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What Do Venture Capitalists Look For?
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Venture capitalists generate profits by providing equity financing to startups that have high growth potential. Venture capitalists buy the equity of a startup and liquidate their shares either through an IPO or through an acquisition. Given this situation, the growth potential and the risk factor of the startup critically determine the profits VCs generate. The success of a startup depends on a number of factors. Venture capitalists carefully examine each factor before they decide to fund the startup.

Venture capitalists assess the risk using the following factors:

  • Founders/Management Team
  • Competitive Advantage
  • Market Potential
  • Barriers to entry
  • Exit Strategy

Founders/Management Team

Management teams typically constitute the founders along with other individuals committed to the startup idea. This team typically plays the pivotal role in executing the startup’s day to day operations. The management team should be able to steer the startup through risky and volatile situations. Therefore, Venture capitalists assess the strength of a management team by examining the members from three different perspectives.

First, Venture capitalists look for professional experience, most notably a proven track record. Every startup is associated with marketing and operational efforts. Therefore, venture capitalists expect the management team to contain an experienced marketing executive along with an experienced operational executive. And if the startup idea is based on an innovative idea, VCs would like to have the inventor or a technology expert on board.

Second, Venture capitalists look for admirable personal traits in the entrepreneurs such as reliability, reputation, trustworthiness, etc. Venture capitalists want the entrepreneurs to run the show, so they would like to deal with entrepreneurs who have established credibility within the industry. Venture capitalists generally tend to invest in entrepreneurs whose reputation can be verified.

Third, Venture capitalists look for entrepreneurial abilities in the team. Heading startups is much more difficult than heading large organizations, primarily because of the limited resources most startups generally have. Startups are synonymous with huge risks, and the management team should not only be extremely passionate and willing to persevere about an idea, but also have the ability to take a calculated risk.

Competitive Advantage

The competitive advantage of a startup corresponds to the possession of rare core competencies that radically create value to customers. A firm can truly say they have a competitive advantage if competitors cannot easily imitate their core competences. Although it sounds very abstract, a competitive advantage is easy to articulate. The competitive advantage of a company is the unique specialty that no other company has in the market. The competitive advantage of Toyota is that it offers reliable and quality cars at cheaper rates. The competitive advantage of IBM is that it is a one stop shop for all business computing needs. Similarly, the competitive advantage of Google (during its inception) was that it offered better search results than its competing search engines. And the competitive advantage of any high technology startup is the underlying technology.

Startups generally commence with limited resources and aim to achieve inorganic growth and generate wealth for its shareholders. Such inorganic growths are possible only when startups have serious competitive advantages. Startups should be able to leverage their competitive advantages and become successful business organizations. Venture capitalists look at the competitive advantage a startup has before they determine the startup’s growth potential. Every entrepreneur should articulate the competitive advantage of his/her business idea before approaching investors.

Market Potential

A startup’s market potential defines the total sales that the startup can eventually make. Market potential depends on three individual parameters: market need, market size and market penetrability. Market need describes the problem the startup intends to solve. The higher the need, the higher the probability that the startup will generate sales. Market size describes the quantity/size of the sales opportunities for the solution that the startup offers. A bigger market can allow the startup to generate higher revenue. Finally, market penetrability refers to how easy it is to make sales and generate revenue. In other words, market penetrability refers to the marketing efforts that the startup needs to exert before it penetrates into the market. Not all markets are easy to enter in spite of the market need and size. For example, even if a startup develops a revolutionary car that gets 1000 miles per gallon millage, the startup wouldn’t find it any easier to penetrate into the market than a better marketed vehicle that gets 500 miles per gallon. The new car still has to pass several safety regulations set by the National Highway Traffic Safety Administration before it can be brought onto the market. This is a relatively time consuming process. And even after the governmental regulations, the car has to appeal to the general public.

Startups face several challenges in determining the size of their markets. First, researching the market requires resources that most startups cannot afford. Second, as startups are based around radical ideas, it can be difficult to identify the target market. Third, at times, it becomes very hard to clearly define what kind of value the business idea offers to customers. For example, the venture capitalists that funded Splunk (www.splunk.com) had trouble articulating the company value offered to customers. However, Splunk turned into a successful company.

Venture capitalists closely look at the market potential for a startup idea before they decide to fund the idea. Entrepreneurs should focus on clearly defining the market before approaching investors.

Barriers to Entry

A startup’s barriers to entry represent the unique circumstances that thwart competitors’ attempts from entering the startup’s target market and capturing a major market share. The startup can establish several different barriers to defend itself against competitors. Such barriers include internal capabilities, government regulations, intellectual barriers, market share, partnerships, first mover advantage, brand name, economic and market conditions, competitors' reactions, customer relations, etc.

Note: Although patent attorneys claim that patents constitute the best defense, in reality, large companies that are not in the medical/pharma space use patents to sue each other. Although patents theoretically offer protection to startup’s intellectual property, it is easy to reengineer the intellectual property and create a new product. For example, patents are more or less irrelevant in the IT industry. However, the role of patents in the pharmaceutical industry is completely different. Patents constitute the life line for most pharma startups. Entrepreneurs should clearly examine the pros and cons of investing in intellectual property before they approach investors.

Venture capitalists seriously consider barriers to entry. Entrepreneurs should clearly articulate the barriers of entry that they wish to establish.

Exit Strategy

Startup founders should initially plan for a strategy of "cashing in" on their company allowing venture capitalists to liquidate their shares. In general, venture capitalists prefer one of two kinds of exit strategies: IPO and acquisition. Going public is the ideal exit strategy that every venture capitalist would prefer. However, not all companies have the potential to go for IPOs. The exit strategy for such companies is to be acquired by a bigger company. It is very important for entrepreneurs to articulate the exit strategy.

Written By
Pradeep Tumati (Principle, go4funding.com)

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