Out of the 5 million startups founded in 2020, only 10% will still be operating by 2030.
According to research, the second most common reason why startups fail is a lack of capital. In order to succeed, entrepreneurs must secure the necessary funding. Many avenues exist for founders to obtain funding, including loans, grants, or investments from friends and family; however, one of the most common strategies for raising funding is from venture capital funds (VCs). VC firms invest in early-stage startups in exchange for a percentage of equity in the company. How do venture capital investors determine if a startup is worth investing in is the question every founder needs to consider.
Although every venture capital firm has its own investment thesis, VC firms universally examine three factors when making an investment decision:
- FOUNDING TEAM
- MARKET SIZE
- PRODUCT OFFERING
Nailing the pitch is crucial to piquing the interest of investors and distinguishing the startup from competitors in the crowded field. If student entrepreneurs at BYU focus on these key points when creating their founder pitch decks and presenting to VC firms, they will be more likely to obtain the funding necessary for their startup’s success.
TEAM
The founding team is the most critical factor in an investment decision; when a business fails, 60% of venture capitalists believe that the founding team is to blame.[1] No matter how good the idea is, if the VC firm does not believe that this is the best team to fulfill the idea, they will not invest. Any entrepreneur seeking an investment must understand why and how VC firms will evaluate the founding team.
First, venture capitalists look at experience and qualifications. A pitch should explain any relevant experience and qualifications. Try to answer the question, “Why is this team the one to make this idea a success?” The greatest asset a founder can have in this regard is previous success in founding a business. Knowing the founders are capable of growing a business to be profitable will give a venture capitalist some peace of mind in trusting the team with their money.
In addition to evaluating the founders’ experience and qualifications, VC firms will assess the team’s personality—especially the founder or CEO. Statistically speaking, certain personality traits either negatively or positively correlate with successful entrepreneurs. Specifically, hasty decision-makers have been negatively correlated with successful startup founders. Studies show that successful founders tend to be calculated and deliberate in their decision-making, while people-focused founders tend to fail. Successful founders need to be willing to make tough decisions and have a pragmatic tolerance for risk. Lastly, good self-awareness has proved to be a critical attribute in a founding team. Founding teams need to be aware of each other’s strengths and weaknesses in order to capitalize on them. Above all, VCs want to know that the founders are passionate enough about their idea to persevere through both the highs and lows of starting a business.[2]
MARKET
When evaluating a potential investment opportunity, venture capitalists want to see that the potential market is large enough to return good profits. For VCs, a “large market” generally means a market that can return $1 billion or more in revenue for the company. Larger markets are more stable and have greater room for growth.
In the pitch deck, founders need to demonstrate to the VC firm how big the potential market is. Venture capitalists generally look for three statistics: the TAM, SAM, and SOM. TAM stands for total available market, or the total market demand for a product or service. SAM stands for serviceable available market, meaning the segment of the total market targeted by the product or service. SOM stands for serviceable obtainable market, or the portion of the target market the company can realistically capture.[3] These numbers help VCs estimate how big the company can become and what the projected revenues will be.
Other than the size of the market, venture capitalists look at the competition within the market. VCs evaluate what other current solutions to the proposed problem exist, how big the competing companies are, and how the startup’s product or service differs. Often, intense competition within a market can make it hard to gain market share. Startups offering a product or service that serves a “blue ocean,” or a niche market, are more likely to succeed.[4] The table below outlines some of the differentiating points between a traditional “Red Ocean” strategy and an effective “Blue Ocean” strategy.
Red Ocean vs Blue Ocean Market Strategy
PRODUCT OFFERING
Lastly, VC firms will evaluate the startup’s product offering. VCs love to invest in products that solve a real, pressing, unaddressed issue. They need to believe the product will be able to attract customers. The job of the founder is to show them that the product or service has a long-lasting competitive advantage, is defensible, and solves a real problem.
A competitive advantage consists of circumstances that enable a company to solve an issue for its customers in a better or cheaper way than its competitors. A product or service with a competitive advantage yields a higher market share and higher margins. An abundance of different factors or circumstances can result in a competitive advantage. Common factors include distribution network, intellectual property, cost structure, and branding.[5] The greater the competitive advantage, the greater the startup’s defensibility.
The product must also have a meaningful point of difference, meaning that it is cheaper or higher quality compared to a rival’s product.[6] Any VC firm evaluating a startup will ask themselves, “What is keeping someone else from doing this exact same thing?” Good pitches will address this important question thoroughly.
In conclusion, the most important tool any startup or founder needs to secure the funding for their product’s success is a good pitch. Understand how VCs evaluate potential investments. Be aware of what can make or break a pitch. Focusing on the strength of the founding team, the market size, and the product’s offering will answer a venture capitalist’s questions and help secure success.
[1] “How do venture capitalists assess teams?” Koor and Associates, accessed February 22, 2021, https://koorandassociates.org/selling-a-company-or-raising-capital/how-do-venture-capitalists-assess-teams/.
[2] “Investment Checklist: 5 Things VCs Evaluate Before Funding Early-stage Startups,” Tech Startup Founders, RocketSpace, last modified June 5, 2018, https://www.rocketspace.com/tech-startups/investment-checklist-5-things-vcs-evaluate-before-funding-early-stage-startups.
[3] “TAM SAM SOM – what it means and why it matters,” The Business Plan, accessed February 22, 2021, https://www.thebusinessplanshop.com/blog/en/entry/tam_sam_som.
[4] W Chad Kim and Renee Mauborgne, “Blue Ocean Strategy: How to Create Uncontested Market Space and Make the Competition Irrelevant,” South Asian Journal of Management 15, no. 2 (2008): 121-124, http://search.ebscohost.com.erl.lib.byu.edu/login.aspx?direct=true&db=buh&AN=35962737&site=ehost-live&scope=site.
[5] Clayton M. Christensen, Michael E. Raynor, and Rory McDonald, “What Is Disruptive Innovation?” Harvard Business Review (2015): pp.44–53, https://hbr.org/2015/12/what-is-disruptive-innovation.
[6] Ben McClure, “How venture capitalists make investment choices,” Markets, Investopedia, last modified April 9, 2020, https://www.investopedia.com/articles/financial-theory/11/how-venture-capitalists-make-investment-choices.asp.