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Thesis: As a startup, the venture capital process looks daunting, and it is. Yet, there are key ways to prepare your company and yourself to have the best chance of success. It all comes from knowing how the venture capital firm operates and how they will go about assessing your company.

If you haven’t read my Introduction to Venture Capital Post, I’d highly recommend it before reading this article as some of the terminology can be difficult to understand.

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When interviewing for a new job, how do you prepare for the interview if you don’t know anything about the company or the job?

The same scenario is true with startup companies. Many startup companies apply constantly for Venture Capital funding, yet many don’t know what these VC funds are looking for and how these funds operate.

The Venture Capital Investment Process

Venture Capital firms want to make money. So, naturally, they will invest in companies that they think have the most likelihood of making them money.

So, how do these firms evaluate and measure which companies have the highest likelihood of making them money?

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Step 1: Sourcing

The first step Venture Capital firms take when going about evaluating potential companies is actually finding the companies themselves.

There are widely 2 methodologies that they use to find companies, organic and inorganic.

Inorganic sourcing is when venture capital analysts research and find the company themselves. This is the most common model and is far better for the venture capital firm as you know the company already generally fits your criteria and you’re able to find the “best of the best” in your field. The hard part then becomes getting the startup company to want you.

Organic sourcing is when startup companies come to you, seeking funding. There are advantages and disadvantages to this method. First, many startup companies coming to a venture capital firm won’t fit the investment criteria the firm has (see Step 2). Second, these companies generally send out many of these cold messages to try to get seen by as many venture capital firms as possible, so that may decrease the quality of company.

Advantages of this model are that the company already wants your firm and your funding, and you don’t have to spend as much time or effort convincing them of that since they reached out in the first place. It also allows venture capital firms to look at some companies that they might have missed in their inorganic sourcing process.

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Step 2: Initial Assessment

Every Venture Capital firm has a general criterion (a list of rules or specifications they choose to invest by). For instance, Versatile VC’s investment criteria, as posted on their website, is the following:

• Businesses that target niches
• Businesses that operate in “boring” spaces
• Companies that are at the intersection of more than one domain
• 40%+ gross margins
• Can easily be profitable (if they aren’t already)
• Founders that come from non-traditional backgrounds
• Company headquarters based outside of major US tech hubs (i.e., NYC, Boston, California)
• Etc.

Companies use these initial criteria as a mass screen, easily eliminating companies that don’t fit most of their criteria.

For instance, a software-focused Venture Capital firm wouldn’t invest in a clothing company, so they can eliminate any clothing companies from their search immediately.

These initial assessments take the market of millions of companies down to thousands if not tens or hundreds.

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Step 3: Due Diligence

If the company passes the initial criteria scan and the Venture Capital firm decides they want to pursue the opportunity, there are a bunch of different ways they will go about the due diligence process.

Industry Research

Generally, venture capitalists will have contacts with companies in their target industry (whether that be companies in their portfolio or elsewhere). When approaching a new company or space, the first step venture capitalists will take will be to get as knowledgeable about that industry or space as they can.

This includes talking with competitors, reading about the market, reading about company news, researching the management team’s backgrounds, etc.

This process generally takes anywhere from days to months and can weed out many companies. Once you start to look under the hood of a company, you can find things that weren’t completely visible at a quick glance.

Management Call

Once the company has passed all initial screens and research, the venture capital team usually puts together a list of questions to ask the management team to further investigate the opportunity.

On this call, the management team is also able to get some more background on the venture capital firm to understand if they potentially want to do business.

If all goes well, the Venture Capital firm will generally sign an NDA (non-disclosure agreement) that enables the startup company to give them internal, non-public data to look at the company further.

Financial Analysis

After the Venture Capital firm receives information from the company, more internal assessment of the investment opportunity comes into play.

This generally includes building a financial model (as private companies don’t have public financial information and you don’t receive the accounting statements until this point). This financial model allows the venture capital company to forecast into the future (project how they think the company will do). Granted, these projections aren’t always right, but they do cast more data on the issue at play.

