American media is and has been in love with Cinderella stories for a very long time, particularly when it comes to startups. If you were to follow media coverage of the new companies, you would think that it’s so easy to come up with a cleaver business idea, set up meetings with venture capitalists and raise millions of dollars used to expand company’s operations. In fact, that’s the predominant type of story that media likes to cover, so there’s a recent trend, popular particularly with Millennials to become successful a entrepreneur right of out of college and then get rich. Startup infatuation culture is alive and kicking: valuations of the unprofitable private companies reaching billions of dollars; incubators and accelerators teaching new entrepreneurs how to pitch to investors are sprouting all over the country. Hence, venture capitalists are ready to capitalize on this strong startup ecosystem, because they have raised 62% more funds in 2014, having about $33B available for investment this year alone. Clearly, the money is there to be earned, but that doesn’t mean that it will be easier to actually close on the investment round. Because of that, I am writing this paper to save entrepreneurs lots of aggravation by explaining what is the profile of a new company that has traditionally been attractive to venture capitalists.
Venture capitalist industry is traditional and conservative
What’s hidden from the press is the stubborn, long standing statistics that over half of new companies die within first five years. When it comes to raising venture capital, the odds are not really in your favor either; it’s even worse. A typical venture capital fund managing partner evaluates about 1,000 business plans per year only to fund a single startup. Assuming that you a pitching to about 100 VCs, the probability of getting funding is still going to be around 1%. This long standing statistics is pretty discouraging for startup co-founders. To understand the reasons behind this low probability of funding, it’s important for entrepreneurs to understand how does venture capitalist industry operate on the inside and determine really early into company’s formation if their business is venture capital material or not. If they are not, they should not spent their precious time chasing venture capital investment and focus their energy on customer acquisition, bootstrapping, organic growth, debt financing or angel investors.
Even though venture capitalist industry funds innovative new companies with disruptive technology, their own industry is very low tech and conservative. Usually, venture fund managers raise money from limited partners who are portfolio managers in charge of traditional asset classes, such as mutual funds. In turn, they are expected to provide an attractive return within specified amount of time, ranging from five to ten years, on the average. A decision to invest in a startup is being done by a managing partner that is getting research support from one or two analysts and external consultants, technical experts in the particular industry. Obviously, the team running the venture capital fund is very small and it’s internal modus operandi resembles more a mom and pop shop rather than a sophisticated, modern enterprise. Such small team is time constrained, doesn’t have big data analytics tools, but rather does the work with pen, paper, phone and disjointed set of spreadsheets. Because of these operational constraints, venture capitalists frequently rely on past experiences to make future decisions:
- they invest primarily into a handful of familiar sectors
- they invest only into large markets that are at least $1B in size
- they are susceptible to group think, and some cynics like to use the word “lemmings” for VCs. Because VCs are inherently risk averse, despite the fact that they invest in risky new businesses, they feel more comfortable in a group where majority invests in the same sector, in companies implementing familiar, proven business model. Because of that, a new startup that doesn’t fit into current VC investment landscape would have a hard time getting their voice heard. This investment landscape changed every few year, so a sector that has been popular two years ago, may be getting out of favor today.
Industries funded by venture capital
Historically, limited number of industries have benefited from the infusion of venture capital funds. Because venture industry is conservative, I don’t anticipate that their investment preferences will change significantly in the future. Software sector is historically taking the lion share of VC funds, followed by biotech. Almost all of the companies in sectors listed in the chart are heavy on technological innovation; they are prime to achieve double if not triple digits growth year in and year out for the first five years by relying their computing power and innovative algorithms, not necessarily by adding more labor.
The other important metric to keep in mind is the amount of money venture capitalists allocate for different stages of company development. Only few percentages (around 4%) of all deals are being sealed with companies that are in the seed stage, while about 50% of all deals goes to the companies in the early stage. Seed stage company typically does not generate any revenue yet, it may still be in R&D phase improving the prototype while acquiring first beta customers. Such company is more suitable to get off the ground with the investment from friends, family and angel investors, rather than institutionalized venture fund. The typical investment round in seed stage is from $10k — $500k from angel investors, around $1M from venture fund, but usually no more than $3M.
