How does VCs select a startup to invest?

VCs invested $445 billion in startups globally in year 2022.

In 2022, Private Equity and Venture Capital Firms invested, in 1261 deals, a total of $ 46 Billion in Indian Ecosystem. In year 2022 itself, Indian ecosystem created 21 unicorns (A company comes in a unicorn club if its valuation crosses US 1 Billion mark).

5120 angels invested in Indian startups in 2022 itself. Trend in angel investment have increased in 2022 as compared to VC, PE investments.

Whether VC or Angels, one thing which is common here is the criteria investors consider for entering into the investment. In this article, we are going to explain what exactly goes in the mind of the investors while offering the deal.

It’s obvious that all the startups have prepared their business plans, pitch decks, projections and other documents. But the question is what decides the selection and how investors evaluate a case?

Following points will help startups if they are planning to pitch to investors

1. Potential

Investors are curious to understand the potential of the company in near as well as long term. They don’t want to be invested forever. While inspecting the company, their vision is to create the exit route as per their expectation of the exit multiple. Strategic investors have detailed understanding of the specific sector and what maximum they can reap from the investment. Startups should explore ideas to showcase the potential of the company for long and short term scenarios.

2. Growth and consistency in Revenue

Startup plot numbers in their projections but if they are not able to justify these numbers, it will be difficult to convince investors. Revenues are a big indicator and first ask of the investor during pitches. Suppose if we are projecting revenues in the business plan according to the revenue model, these revenues should be consistent (monthly / annually) in current and past time as well. If there are fluctuations, you should have strong reasons behind it. At least you should have a strong business model and a convincing plan how you will resolve these issues in the coming time.

3. Disruption

If a startup has a potential to disrupt the market and your pitch conveys this effectively, you can raise higher amount at better valuations. Although it is tough but if a startup can convince possibility of disrupting the market, there will be least hurdles in raising the money.

4. Background of the founders

Especially in case of pre-revenue startups there is little to convince and show case. Here background of promoters helps and provides an edge. If promoters have proven track record of any other venture or experience closely related to the subject company, you can win the deal.

5. Team

Management team is also the factor which is important for investors. Investors are not going to sit in your office for the whole time so they should have trust in managing capability of the team and coordination among team members.

In shark tank, you can see various instances where sharks are testing teams for this specific factor. Sometimes they create scenarios where disputes may arise. So it’s good if you are organically away from this situation and you have good coordination but if there is any gap, you should work it out first. There should be respect for new ideas and execution should not stop in any case. Investors often test this while doing investments.

6. Confidence and Trust in your product / services

Apart from creating an MVP (Minimum Viable Product), product you are building, you should have confidence that if available you will buy this product / services for yourself. Trust and convictions for your gets reflected in most of the pitches. If you have confusion, you should think in advance. This approach will help to improve the existing as well as future versions of the product. For this your market understanding should be sound. It’s better to understand market dynamics, market size, target market etc. to convince investors.

7. Good Side Bad Side

In most of the pitches, startups usually present positive side and somehow hide the negative side. In the technical aspect, it known as risk assessment of the product. Its fine to present on the positive note but it should be balanced with downside as well. Here, if investor fits in and can fill this gap, you may offer the solution assuming the investor in the team. This will turn out to be a pull strategy instead of a push strategy and you will not be considered as over pitching the case.

8. Break down projections

You should breakdown the projections and its better to assume that you will get query from almost every number punched in the financial model. If you have track record of 1 year or more, these numbers should be considered while building future projections. Your projections cannot be far away from your existing performance. If they are quite distant, proper logic and evidences must be ready with you. It’s better if you can justify your number from existing market reports and cases.

9. Future Revenues

It’s fine if the company is in pre revenue stage currently but revenues must be expected in coming 6 to 12 months. If you are expecting revenues in 1 or 2 years in future, it will lack interest from the investor perspective. Most investors are looking to take exit in 3 to 5 years period and if they foresee revenues getting delayed, they know that it will impact future valuations when they are planning to exit.

10. Replication

Apart from other factors, if your product can be replicated easily then how you will be going to protect your venture from the competition. If it can be replicated easily, you should have action plan to tackle this situation. In this type of cases “do fast or die fast” is the case.

11. Already raised money

If you have raised earlier through angel investors, it can be an added advantage. But how you spent that raised money is also important for the VCs because it will convey the way you are tackling execution as well as financial management.

12. Transparency

This is the core of all above points as it comes under the checklist of ethics for almost all the investors. It’s not suggested to hide anything from your potential stakeholders. It brings drifts in future and distorts relationships and brand image. You should be transparent and need to bring everything on the table in the beginning itself.

13. Your research & VC knowledge

Try to know everything about your product/service and industry and even you should be aware more than the investor. It is obvious as well because if you don’t understand your industry completely, it will difficult for investors to build confidence because in actual they are betting on you.

14. Key Performance Indicators ( KPI )

Founders should work on their KPIs and working on these indicators can help you justify your projections as well as valuations. Each KPI should be mapped and addressed in your business plan. Actually it’s important to strategize all KPIs in case of a startup. You can do wonders if you keep improving KPIs and align everything according to these indicators.

15. Traction and Profitability

Before mid of 2022, investors were focusing mainly on traction but this mindset shifted to Profitability after that time. Apart from traction, that can be developed using marketing hacks, investors are looking for bottom lines of startups. From the investments that are taking place around the globe, investors are expecting more explanations regarding profitability rather than tractions. It’s not the case that traction is not important but focus has been shifted and you cannot raise funds on the basis of tractions alone.

In May 2022, Sequoia Capital sent a detailed 52 page letter to all founders in which they have invested. In this letter, Sequoia warned to “focus on profitability and growth at all costs are no longer will be rewarded”.

I hope that above points will help you to structure the process of fund raising in an effective way.

All the very best to entrepreneurs across the globe, let’s make this world a better place for us as well as for our coming generations!

Thanks for reading!