executive summary or power point presentation and have submitted it to the venture capital firm.

How will the venture capitalist analyze the materials that you have submitted, specifically, what are venture capitalists really looking for?!

In order to answer this question, it is helpful to think about things from the venture capitalist's perspective.

The traditional venture capital model is to "invest in 20 and pray for 2."

This means that you invest in 20 companies, hoping to have two big successes.

Why is this necessary?

Probability.

Specifically, despite the best efforts of everyone involved, a large number of companies will fail, while others will generate only modest returns.

Accordingly, venture capitalists need big successes in order to make up for all of the companies that fail or generate insignificant returns.

Given this scenario, venture capitalists are typically looking for companies that can generate large returns.

What constitutes "large returns"?

Typically, venture capitalists want the chance to earn a 10x return.

That means, they want to make at least ten times the amount of their initial investment.

In some cases, venture capitalists are willing to invest in companies which offer slightly lower returns, in exchange for a greater likelihood of success, however, this usually only occurs when the venture capitalist wants to balance his or her portfolio with some less aggressive bets, and normally they want both higher returns and lower risk!

Given this scenario, we can draw two general conclusions:
(1) venture capitalists are looking for large returns (10x or more), and
(2) low risk.

How do these issues manifest themselves during a venture capitalist's analysis of your project?

Essentially, everything that the venture capitalist evaluates will relate to either quantifying the potential return, or gauging the potential risk.

Though investment criteria vary from firm to firm, venture capitalists generally analyze some combination of the following:
(1) Entrepreneur
(2) Team
(3) Market size
(4) Market growth
(5) Company growth (or, in the alternative, evidence of demand)
(6) Road to profitability
(7) Probability of exit
(8) Profitability of exit

[Each of these criteria deserve their own post but, in the interests of brevity, I will only give a brief description of each. There are, of course, many other things that venture capitalists look at, ex. competition, barriers to entry, etc., however, I think that the listed criteria are typically at the top of everyone's list.]

Entrepreneur -
The better the entrepreneur, the greater the likelihood of success, and, consequently, the lower the risk. That is the rationale behind backing experienced entrepreneurs. Essentially, the logic is that they have gone through the process before, so they know how to overcome the various challenges that inevitably arise.

Team -
The better the team, the greater the likelihood of success, and, consequently, the less the risk. A venture capitalist would much rather invest in an excellent team with an OK idea, than an excellent idea with an OK team. This is because execution accounts for a great percentage of a company's success.

Market size -
The larger the market, the better.
If the market is too small, then it isn't worth doing the deal because the potential return will not be large enough to justify the risk. The larger the market, the greater the leeway, i.e. in a large market, you don't need to be the number one player to still be hugely successful, some markets are large enough to accommodate multiple players, etc.

Market growth -
The health of a market, as measured by its growth characteristics, is important. Venture capitalists want to invest in companies which are in growing markets. You don't want to be in a dying market. So, for example, a venture capitalist would want to invest in a growing market like virtualization or social media, rather than a dying market, like word processors.

Company growth curve -
In an existing business, you want to see exponential growth. Specifically, you want to see a company's sales doubling or tripling each year, rather than growing slowly, arithmetically. In a new business, you want to see strong evidence of demand/need. You do not want a "build and they shall come" model, you want to see evidence of customers banging down the door for a product or service and an ability to pay.

Road to profitability -
The shorter the road, the better.
You don't want a pure research company that will take forever to break even.
Timing is everything, yet it is unpredictable. Since no one can predict how long it will take a market to materialize, ex. open source, online video consumption, etc., it is essential that you have a short road to profitability so that you can survive in the event that it takes longer than you expected.

Probability of exit -
Capital invested must be returned. Accordingly, the venture capitalist needs a way to exit the investment. In evaluating a potential investment, the venture capitalist needs to know that he or she will be able to achieve an exit at some point whether via an IPO, merger, or other type of liquidity event.

Profitability of exit -
Not only do you need to be able to exit an investment, but you need to be able to do so profitably. Accordingly, it is essential that the venture capitalist determine the types of multiples for companies in a given industry.

Finally, a few other important things to remember:

(1) An excellent idea alone is not sufficient.

Venture capitalists hear great ideas all of the time.
But having a great idea is not enough.
In order to invest, a venture capitalist needs to be confident in your (and your team's) ability to execute.

(2) Not all businesses are appropriate for venture capital.

There are many small, profitable markets that are good niche businesses, but are not appropriate for venture capital investment. An opportunity needs to meet a certain size threshold (usually determined by the size of the venture capital fund) in order to justify receiving venture capital.

(3) Don't approach a venture capitalist too early in the process.

Even if your business is appropriate for venture capital, you may have to develop your idea further before approaching a venture capitalist, i.e. You may wish to raise seed funding from friends and family in order to build a proof of concept before contacting a venture capital firm. Generally speaking, the further developed the idea, the better your chances of receiving funding.

(4) Companies do not exist in a vacuum.

Your company is evaluated, not just by some neutral objective criteria, but relative to every other company in a venture capital firm's pipeline. On a scale of one to ten, your company may be an 8.5, but if a firm is receiving all 9.5's and 10's, then your company may not get funded, even though there is a great chance that you will ultimately be successful.

Comments

[Colin Stroud]

Hi Simon,

A great article and just what our members at Million Impossible are interested in.
I have taken the liberty of linking this article to our home page so that our members can read the whole thing.

We also list Venture Capital houses on our web site, so if you would like to be included please e mail me and I can arrange for you to be included.

regards,
Colin Stroud,
www.millionimpossible.com

[Simon Olson]

Dear Colin,

Thanks for the feedback, and congratulations on your excellent site!

We only invest in Brazil, so it is probably best that we not be listed on your site, but thanks nonetheless for your kind offer!

Best of luck!

Kind regards,

Simon