High growth technology company profile, a “Gazelle”; Small business vs. high growth ventures
Venture capitalists prefer to invest in high growth technology companies, so called “gazelles”. Such company has annual growth of at least 20%, is younger than five years and has significant profit margin (50% has a nice ring to it; iPhone profit margin for Apple is a good example). Similarly, economic developers all hope that “gazelle” type of startup will take root in their neighborhood because historically these new companies have contributed to over 10% of all new jobs created.
High growth technology startup is targeting market segment that is at least $1B in size. Anything less that that, is financially not attractive enough to a venture capitalist, so such business is more suitable for angel investment and good old fashion bootstrapping. The next step is to compare company’s competitive advantage and if can it be sustained in the long run with their proprietary technology or efficient processes. New entrant to the market should offer to the end customer a product or a solution that is significantly better than currently available industry average products. For example, a product that is at least 30% better, faster, or cheaper than industry average is significant improvement. Finally, profitability is the key.
I have seen and evaluated hundreds of investor pitches; without a fail, all of them have a “hockey stick” chart promising potential investor incredible ROI in just few years. Because it’s hard to accurately estimate revenue and expenses beyond the first two years for a new company, investors do not put a lot of stock in these hockey stick charts. Most inexperienced entrepreneurs make hockey stick chart in a spreadsheet by heavily overestimating customer acquisition costs, underestimating operating costs and number of employees that needs to be hired. If you are very confident that your company checks off all major VC filters and you truly have a potential to grow the company following the hockey chart model, then, please don’t wait any minute longer pitching to VCs.
Keep perspective: very few public companies have $1B valuation
“With your seed investment, in few years we can grow our company to $1B.” Can you imagine how many times did investors hear such cliche statement? Unfortunately, frequently. Such statement only highlights inexperience of the founding team that is dreaming to be the next Facebook, Twitter, or Microsoft. Reality is quite different as it’s incredibly hard to grow a company to a large market size. Russell 3000 index includes 3,000 publicly traded companies, which covers 98% of all publicly traded securities, almost all of the US market. Russell Microcap index, tracks 1,633 companies, representing more than half of all public companies, but they carry less than 3% of the US equity market combined. The median market cap is $218M, with the company with the lowest valuation having a market capitalization of $30M. In other words, about a third of all public companies have market cap less than $200M. It’s important that startup founders think about this data point because venture capitalists spend a lot of time analyzing the market data as they ultimately have to make a return on their investment, ideally by taking their portfolio companies to an exit via IPO. Knowing what is the market capitalization of the publicly trading companies in your industry is extremely valuable comparative data point during the discussion around valuation of an early stage technology company. Also, keep in mind that most companies never become public.
Despite news and media infatuation with startup culture and billion dollar valuations for few young companies, most new businesses are not suitable for venture capital investment down the road. Unfortunately, a number of new entrepreneurs reading business magazines and blogs are lead to believe that the only way for a business to succeed is to raise funds from venture capital groups, so they spend time chasing a goal that is not attainable in the first place. Venture capitalist industry is mature, conservative industry that invests primarily into “gazelles”, high growth technology companies with double or triple digit EBITDA growth, owning proprietary technology that allows them to have significant and sustainable competitive advantage. I recommend entrepreneurs to evaluate their own business model first to assess if their company in the making fits the profile of a startup that could be venture capital ready. If it is very obvious that this new company doesn’t fit the profile, entrepreneurs should focus all of their energies on bootstrapping, customer acquisition, organic growth, debt financing and angel investors, in that order. Since angel investing is growing, and because most new businesses can benefit from cash infusion from a high net worth individuals, I will have a series of articles on angel investing.
Dragana Mendel, a management consultant for startups, small and medium size businesses develops and executes growth strategies for her clients. Please call for 30 minutes complimentary discovery session to assess your business current situation and market development needs.