What Type of Company Do Venture Capitalists Fund?
Occasionally at ArabCrunch English we publish guest posts by experts and Industry leaders, who would share their experience with our reader, today’s guest post is by Laila Kassis who has many years of experience with venture capitalists in the states. (if you want to be a guest writer use the contact page.)
Laila is currently pursuing an MBA at the Harvard Business School and an MPA in International Development at the Harvard Kennedy School. This summer, Laila is interning with the Jordan office of Endeavor, a global non-profit supporting entrepreneurs in developing countries. Laila has five years of venture investing experience at Key Venture Partners and Spectrum Equity Investors, and two years of investment banking experience at Bear Stearns. She specializes in technology, media and communications investments.
Venture capital (also known as VC or Venture) to those who do not know is a type of equity capital (cash provided in exchange for an ownership stake) typically provided to early-stage, high-potential, growth companies in the interest of generating a return through an eventual realization event such as a sale or IPO of the company. Here is Laila’s post:
I spent 5 years in the venture capital industry in Boston, and entrepreneurs commonly asked me this question. Generally, entrepreneurs find securing venture funding to be a daunting task, with the keys to its success ever-elusive. Ironically, as a venture professional, I had the opposite problem: How do I find the best companies and convince them that they should bring us on as partners, as opposed to selecting another firm or taking no funding at all? I spent five years doing this, and it is a grueling task.
However, the file of companies I turned down grew to about two-hundred by the time I left the venture business to pursue my MBA. Thus, I do have deep experience regarding what causes one company to go to the reject pile and another company to become heavily sought after by venture funds. My experience is solely with U.S. East Coast venture capital so I will write from this perspective. However, given that I’m spending my summer meeting with venture funds in the Arab World, I will touch upon how venture in this part of the world may differ slightly.
Since seven is a lucky number, here are the top seven things venture capitalists look for in a company they might seek to fund. Good luck to all of the readers out there who are entrepreneurs seeking capital themselves!
Attractive Risk-Reward Profile
Simply stated, investors analyze various types of risk involved in an investment and compare this to the likely potential return of the investment. The higher the potential return compared to the risk, the better the investment opportunity.
- Types of Risk:
A high degree of market risk means there is a question about whether there are even buyers for the company’s offering. This is bad for all but the most aggressive early stage investors. Technology and product development risk means there is a question as to whether the technology works properly and how much it will cost to continue to develop the technology, both early stage risks that early stage VC funds are more comfortable with.
Sales execution risk and management risk are growth stage phenomena. Does the sales model work? Can we sell in a cost effective way? Can we find the right C-level executive for a key position? It’s not an exact science but venture capitalists are experts at assessing the degree of each of the risks mentioned and determining if the investment fits their strategy.
Most of the things VCs “look for” are in essence things that mitigate the risks mentioned above. Entrepreneurs should understand the way a VC thinks and be prepared to address concerns about these different types of risks.
For venture funds, return comes from an exit. An exit most commonly comes from sale of the company to a larger strategic acquirer (for example, Google buys Picasa), and less commonly from an initial public offering (IPO) or sale of the VC’s stake to another investor. Investors must believe there is a universe of potential acquirers for the company or else they will not invest.
Venture funds want innovative ideas, but innovation comes in many different forms. If you have developed the next big thing, the newest gadget with proprietary technology to hit the market, this can give you an edge. However, it’s not enough on its own, and it may not even be necessary. Innovation means doing something in a new way. That can mean rich proprietary intellectual property, or it can mean doing something old in a different, better way.
For example, my last fund invested in a provider of sales compensation management solutions. While the industry had been around for ten years, this company was the first in the industry with a software-as-a-service (SaaS) architecture. Its web-enabled solution allowed for more efficient low-cost service delivery, robust features and functionality, and a stable recurring revenue business model. That’s innovative.
We also invested in a traditional bricks and mortar outdoor advertising business; something that has been around for fifty years. However, this start-up had a unique acquisition strategy that allowed it to capture market share in an industry with high barriers to entry. Thus, innovation came in the form of business model and deal structuring, not necessarily in the end product to the customer.
Venture capitalists want large addressable markets with demonstrated customer demand and some barriers to entry:
- Target Market Size:
Entrepreneurs should know how to define their target addressable market and calculate its size. Target addressable market refers to the universe of potential buyers of a company’s current product line, and the size of this market is the total annual revenue currently being generated by all companies providing similar products and services.
