Is Your Startup a Good Fit for Venture Capital? | by DC Palter | Dec, 2022

Photo by Austin Distel on Unsplash

I spent last week reviewing 200 early-stage startup business plans. My brain hurts.

The businesses were for all sorts of products and services. But the plans were painfully similar: give us money, we’ll develop the product, then get more money to expand the business. No different from all the other plans and pitches I see every day.

The vast majority of those 200 plans seemed to have the potential to become viable businesses. But perhaps 10% of them seemed suitable for venture investment. The other 90% need to consider alternatives to venture capital to fund their startup.

With the wild success of venture capital-backed startups over the past decade and the explosive growth in venture funds, a misconception has taken root that venture investors will throw money at any good business idea. Getting funded is therefore simply a matter of finding the right investors who believe in the company and the founders.

Unfortunately, that isn’t true. The venture capital funding model requires investing in a very specific type of business. If your startup doesn’t fit the model, and most early-stage startups don’t, you can either change your business plan to fit the venture model, or you can find a source of funding that better fits the business.

Before wasting half a year pitching angels and venture funds, make sure your startup meets the following criteria to be suitable for venture funding.

The first thing I do when I look at a pitch deck is turn to the revenue projections. If it doesn’t show the startup reaching at least $100M, there’s no point in looking any further.

That’s not to say a smaller business isn’t a great opportunity, but the math doesn’t work for venture investment.

Let’s say a fund invests $1 million in a startup at a valuation of $5M that gets acquired at $20M a few years later. That’s the kind of win everyone should be jumping up and down for. But for most VCs, it doesn’t move the needle.

Imagine a fund with $100M to invest. With a target return of at least 20%, they have to grow the fund to $360M in 7 years. They only have enough bandwidth to make 20–30 investments. Since 90% of those investments will fail, that requires the 2–3 successes to return $100M — $200M each. A $15M return isn’t worth the effort.

Although angel investors and small funds work on the same principles as venture funds (and I lump them together as venture investment), their smaller scale means the math is slightly different. If the company can fund its growth through to exit on less than $2M in angel investment, the minimum is $25M in revenues, which is the point where large businesses will start considering acquiring a business.

It’s not enough for a startup to grow large. It has to grow large quickly.

Many great businesses take a long time to develop. There might be complex technology that has to be built and tested, a nationwide expansion that takes time to build out, or production processes that have to go from lab to pilot to constructing factories. These can become large, world-changing businesses, but they’re hard to fit into the venture funding model.

The standard venture fund has a fixed, 10-year life. Investments are made during first 3–4 years. From the time of investment to closure of the fund is somewhere between 6–10 years. Add in safety margin so the fund doesn’t get stuck with investments that have to be liquidated in a panic at the end, funds need their investments to exit within 5 years, 7 at the longest.

In addition, the longer the time to exit, the lower the ROI. A 2x return on an investment in a year is a great success. A 2x return in 7 years is considered a loss.

Lastly, the VCs need to show a track record of success to raise their next fund and their next. The 2nd fund is raised based on increases in valuation of the 1st fund’s portfolio. The 3rd fund is raised based on the cash return of the 1st fund. Fund managers need big, quick successes to keep their jobs by raising new funds.

No big company will acquire a startup at a huge multiple if they can build a competing product themselves at a fraction of the cost. They have huge development teams, an existing customer base, and strong sales and marketing channels. Why do they need you?

There’s only 3 answers to that critical question: patents, specialized knowledge, or brand name. This is what an acquirer is buying, not the product itself.

I’ve been pitched many startups that could become wonderful, profitable businesses. But if there isn’t a viable exit strategy, it isn’t a good investment.

An example is a construction business specializing in installing EV charging stations for apartments and shopping centers. This has the potential to be profitable, repeatable, and huge. In other words, a great business. But not a venture business.

There’s nothing proprietary about this construction business or its operations. There’s no technology to protect, no special knowledge competitors can’t figure out, no brand name as the go-to provider. Despite the enormous scale of the opportunity, there’s no reason why a large construction company would acquire the business at a huge premium instead of creating their own.

The corollary is that almost all venture businesses build products rather than services. Services can make great businesses, but are nearly impossible to protect.

For software products, it’s usually easy to find an acquirer once the company has proven its value. In life sciences, the pharma and medtech giants have essentially given up on their own research and acquire startups instead once they’ve passed regulatory approval. But this is the achilles heel of many startups, especially in specialized industries.

That’s not to say there won’t be acquirers for any profitable business that reaches at least $25M in revenues. But the venture model requires an exit at a huge premium that in many industries is unlikely.

Imagine a startup that invents a great new adhesive. They would be an obvious buyout target for 3M, BASF, Henkel, and others. But adding another adhesive to those company’s catalogs won’t transform their business. They’re unlikely to get into a bidding war with each other to buy the business. They’ll only acquire the startup at a valuation that will quickly generate a profit. In other words, the acquisition price will be a moderate multiple of EBITDA.

At $100M revenue, the company is probably generating around $10m in profits (assuming they’ve reached profitability at all). An acquisition is likely to be in the $30M — $50M range. Not bad, but not the kind of returns venture investors are targeting, especially if they put in $25M to build the factory and scale the business.

Similarly, private equity buys up profitable businesses based on a moderate multiple of profits. It can be a successful exit for the founders, but not a great end for investors who are targeting returns 10x or more than PE firm typically shell out. If a startup pitches private equity as their likely exit, that’s usually the end of the conversation.

The ultimate goal of the startup is to reach a successful exit at a high multiple. Unless the company is targeting $1B in revenues and doing an IPO, exit means acquisition by a large company.

An important question founders need to ask themselves is whether they’re building the business for acquisition or for themselves.

If the goal is to build a business that you’ll continue to run indefinitely, I salute you. We need more founders looking to build strong, long-term value. And most successful businesses are built with the needs of the customer in mind rather than the requirement of venture capital to grow big quickly and exit. But that isn’t the venture funding model.

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