The answer to what venture capitalists look for in their investments is complex and there’s certainly no checklist that you can follow for investability. I’ll share an overview of my perspective on Venture Capital Investing.
If you were to ask me the ONE thing we look for in an investment, I will give you a simple answer that varies from some other fund managers – I look for a clear path to an attractive exit.
I ask about the exit first because my job is to return capital and profits to Limited Partners. If I am asking about anything else, I’m not doing my job. I look at many factors, but I look at them through the lens of the exit.
Many fund managers will tell you that the main thing they look for is a great team. I have met many nice and passionate teams that I liked, but that didn’t have any idea about how to create value for shareholders by engineering a good exit. They could build a company over time and overcome many obstacles, but at the end of the day, they didn’t know how to exit.
A clear path to exit includes several elements, including an experienced team who knows how to create value, pivot when necessary, and exit at the best time. These teams have deep industry knowledge and they know where the industry is going and who the acquirers are who will be needing their company’s technology/customers/or other value proposition in a 3-5 year window. I call this the “Wayne Gretzky Factor” after Wayne Gretzky, the hockey player famous for saying that his hockey prowess was due to skating to where the puck is going, and not where it is.
Great team characteristics include an ability to work together, experience in working with fast paced venture-backed companies, willingness to share ownership with investors, coachability, complete team with finance, strategy, technical, sales and marketing skills, and people with industry experience and connections. Finally, teams that have “grit” are going to work through all the tough spots are the ones that succeed. They are continually doing the hard work needed to achieve success.
A tight strategic plan is a differentiator between companies that are investment ready and those that are not. I don’t want to invest fund dollars into a company that has “many possible customers” – I want a team who has analyzed all possible customers and determined those for whom the product creates the greatest value and for whom the cost of acquisition is lowest. The company should not be figuring these questions out with investor money. A tight strategic plan should include a clear mission, vision and values for the company as well as the major objectives and the strategies the company has to achieve them. A clear plan will not eliminate bumps in the road, but it will help to navigate a path to exit that is as straight as possible. It’s well known that companies with written strategic plans outperform those that don’t by 65% or more. Demanding a tight strategy doesn’t ensure success, but it certainly helps.
Unfair competitive advantage is an important quality we look for. A company should not be easily copied and it should be clearly different from its competition. “First to market” is not a viable unfair competitive advantage, though it can sometimes provide advantages over late comers. The main reasons for desiring unfair competitive advantage is that it allows a company to grow with relatively smaller competitive threats, and it creates greater value for acquirers at time for exit.
Traction to Value Ratio is an important consideration in deals we look at. Ideally companies have accomplished various types of traction, though there are no hard and fast rules about what that might be. For some companies it might be having several patents. For others it could be acquiring FDA or CEMark certifications. Still others might get traction through technical development, customer and revenue development or other benchmarks. Having significant traction shows us that the company can execute and it’s more than just a plan. Achieving milestones adds value to the company. Since our average valuation at time of investment is in the $3.5 – 4 million range, the company needs to be able to show it has accomplished enough to be worth that amount. Some companies that have achieved higher levels of traction will warrant higher valuations. We’re always looking for a good,but fair, deal. This means we’re wary of companies that are asking for high valuations without the traction to back it up.
A good deal is important for investment. I’ve read some ridiculous blogs by investors who claim that valuation doesn’t matter. They point out that the difference between a valuation of $4 and $5 million dollars today with a $1 million investment is the difference between 20 and 25%. After multiple rounds of dilution, the total ownership may drop down to a difference of 8 and 10%. So, if there’s a $100 million exit, the difference in return is only $2 million out of $100 million. That’s one way to look at it, but another way to look at it is that the $5 million initial valuation yielded an 8X return and the $4 million valuation yielded a 10X return. This is a 20% difference in return to investors – it is not insignificant. The fund manager’s job is to return maximum return to investors and this is done in a variety of ways including determining a fair valuation. Note that a fair valuation is not necessarily the lowest valuation, but one that will return the highest returns to investors. Too low valuations often result in unmotivated founders, or insufficient equity to raise additional rounds needed to grow the company to its greatest value.
The benchmark we’re looking for is to return 10X to investors within five years.
This is about a 60% IRR. This is the same as getting 25X in seven years or 4X in three years in terms of IRR (internal rate of return). We invest with a portfolio strategy, so we look for companies that have the ability to return 10X or more and invest as if it was our only investment, but understand that some will be winners and others will return less than 1X. If a company can’t demonstrate a clear path to a 60% or greater IRR for investors, then it’s not something that we would pursue.
Negotiating the deal goes beyond valuation.
We also look for deal terms that provide industry norms such as 1X liquidation preference (non-participating), control provisions, board seats, right of first refusal for follow-on investment to maintain pro-rata shares, and more. The terms of the deal can be as important or more important than just the valuation and we look for terms that are reasonable and fair for everyone while protecting the investors interests.
