As I complete my first six months as a venture capitalist, I feel compelled to share with entrepreneurs the many insights I have gleaned from sitting around the partnership table and gaining a deeper understanding of the economics of venture. This is a continuation of my earlier post on the subject.
Not all firms are the same. Fund size, fund tenure (how far into the current fund is the firm?), firm’s track record, partner’s areas of interest and the firm’s areas of focus all affect the types of deals a fund wants to do and their expectations for returns. It is essential to understand this matrix before deciding to pitch a firm. Here are some tidbits:
Why we say “no”
At Venrock, each active partner will probably look at between 200 and 1000 deals a year and will invest in, at most two or three. As a firm, we are seeing thousands of deals a year and funding, on average, about 12 to 18 . With the realities of that ratio, VCs are highly selective. Getting a “yes” is as much about finding the right fit into the matrix I describe above as it is about having great prospects as a company. It’s also important to note that a “no” is often not an indictment on the quality of your idea but more a statement about fit, timing, scale, stage and return prospects.
The new importance of traction
As the costs of creating IT/digital media statups has fallen dramatically, the expectations for early progress have increased. Series A deals used to be two guys and 10 slides, but now the expectation is that you will have a core team, a product in the market, at least as a beta, and are showing some customer adoption. VCs are prepared to take plenty of risk, but make sure you know the size/stage preferences of the firm you are pitching. At Venrock, we focus largely on Series A deals, meaning first institutional money in and also have a seed program called The Quarry.
What does it mean to “knock down risk gates”?
VCs view the long path to success as a series of milestones. Achieving each milestone decreases risk. When you approach a VC, it may be helpful to think about the milestones, or “risk gates” you have already achieved. Things like assemble a team, design the architecture, get the code into alpha or beta, incorporate early customer feedback, sign a distribution partnership or two, bring in early revenue are all examples of milestones you may have identified or accomplished by the time you meet with a VC. Here’s a good example of the different languages spoken by entrepreneurs and VCs. An entrepreneur came in and during a pitch said he was just “weeks away” from signing a huge revenue-producing deal with a major customer. He clearly thought that was a validating piece of market feedback. But that made all of us think, “why would he possibly come out for funding now since signing that deal completely changes the prospects of the company?” In other words, if he was so close to knocking down a risk gate, then knock it down before seeking funding.
It’s about the team first and the market second
The quality of the team is more highly correlated to success than any other factor. Knowing that, we bet on a team. VCs look very carefully at the strengths and capabilities of the founder and the key management. For that reason, it goes without saying that you should be highly selective in assembling your early team and you should make their capabilities and background clearly known in your pitch. If you bring any colleagues along, make sure to let them speak. We look at the market second. If it’s really big and ripe for disruption, we get excited. If it’s small and getting smaller, it is likely uninteresting.
Understand the expectations for how big you can be
Depending on the size of the fund, most VCs are looking to fund companies that can get big. Typically this means a company capable of achieving at least $50 million in revenue within five years. This is not a hard and fast rule, but the notion of finding companies with big potential is what VC is all about. If your company, no matter how exciting, will likely reach $5 million in revenue in five or six years, seeking venture capital may not be your best funding source. Again, this isn’t a statement of the worthiness of your idea, but more a reality of the economics of venture capital and the returns LPs expect from VCs. Of course there are exceptions and some VCs use a different rule to measure impact. For example, plenty of companies have been funded which demonstrate substantial consumer traction without a revenue model (iMeem and Twitter are but two). But in any case, VC is about making a bet that a company can be big.
Find the right partner
Each firm is a collection of partners, each with their own point of view, track record, background, and areas of focus. Venrock works hard to incorporate the feedback of all of our partners on our deals. But given our relative strengths, it makes sense for you to target the partner most focused on the market segment of your company.
We are beholden to our LPs
Remember, at the end of the day, VCs are managing money for a bunch of sophisticated investors. Those investors have expectations about the range of returns their investment will produce. Venture investing is extremely high risk and for that, high returns are ultimately expected. To meet this goal, many firms have developed thought patterns about what types of companies and entrepreneurs are likely to make that happen. In Venrock’s case, in 40 years, we have invested in more than 430 companies. Of those, 124 have IPO’d and 126 have M&A’d. With that many deals under our belt, you can see how we would have a perspective about how to invest. It’s not necessarily the right one, and it is certainly not the only one, but your job is to find a firm that is looking to do the type of deal you are presenting.