Why VCs don’t invest in ‘good’ companies

No

GUEST:

Every VC says they are looking for great founders that are solving real problems in big markets. So why is it that so many “good” companies that seemingly meet these requirements still fail to raise money from VCs?

Venture capital is a hits driven business, with ~4.5 percent of dollars invested generating ~60 percent of total returns. This is why the VC model is built on the expectation that most returns will come from companies that pay 10X+ on investment, and on the expectation that many investments will lose money.

Most founders already know this. But what is less obvious to many is that companies that achieve moderate success are not much better from the VC point of view than those that go bankrupt.

This is why any signals that your startup has limits to its upside potential is a reason to say no to investing in you. With that in mind, here are the top reasons why VCs don’t want to invest in your “good“ startup.

Top 6 reasons to say no

1. Weak barriers to entry

The first mover in many industries often ends up with an arrow in their back. In cases where you are unable to build a combination of network effects, brand, proprietary technology, or economies of scale, fast followers and incumbents may be better positioned to take the market than you.

You may rationalize that this means they’ll likely buy you to get to market faster. While this sometimes is true, VCs are usually not interested in these relatively modest M&A scenarios, or in the founders who aspire to them.

2. Lack of meaningful differentiation

Crowded markets and low margins don’t usually result in outsized exits. The new modus operandi for VCs is that competition is for losers, and they look for businesses that can do something that others fundamentally can’t.

3. Unsustainable unit economics

Challenges such as identifying the right traction channels and finding product/market fit are common to all startups in their early days. But fundamental issues with price/product complexity fit may leave you in the startup graveyard as you try to scale, so get used to being asked early on what your CAC/LTV ratio is and how it can be improved over time.

4. Niche markets without explosive growth

It’s great to start off focused on a specific segment’s critical pain point. However, if you start this way and want to raise VC financing, you need to provide a credible story as to how you will expand into products targeting large ancillary market opportunities based on the same core competencies you’ve built.

5. Bad cap table

Most VCs, whether good or bad, will hit a winner among their portfolio at some point. When they do, the question is: How much of an impact will it make on their portfolio returns?

The answer depends on how much a company is worth at exit, and how much a VC owns of a company at the time of exit. This is why larger VCs are so adamant on reaching their target ownership percentages and maintaining them over time, and why cap table issues such as overly diluted founders and investors with overly aggressive pro-rata rights can hurt a startup’s chances of attracting downstream VCs.

6. Founder bait and switch

There are some founders who just have “it”. They have a passionate vision, know how to evangelize it, and have the credentials to make it a reality. These are the founders we love to back.

So it should come as no surprise that it’s a downer when we are sold the dream by one founder only to find out later they are involved in multiple startups and have assigned the day-to-day CEO role to someone else. It’s hard enough to get to a good exit in any startup, and without a fully committed and aligned founder, VCs may think twice about investing.

Do you fit the VC model?

In the VC model, moderate success is almost as big of a risk as bankruptcy. So if you are pitching VCs for funding, don’t underestimate the negative effect each of the above factors can have on your story. Tripping up on any one of them can be the dagger that ruins an otherwise stellar pitch.

Jonathan Friedman is a Partner at LionBird, an early-stage fund investing in digital health, commerce, and enterprise software. He blogs at Venture Capital Point of View.

Via:: VentureBeat