Consider the following examples:

• You need the company to become profitable before you make money, so you figure out what factors in the business need to change to make this happen. Is this scenario reasonable?
• You expect the company to triple in market share over the next 10 years. How will that impact revenues and profit?
• The company recently acquired another company. How will that affect the way they grow in the future?

The key behind building a financial model as a Venture Capital firm is understanding how your qualitative assumptions will affect the quantitative data.

In addition, the financial model also helps answer the question of how much the company is worth. Even if you think the company is great, if the current valuation is too high for your liking, you might not invest. Remember, at the end of the day, if the Venture Capital firm chooses to invest, they are choosing to buy a number of shares of equity (tiny percentages of ownership) at a price.

If you do some simple math, the total number of shares that exist in the company multiplied by the price equals the total value of the company.

So, there are some competing motivations here. Venture Capital firms, like any other investor, want to buy low and sell high. So, they want the shares to be a low price (sometimes even lower than what the company is actually worth) when they buy, and then when they sell, they want the shares to be a high price (especially higher price than what the company is actually worth).

Conversely, the company wants their shares to be at a high price pretty much all the time. It allows the owners to sell shares and get the most money for their shares. In addition, it makes your company look better when it is worth more. Furthermore, when a Venture Capital firm has a fixed budget to buy shares, they will have to purchase less of your company for the same price, leaving more for the owners.

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Step 4: Term Sheet

If after signing the NDA and receiving the data and doing further research, and the Venture Capital firm still likes your company, they will usually send over a term sheet. This essentially tells the company that the Venture Capital company is seriously interested in their company. It also outlines what the VC estimates the company is worth and how much investment they plan to make.

This does not mean the deal is done, however, as companies usually don’t like the first term sheet sent over as it is usually heavily in the VC’s favor. So, it becomes a negotiation.

Step 5: Further Diligence

While finalizing deal terms, the VC is generally still doing more research on the company. The essential question they are trying to answer in this step of the process is around what would prevent them from investing in this company.

Are there any red flags they have missed? Is there anything within the industry that makes this company a truly bad investment? Are there any newcomers coming to disrupt this company? Etc.

This further research is done in hundreds of different ways, so trying to explain them all would be extremely complicated and time consuming (if you’re truly interested send me a message and we can chat).

Step 6: Invest

Congrats! If your company has made it through this process to this step, you’ve made it. The Venture Capital firm was deemed “the best” of their options, meaning the firm will invest and your journey together begins.

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What Can Startups Do to Prepare?

As you can see, there are many steps in the process in which your company could be rejected. Many startups see this and choose to take the mindset of “Let’s build our company so they have to accept us every time.”

This isn’t bad, and is definitely better than nothing, but a better mindset would be “let’s figure out all of the ways that we can build a better company, so they don’t have an excuse to reject us.” If you approach your company in the first way, you’re constantly striving to be the best of the best, which is practically impossible. However, in the second scenario, you simply need to be better than the next alternative.

If the choice is between your company and another one, and one must go, you simply need to be better than them. It doesn’t totally matter if you’re “the best” at that point (although it wouldn’t hurt), it just matters if you are 1% better. By making yourself 1% better than the competition, you still made yourself the best of the best in the process without having the strain of perfection.

So, how do you go about decreasing the probability your startup will be rejected?

Tip #1: Focus on Your Business

This might seem counterintuitive, but Venture Capital firms really like startups that only focus on themselves and growing their brand. If you’re constantly focused on seeking Venture Capital funding and attending startup conferences, you’re doing it wrong.

Venture Capitalists want to invest in a management team that is passionate and focused on their product. They want to see you attending conferences associated with your business.

It’s almost like dating where you’re playing hard to get, except in this case, it just means you’re working on yourself to make yourself a better candidate when you do eventually get on the market.

Tip #2: If you’re doing good, VCs will find you!

This is very similar to tip #1.

Many people seek venture capital funding for the wrong reasons. In general, if your startup is doing amazing things, Venture Capital firms will seek you out. This is an infinitely more satisfying source of flattery, having someone come to you because of what you’re doing, not you coming to them, begging for help.

