Venture capital: who they are and what they want from startups

The reasons that drive venture capitalists to invest in companies and startups are many and range from the possibility of monetizing opportunities with high potential returns, to supporting innovation, to diversifying investments in other industries to balance their portfolios. It is no secret that venture capital compared to other types of investment, is particularly illiquid and risky and therefore the expected return must be significant to encourage investment. 

In this context, founders in the fundraising stage, are caught between two fires. On the one hand, the nature and product of the startup must match the VC’s investment thesis (since if not in line, the likelihood of investment is greatly reduced), and on the other hand, the startup itself requires an investor who has experience in its target industry, especially in those situations where the product/service involves complex sectors such as the deeptech.

While it is true that a startup’s fundraise, path is frequently through venture capital, it is necessary for founders to first try to understand how a VC works.

In a general way, the average duration of a VC fund is 10 years; this time frame can be divided into 3 different phases:

• initial investment (duration 2-3 years) – during this period the fund actively seeks and makes investments in new startups.
• portfolio development (3-5 years) – in this later phase the VC focuses on follow-ons and on finding new opportunities for follow-on investments.
• exit (2-3 years) – at this final stage, the fund seeks to exit its investments as it considers the investment cycle to be over.

Venture capital firms may have several funds at once (thematic funds), so it is not unusual for them to raise new capital every 3-5 years to launch new ventures. Intuitively this might lead one to think that a VC is therefore inclined to invest in a large number of startups. However, on average, a venture capital model does not work by ensuring a small return over time on a high number of investments, but exactly the opposite VCs favor a few investments in search of the outlier that brings huge returns (the famous “100x”).

This process is governed by the “power law,” meaning that a very small percentage of startups carries most of the fund’s returns. An example is Sequoia’s investment in Whatsapp, which was acquired in 2014 for $22 billion by Facebook, where the venture had invested in $60 million in Series A, eventually achieving a return of $3 billion.

This is why the startup ecosystem is obsessed with unicorns (companies valued at least $1 billion): VCs need them to stay alive. Any company that VCs invest in must have the potential to become a unicorn, otherwise it is meaningless in terms of “value for money.”

Given this premise then, how can a startup in the fundraising stage succeed with a VC?

As much as predicting the future of a startup (especially in early stage) is a very difficult task, there are some points that VCs look at very carefully when evaluating a new investment opportunity: people (team), product/service, and market. 

The importance of a good business plan lies entirely in the startup’s ability to be able to clearly define and communicate and persuade that the team is working on an innovative product, within a market with great potential.

TEAM

The team is the backbone of any startup (“execution is what matters the most”). The ability to “pivot” when needed and at the right time in search of market-fit, the ability to innovate the product/service by implementing new features and identify new market segments is only the result of the commitment of the people who make up the company.

Knowing how to navigate adverse and unforeseen events with agility is a basic requirement for those who do (and want to do) startups. The most capable founders lay the foundations of their company culture and governance from day zero, knowing that the goal is to build and lead a team that can sustain the company, make the right decisions, and act quickly in difficult times.

PRODUCT/SERVICE

The product/service offered by a startup is the beating heart of the company and the main pull factor for venture capital investors. For a VC, innovativeness, scalability, and the ability to respond to a real market need are key aspects that are evaluated very carefully. In this context, traction metrics assume a key role, as they provide a concrete measurement of the growth and market adoption of the product/service. Metrics such as monthly/annual user growth rate (MRR/ARR), lifetime value (LTV) of customers versus customer acquisition cost (CAC), daily active user (DAU), and conversion rate are vital indicators that VCs use to assess a startup’s potential for success. Strong traction, demonstrated through solid and growing data, can significantly increase the chances of obtaining investment, as it demonstrates the validity of the product/service and the startup’s ability to generate value and interest.

MARKET

The size and attractiveness of the target market are two other crucial elements that venture capitalists consider when evaluating a potential investment. A large and growing market provides the preconditions for significant scalability, which is essential to a startup’s success and the return on investment expected by VCs. In addition, an attractive market is often characterized by strong unmet demand or disintermediation opportunities, where a new entry can revolutionize existing offerings with innovative solutions. VCs look for startups that not only address broad markets, but also have the potential to become market leaders or create new market segments. Therefore, a thorough understanding of the target market, including market size, competitive dynamics, barriers to entry, and emerging trends, is imperative for founders seeking to attract venture capital investment.

The venture capital investment process is a complex and selective mechanism that prioritizes quality over breadth, strategic vision over mere market opportunity. To stand out in this highly competitive environment, startup founders must not only align themselves with VCs’ expectations of performance and innovation but also demonstrate a deep understanding of their product/service and target market. It is a team game where the synergy between the team’s executive capability, the uniqueness and scalability of the product, and the size of the market define startups potential and ultimately their success in the fundraise phase.