The SaaS company mentioned above is part of the huge human resources technology market, but its target addressable market, compensation management solutions, is much smaller.
The market should be large enough that the company has room to grow substantially while making room for a few key competitors. A $10m company in a $100m market does not have much room to grow. The broader market (the huge human resource technology market in the example above) is only relevant if the company plans to develop new product lines to address this market. However, this means a different kind of risk – early stage technology risk.
- Customer Demand:
Entrepreneurs should be able to clearly articulate the customer pain point that their product or service addresses. Ideally they should also be able to measure the value to the customer.
For example, “Large corporations spend 10% of their operating expense on payroll services and HR consultants that are slow and cumbersome” (pain point). “By spending $50,000 per year on our human resource software, customer Y saved $350,000 in annual consulting expenses. That’s a 7x return on their investment in our product!” (measurable value).
- Barriers to Market Entry:
This doesn’t mean that competitors are non-existent or that market entry by a new company is nearly impossible. It simply means that there is some difficulty and time-element required for a new entrant.
For example, a large number of man-hours required to develop a competing product creates a barrier as do strong existing relationships with partners and customers. An entrepreneur must be able to clearly articulate barriers to market entry and how his/her company has an edge.
Attractive Business Model – or at least one that makes sense
Business model refers to how a company earns revenue. Is it via one-time product sales, a monthly subscription, transaction revenue, a combination? Entrepreneurs must very clearly and concisely delineate the sales model and the target customer.
A fundamental equation is the relationship between how much a company spends to acquire and provide ongoing services to an average customer and how much revenue a company generates from the average customer. VCs will ask many questions to better understand this equation: What is average revenue per customer? Who long is your sales cycle? How do you manage your pipeline? How much do you spend on sales, marketing and customer service?
VCs want to meet with entrepreneurs who have realistic expectations about their company’s growth potential and valuation – plain and simple. Financial projections should not be so high that they are not believable.
A Company simply will not grow from $0.5m of revenue to $10m in one year; even $5m is a stretch. On the flip side, projections should not be too conservative – growth from $0.5m to $0.75m is too low and completely unattractive. Likewise, a company with $0.5m of revenue will not be valued at $30-50m, no matter how innovative or how much growth potential; $5m is more like it.
Entrepreneurs should be careful of reputation risk here. The venture community is small everywhere in the world and word travels quickly. The last thing an entrepreneur should do is go to market with unrealistic projections and valuation expectations, fail at raising capital, then come to market a second time with more tempered expectations.
Strong Management Team
VCs prefer seasoned entrepreneurs with prior operating experience. Often, they prefer to fund people they know, or people their friends know. After all, there is less risk investing in that which one knows. They also look for sophisticated entrepreneurs.
It’s easier for a venture capitalist to work with someone who understands investment terms, knows his strengths and weaknesses, understands when he is not the right person for a particular job, and knows how to hire the right people to accomplish particular goals. While VCs like to see a strong management team, sometimes it’s ok if the team contains holes, particularly in early stage companies. VCs can often leverage their network to help the company hire the right people.
Fit with the Fund’s Investment Strategy
Finally, investors look for opportunities that fit their fund’s investment strategy. VCs aren’t managing single companies; they are managing a portfolio of investments and are bound by a mandate from their limited partners to follow a particular strategy. They must balance risk in a way that fits this strategy.
Thus, it’s possible for one VC to reject an investment opportunity that another VC fund finds attractive; and both VC funds have made a smart investing decision. Before meeting with a fund, an entrepreneur should understand its investing strategy and how her company fits into this strategy.
The Arab world:
The items above largely hold true for the Arab World. The key difference is that venture capital is a nascent concept in this region. This changes things in several ways:
1. Investors are generally more conservative, meaning they are less willing to take risk.
2. Many venture “funds” do not actually have committed capital. Once they find an investment opportunity they reach out to their investor network to see if anyone is willing to invest. This can create a lengthier process for the entrepreneur without assurance that the capital for investment exists. It can also mean the venture firm’s strategy is less focused.
3. Many investment funds are comprised of a pool of family money. This often means the investment strategy is less focused and that funds can move more slowly in making an investment decision. It also means that since there is a single investor (one family), the investment strategy can change or investments can be halted at any time.
4. There are some Shari’a compliant investment funds. The process with these funds can be more cumbersome and time-consuming. In addition to ensuring an attractive investment opportunity, they must also ensure the company itself is Shari’a compliant as is the structuring of the investment.
#Photo by Peter Renshaw.