By Justin Biel, trends editor at Grow Wire
This article is part of a Grow Wire Guide on how to get VC funding. See links to published articles below, and stay tuned for more.
Part 1: What to Know Before You Go
Part 2: How to Tell if You’re Ready
Part 3: Pitch Deck & Presentation
Part 4: Finding the Right VC
Part 5: Anatomy of a Term Sheet
Part 6 (upcoming): Closing the Deal
Venture Capital Terminology Cheat Sheet
Venture capital is a useful and powerful financing method, but it's not well-suited for every business. VC is geared toward companies that are designed to grow quickly and have high startup costs. For the best chance of scoring venture capital funding, you need a disruptive idea--ideally in an industry where VCs tend to invest heavily--and an impressive management team.
This article will help you define if your company has the right elements to be considered for VC funding. By evaluating your business as well as the industry in which you operate, you can determine if VC is the best financing option for you.
What kind of companies score venture capital funding?
High-growth, industry-disrupting companies
Venture capital financing focuses on companies that have the potential to grow quickly and disrupt a particular market through product innovation, with an end goal of a successful IPO or acquisition.
“Disruptive innovation” is a major buzzword. It’s “the process by which a smaller company with limited resources is able to launch a product or service that displaces established competitors,” Columbia Business School researchers Dana Kanze and Sheena S. Iyengar wrote in the Harvard Business Review.
Examples of industry-disrupting companies include Airbnb in the hotel industry and Uber in the transportation industry.
Fun fact: Using the word “disrupt” in connection with a business idea seems to influence investors. Kanze and Iyengar conducted an informal study which found that startups looking to “disrupt” received 1.7 times more funding, on average, than startups that were looking to “build.”
See CNBC’s list of the top 50 disruptors for 2018 for more examples of the sort of high-growth, industry-shifting business models that entice VCs.
Companies with high startup costs
VC is well-suited for early-stage companies with substantial startup costs that need funds to grow operations and scale the business. Many small businesses--mom-and-pop ones, or those running out of the proverbial garage with intentions to stay small--can often start with just a few thousand dollars. Venture capital, however, is intended for companies that need hundreds of thousands or millions of dollars to get off the ground.
For reference, the median size of seed-round deals was $1.7 million in Q3 of 2018, according to the PwC/CB Insights MoneyTree Report. See the full breakdown by deal size and stage below.
Venture capital is often the ideal financing source for companies that are capital-intensive, or have large upfront operational costs but not the collateral to secure funding from traditional sources like banks. VC fills a void in the investing market by offering funds for many capital-intensive industries such as software, telecommunications, automotive, media or consumer products.
Which industries receive the most venture capital funding?
In venture capital, not all industries are equal.
“The myth is that VC invests in good people and good ideas,” funding expert Bob Zider wrote in a 1998 article for the Harvard Business Review. “The reality is that they invest in good industries.”
Statistics on the value of U.S. VC investment in Q3 of 2018 show that Internet business is still the clear leader, followed by healthcare, then mobile and telecommunications.
The entire breakdown of VC funds invested in Q3 of 2018 by industry is depicted below.
A large portion of VC funding is directed at specific industries, but that doesn’t mean you should abandon ship if your company doesn’t belong to one of them. You can still get venture capital funding. However, it's important to know what you’re up against.
How baked does my idea or business have to be?
It’s very rare to get a VC excited on a pitch deck alone. In most cases, the VC wants to see initial progress, such as a founding team and an MVP. And the farther along, the better.
Whenever possible, come to the table with a few large customers, testimonials and a working prototype. Tangible progress will go a long way in establishing trust and interest from the VC community.
You should also evaluate your business idea, model and team with questions that include:
- Is your product different from any other on the market?
- Does it serve a unique need within a large, untapped customer segment?
- Can your business model scale, growing larger to support an increase in load, be it customers, transactions or revenue?
- Is your management team uniquely positioned to understand the customer pinch point and capable of spurring company growth?
If you answered “yes” to each of the questions above, then it’s likely your company will be attractive to VCs.
Mike Whitmire’s company FloQast, for example, fit the bill described above when it secured VC funding.
FloQast sells software that helps accountants and auditors close their books faster. VCs saw it as a unique and scalable product within a potentially large market. Plus, Whitmire had previous experience as an auditor with Cornerstone OnDemand, a company he joined pre-IPO, which offered benefits like product insights and hands-on training running large teams. Whitmire was also familiar with scaling a business and had experienced the process of taking a company public. To the VCs that eventually funded FloQast, Whitmire and his company inspired enough excitement and confidence to close the deal.
How important are my company's founders?
Very. VCs look closely at company management in regards to their skill set, past experiences and even where they went to school.
The management team
In the research study “How Do Venture Capitalists Make Decisions?", researchers from universities including Harvard and Stanford surveyed over 680 venture capital firms to better understand their decision-making processes.
They found that a company’s management was the number-one factor VCs considered when deciding whether to invest.
“The management team was mentioned most frequently both as an important factor (by 95% of the VC firms) and as the most important factor (by 47% of the VCs),” the study states.
Some elements of the management team seem to be more important than others: The study found that VCs judge a management team first on ability, followed closely by industry experience. Secondary factors include passion, entrepreneurial experience and teamwork.
The question of pedigree
Pedigree relates to the past experiences of the company founder, including where they went to school, previous work experience and connections.
Pedigree matters, according to Reuters. The news agency’s 2013 analysis of startups with early-stage VC funding found that nearly 80 percent of them had founders who “had held a senior position at a big technology firm, worked at a well-connected smaller one, started a successful company already or attended one of just three universities--Stanford, Harvard and Massachusetts Institute of Technology.”
Lacking an Ivy League degree won’t ban you from receiving VC, but it likely won’t hurt. Regardless of your background, the most critical factor is a solid management team with strong abilities and industry experience.
Finding personalities that fit
Ann Winblad is a software VC and co-founder of her own early-stage venture capital firm. She agrees that company founders impact investment decisions. Beyond a founder’s professional background, Winblad also assesses how founders will work together over time.
“Relationships are a huge component of venture capital investments], especially in the early stage where a company expects to stay onboard anywhere from 6-10 years,” Winblad said on a recent episode of the “Grow Wire Podcast.” “People have to fit.”
One of her firm’s recent successful investments, Mulesoft, took 10 years to go public, which is nearly two years longer than the median time to exit of 8.2 years. Winblad’s firm coached Mulesoft’s leadership team through the entire process.
The long-term nature of VC deals makes relationships important to Winblad and her partners, as they take board seats on portfolio companies and offer ongoing strategic guidance to every partner.
“We have to feel that there will be mutual respect [with a founding team],” said Winblad. “We have to really like, respect and trust them.”
To Winblad, a founder's pedigree is less critical than having a great product, excellent communication skills and trustworthiness.
🌱 The bottom line
Let's review: To receive venture capital funding ...
- Develop a disruptive idea, in a
- hot industry, with
- the best possible team.
Getting funded is more art than science, and not everyone who wants venture capital financing gets it. So give yourself an advantage against the competition. Develop scalable, disruptive businesses that can grow quickly, choose industries that VCs are keen to invest in, and build management teams that inspire investor confidence in the company’s ability to succeed.