Strong marketing and go to market strategy are important. By the time a company comes to us they should have solved all or most of their technical challenges and the funds we’re providing are to validate the market and let the company build to a run rate of $1 million or more. These are rules of thumb, but apply in many cases. So, this means that the primary risk facing the company at this point is a failure to execute a go to market strategy with sufficient channel penetration to grow quickly and utilize leverage through use of multiple channels and or partnerships. We see a number of companies whose strategy is to market through “word of mouth”. This is an example of a good starting point, but a strategy that is probably not scalable. It’s typically much harder for companies to achieve sales objectives than they think, and we like to see a well thought out plan vs.a 1.0 strategy which will not achieve the objectives.
A believable proforma is a key factor, but not for the reasons some would believe. We don’t expect companies to hit the numbers that they project, but we do expect that they will have done the work to research industry norms for key ratios and that they are able to model out their strategies in sufficient detail to understand their capital needs and develop a solid capital strategy from there. The proforma should show not only the current raise, but should also show all planned subsequent raises. The valuation, proforma, exit strategy, marketing strategy and capital strategy should all be aligned and in agreement with each other. The proforma should show growth at believable rates which nonetheless result in a target revenue number by year five that is in the norm for acquisitions in their industry. If the number is significantly lower, then they may not represent an attractive M&A target. If the number is significantly higher, then they may be too expensive for M&A, leaving IPO as the only exit option. IPO is not a bad thing, providing that it is a realistic goal.
It’s important for the CEO to be comfortable with uncertainty.
This isn’t a quality you hear about often from fund managers, but here’s why I think it’s important. I’ve met a lot of CEOs who tell me that it’s ridiculous to ask for a proforma because we all know it will be wrong. Others tell me that asking for an exit strategy is an exercise in futility because you can’t know who is going to acquire you or when it will happen. Both of these statements are true with regard to the fact that there is extraordinary uncertainty facing the company. Some CEOs are afraid of uncertainty and resort to inaction. These CEOs don’t pave their own way into the future, but wait for it to come to them. The likelihood of success for these CEOs is far less than those who recognize uncertainty and strive to understand its limits and build a plan to achieve success. They make the future rather than just waiting for it to happen. In the case of exit strategies, this shows itself in how the CEO plans for exits. While it’s true that you can’t know who will acquire you or when, you definitely can understand how your company would provide value and for whom it would be valuable. You can then design your company to meet the needs of possible acquirers and, having identified them, create relationships with the CEOs, strategists and business development teams within those target companies. That way, when eighteen months from now, their board decides that it needs to acquire a company just like yours, they know exactly who to call. These calls result in “strategic” acquisitions vs. “financial” acquisitions. Because strategic acquisitions result in multiples that are 4-20X more than financial acquisitions, having spent the time to identify these acquirers and create relationships can more than double the return to Limited Partners in a fund.
Meta Due Diligence is as Important as the Due Diligence Itself.
We look at all of these factors ranging from markets, to finances, team dynamics, product, IP, legal, valuation and the deal while we’re going through the due diligence process. The other thing I look at is what I call “meta-due diligence.” Meta-due diligence refers to how the team responds to the difficult process of investigation that investors go through. Great companies welcome the process, and are organized with their information. They respond well and with candor even when tough questions are asked. Ultimately they know that one reason that investors who do thorough due diligence on companies isn’t just because they’re weeding out the losers, but that by pushing for validation of strategy, investors are actually making companies stronger and more likely to succeed. Investors who do 40 or more hours of diligence on a company report returns of up to five times greater than those who do casual diligence. Rockies Venture Fund does over 100 hours and often much more than that on the deals we invest in. Some companies are technically “cleared” in the diligence process, but the relationship becomes so strained and confrontational by their refusal to participate and their belief that diligence takes away from their time to “build their company”, that they end up revealing that they don’t understand the value of diligence in building their company’s value and they would rather pursue a “ready-fire-aim” approach to business without validated strategy. Rockies Venture Fund avoids these companies.
I hope these points help to clarify what we look for in the companies that become part of our portfolio. There are many more factors, many of which are balances between subtle polar opposites. We ask our CEOs to be confident and humble at the same time. Proformas should show a hockey stick path, but should be researched and realistic as well. Startup CEOs should be coachable, but should show the leadership to know when to decline well meaning advice. Companies need to show fast growth, but they need to operate within their resources or risk crashing and burning. And the list goes on.
I believe that it’s easy to teach someone about venture capital and how it works. The mechanics and best practices are well known and can be taught. The art of choosing, nurturing and exciting great companies continues to improve after a fund manager has spent their 10,000 hours that Malcolm Gladwell talks about in Outliers. It takes so much time because the cues are subtle and it takes experience to watch which companies succeed and which companies fail. A good fund manager knows they won’t be right all of the time, but they will be right enough of the time to provide great returns to investors and to help foster economic development and job creation in their communities.
Peter Adams is Executive Director of the Rockies Venture Club, Managing Director of the Rockies Venture Fund and teaches in the Colorado State University MBA Program. Peter is co-author of Venture Capital for Dummies, (John Wiley & Sons 2013) Available at Amazon, Barnes and Noble and your local book store.