Understanding How Venture Capitalists Make Decisions

Why Startups Die #6: Run out of cash after raising capital

There’s a lot to understand about how VC’s make decisions.  Even if you raise money from friends and family or angel investors, many companies, particularly those with big tech demands or big market opportunities, will usually need that next round of funding – and many will die on the vine, having met their first stage goals, but unable to meet the next stage.

So, for our sixth reason that startups fail, Run out of cash after raising capital, I’m digging a little deeper into what professional investors want in their investments.

As mentioned, Stanford’s b-school is studying Venture Capital to better understand how it works, and its role in the economy.  The Stanford research team has surveyed many VC’s and gathered a lot of data, and they’ve unearthed some juicy info that helps entrepreneurs!

As a result of this work surveying VC’s on the most important factors in deciding whether to invest, Professor Ilya A. Strebulaev says,

“Entrepreneurs, especially in the tech world, have a lot of levers they can use to attract investors. But if entrepreneurs are not perceived to be passionate, there’s little chance they’ll get funding, and if they can’t demonstrate that they’re capable and experienced, then VCs will pass.”

You may have heard the “jockey vs horse” analogy in the VC world.   The team is the jockey, and for the majority of VC’s, the capability and passion of that team is more important, perhaps, than the market/opportunity or “horse”.  Apparently this is even more consistently the case in the IT space (because of the number of pivots!). According to the Stanford research paper, key elements of the team that matter are industry experience, prior entrepreneurial experience, passion, and team dynamic. The research shows that  VC’s love to see real commitment and effort on the part of the team.  Of course, they love initial bootstrapping and personal investment to show that you are “really serious”.

I’ve mentioned before that you really have to know your stuff with potential investors!  They will be running the numbers in their head, and if they’re a Perfect Investor, then they will already want the market opportunity you are pursuing – so they will know a LOT about it.  They will know the competitors, the regulatory framework (if that’s important), they’ll know about past failures. The research backs this up! So be prepared to be grilled!!!

So drawing from the paper, How Do Venture Capitalists Make Decisions?, what do VC’s report are the most important elements in selecting an investment in a startup?

  1. Management/founding team – mentioned by 95% of VC’s as “an important factor” and by 47% of VC’s as “the most important factor”
  2. Business / business model (or horse) was an important factor to 83% of VC firms
  3. Product was important to 74% of firms
  4. 68% of VC’s said that the market was an important factor
  5. Industry was an important factor to just 31% of firms.

Your startup needs a funding pipeline!Interestingly, these business factors were only rated as the “most important factor” by 37% the VC’s in the study. Far behind were factors like “company valuation” (especially in early stage deals) and “fit with fund” or “ability of the VC to add value to the startup”

Something else it’s important to understand is the VC vetting process – or what happens once you get that introduction!  For each VC deal completed, the VC looks at about 100 potential opportunities. At each step, a majority of companies are eliminated from consideration.

Step 1: Get the intro and interest of a Perfect Investor
Step 2:  One in four companies (25%) which appears interesting leads to meeting the management of the VC firm (at least one member of the firm) – your first pitch!
Step 3: Of those who meet a member of management, 1/3 will be reviewed at a partners meeting.
Step 4:  After a company has weathered the partners meeting, about half of those reviewed at a partners meeting proceed to the due diligence stage.
Step 5: About one third (1/3) of companies which pass through due diligence are offered a term sheet.(ideally the entrepreneur has competing term sheets!)
Step 6:  The legal documentation and representations/warranties can cause deals to fall apart between agreeing to a term sheet and the deal closing.

(note if you play along at home, that math does, in fact, yield about 1.3% of companies considered get a term sheet!)

For each VC deal completed, the VC looks at about 100 potential opportunities.

The research indicates that VC firms offer an average of 1.7 term sheets for each deal that they close, a close rate of roughly 60%, which suggests that deals either fall apart or the entrepreneur gets a better term sheet!

Don’t forget, with the odds so against you, make sure you get the inside help info that you need to improve your odds of success! Remember, there are very few people out there who have both raised money from VC’s (remember that 1% number) AND who have been on the funding side and are willing to share investor and VC insider info. We will because 1) we’ve done both and 2) we are focused only on helping entrepreneurs win. Be sure to get your free VentureWrench Guide to Investor Capital (see below) and check out our online course (or course plus personal coaching) “Designing the Perfect Investor™.” For less than the price of one failed airline ticket to visit a “wrong investor”, you can get our inside scoop, plus we are giving members of our community a discounted search of our upcoming InvestorFind™ curated investor database! Just drop us an email at VentureWrenchCommunity [at] gmail and let us know you want to take advantage of this special offer! (Put InvestorFind Deal in the subject line!)

We are Working our Way Through 10 Reasons Startups Die
  1. Destructive corporate culture
  2. Failure of product – market fit
  3. Founder issues and conflict
  4. Staffing and Team problems – poor hiring choices or inability to prune staff appropriately
  5. Can’t raise sufficient capital
  6. Run out of cash after raising capital
  7. Scaling too soon or improperly
  8. Intractable technical problems
  9. Poor strategic environment (customers, suppliers etc)
  10. Regulatory problems (forseen or unforseen)

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