If you’re looking for venture capital funding because you absolutely need the money, you’re probably doing it wrong.

Tip #3: Understand your business.

Understand what your business is, and more importantly, what it isn’t. Where does your business start and stop?

You would be surprised by how many entrepreneurs and even large businesses don’t truly understand what they do.

For example, recently a private equity firm bought a multi-billion-dollar business. On the first day, they surveyed everyone in the company to understand what that company actually did. Everyone’s answer was different.

If you truly understand your business, you’ll be more equipped to run it and to talk about it to internal and external parties.

Tip #4: Achieve Product Market Fit.

Attracting VC money is exponentially easier when you have a product or service that works and people want it. It’s as simple as that.

Very few venture capital firms are going to invest time, money, and effort into a company that doesn’t already have a working product and some customers.

Tip #5: Be at least 10% better than your competition.

This tip is beneficial in many ways. Firstly, being 10% better than your competition enables you to attract customers more easily than being worse or only slightly better than your competitors.

Second, one of the first things a Venture Capital firm will do when researching your company or market will be understanding your competitors. If you’re not at least 10% better than all your competitors, why wouldn’t they just invest in them?

Tip #6: Network with Venture Capitalists.

In tip #1 I specifically stated not to attend startup conferences and always seek venture capital funding. This is true. This tip is not about that, but it also is in a 4D chess sort of way.

As Venture Capitalists spend everyday looking and understanding companies in your industry, they can provide good insights from an educated outsider point of view. Interesting questions to pose could be along the lines of the following:

What are areas/subsegments of my industry that you think it would be beneficial to investigate expanding into? How do other companies within this industry approach XYZ problem?

This is beneficial in 2 ways. First, you get powerful insights on your company and industry from an educated viewpoint. Second, you also get to know the venture capitalist well enough to create a slightly better chance of your company ever getting funding from them.

To be clear, this is an art, not a science, and can go horribly wrong, but if done correctly can dramatically increase your chances of being a successful business and getting VC funding.

Tip #7: Hire people that know how to speak finance.

Many startup entrepreneurs overlook this portion of the business. When attracting startup capital (in whatever form), your business needs to have a spokesperson that understands the world of funding and money. Many entrepreneurs passionately understand their product and industry but fail to properly speak the language of finance.

This entire game is made easier if you know how it is played. It is made even easier if you have someone that’s played the game before on your side.

Tip #8: Have a complete website.

Note, this doesn’t mean a perfect website, but it does mean that your website contains all of the necessary information to competently understand and assess your business.

This is beneficial for VCs and customers as they are both trying to understand your product/service and how it might be beneficial.

Especially if you do anything technology-related, your website is your brand. Even if your technology is amazing, if you can’t make a competent website, it won’t matter.

Tip #9: Confidently pitch your brand.

In my first Venture Capital post, “Venture Capital: Legalized Gambling?” I cited that Venture Capital is all about sales.

If you can’t confidently and competently sell your company (either to investors or customers), you’ll fail. Simple as that.

Strategies to improve can include creating a pitch deck, practicing during networking calls, practicing during customer calls, creating a massive diagram explanation of what your business is, etc.

Tip #10: Don’t be afraid to change.

Businesses are fluid. They can and should change.

People are fluid. They can and should change.

If someone—customer, investor, employee, consultant, anyone—gives you good feedback, take it and change.

If you try to stay rigid, or even worse, if your company tries to stay rigid, you will be punished. Simple as that.

What’s the whole point of research, development, communication, of business really, if you aren’t planning to do anything with the information you gain?

If you need to change, don’t be afraid to change.

Don’t give the Venture Capital firm a reason to reject your company.

Anywho, that’s all for today.

-Drew Jackson

Disclaimer:

The views expressed in this blog are my own and do not represent the views of any companies I currently work for or have previously worked for. This blog does not contain financial advice - it is for informational and educational purposes only. Investing contains risks and readers should conduct their own due diligence and/or consult a financial advisor before making any investment decisions. This blog has not been sponsored or endorsed by any companies mentioned.