What Makes a Startup Attractive to VCs?

Have you ever wondered what are the requirements that Venture Capitalists (VCs) assess startups based off of to make the invest / no invest decision?

Distinguishing between VC-fundable startups and lifestyle businesses, I wrote a short article on the distinction between VC fundable and Lifestyle Startups, it's evident that VCs primarily look for two crucial aspects before considering an investment: a clear exit plan and a venture that addresses a sizable market.

• Exit Plan: A clear exit plan is imperative. Why? VC capital is sourced from other wealthy individuals or entities (Limited Partners or LPs). Since LPs pay annual management fees of between 1 - 3% of the total committed capital to VC General Partners (GP) to manage, invest and ultimately oversee the exit and profit distribution of their investments, the LPs want the investment to exit with the highest profit and as quickly as possible (ideally yesterday!). Moreover, General Partners (GP) will also receive 20% of the profit after the exits. For these reasons, GPs won't consider investing in startups without an exit strategy, IPO or acquisition. Side note: the LP and GP desire for exit is also the source of the dreadful rumored stories of entrepreneurs faced with pressure from investors to exit, despite the founders intention to keep growing and building.
• Large Addressable Market: The Venture Capital fundamental philosophy is high risk, high reward. Investors invest substantial amount of money at incredibly high risk ventures, in the hope of super handsome returns at least at some. Such returns are only materialized if the startups find product market fit and figure out a profitable business model in a large existing (not potential) market. At the minimum the total addressable market should be in the order of 1 Billion USD and in reality the expected market size is in the order of several, if not tens of Billions of USD, if not larger.

Qualifiers Per Raise Stage

Moving on to the specifics, at each stage of startup fundraising VCs look for specific qualifiers to make an invest / no invest decision.

Here I categorize the important characteristics of the VC fundable startups at each stage. While almost all factors remain more or less relevant throughout all phases of fundraising, some become critical and pivotal at specific stages.

1) Pre-Seed Stage: In this very early stage VCs are primarily betting on potential rather than proven outcomes.

• Strong Team: The quality, passion, and expertise of founders are paramount. VCs seek teams with complementary skills, chemistry and a track record of executing visionary ideas.
• Unique Value Proposition: The startup should have a clear and differentiated idea addressing a genuine market need, ideally a solution to a niche problem for an underserved segment of market, a solution that is scalable to other neighboring market segments problems, even if it's still in the ideation phase.
• Large Addressable Market: While detailed metrics might not be available, there should be a clear indication of a sizable potential market. It is more important for VCs to learn if the founders understand their market and how they have estimated the market, not as much if the market estimate is precise.
• Strong Vision and Mission: A compelling vision, and an ability to evangelize what the startup aims to achieve can attract exceptional talent, customers and ultimately investors, specially before the startup has any results to show.

2) Seed and Series A Stages: As we transition to the Seed and Series A stages, these stages require more tangible evidence of a startup's potential.

• Traction: Demonstrable signs of progress, such as proof of principle, product market fit and growing user engagement, successful pilot projects, or early revenue, are essential to showcase market validation.
• Scalability: The startup's business model should indicate potential for rapid growth without a proportional increase in costs.
• Defensible Moat: Intellectual property, unique tech or early partnerships with key customers that provide a competitive edge over competition.
• Clear Business Model: While profitability might not be immediate, there should be a discernible path to it.
• Positive Unit Economics: By this stage, the cost dynamics of serving customers versus the revenue they bring should be favorable or show a clear path to becoming so.

3) Series B and Beyond: At more advanced stages of growth and expansion, VCs look for signs of growth, market leadership, and sustainable competitive advantages.

• Continued Traction: Steady growth in key metrics such as revenue, user base, and market share becomes paramount.
• Transparent Financials: Detailed, organized, and clean financial records are crucial for due diligence at these stages.
• Fit with VC's Portfolio: As the amounts invested increase, alignment with a VC's existing portfolio or domain expertise becomes more critical. In contrast, some VCs have a more domain flexibility at pre-seed and seed stage.

While emphasis on particular criteria may shift based on multiple variables, founders aspiring to raise funds must be strategic, considering all the aforementioned qualifiers.

For example defensible moat is critically important at growth stage, however, even at pre-seed stage, the founders need to have some idea of how to create such defensible moats. Otherwise, why would VCs invest on a business that is easy to copy?

Some qualifiers could be less critical at earlier stages, for example highly structured and regulated financial management might not be as critically important during pre-seed or seed stage, where as it is an impeachable offence to not have the correct infrastructure in place when a startup is gearing towards growth and expansion stage.

Ultimately, startups seeking VC funding must continuously evolve, and adapt. They should demonstrate progress, and choose their investors wisely and align with the investment objectives of their potential investors.

Do you agree or disagree? What did I miss? Please share in the comments.