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
Venture capitalists assess the risk using the following factors:
- Founders/Management Team
- Competitive Advantage
- Market Potential
- Barriers to entry
- Exit Strategy
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
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
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.
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,
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
Venture capitalists seriously consider barriers to entry. Entrepreneurs should clearly
articulate the barriers of entry that they wish to establish.
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.
Pradeep Tumati (Principle, go4funding.com)