Venture Capital FAQ Part I: What makes a venture-fundable business?
In my “office hours” – by the way an initiative that I’ll keep around since I am getting in touch with great people – I always get some of the same questions. I decided to try and answer a few of those on my blog.
Question #1: What makes an idea or a business fundable for a venture capitalist?
- The “is it a big story” piece of the business
A VC typically looks for companies that have the potential to either effectively address a new and growing market or disrupt or take a new approach to an existing one. To do so, a company typically has to be either early in its market (the often overstated, yet still really important “first mover advantage”) and introduce a new model, or have a new product or application that is difficult to imitate by the competition. Doing so, a company is building an asset protected by barriers that are hard to overcome. These barriers can be some rocket science or a dedicated user community on the web or anything else that will make it hard to copy the company’s value proposition.
Here are some example of big stories:
Ebay was the first to build an online market place based on auction. It was a new model on the web and over time, due to fantastic execution, built its asset, the user community. It’s hard to establish a marketplace because you don’t get sellers where there are no buyers and vice versa, but once you have a critical mass of both it starts to grow nicely and become hard to imitate – not on a technical level, but it’s hard to attract the same userbase to any similar, non-differentiated service. This is what makes it so hard for any direct competitor to attack Ebay. Skype, by the way, is somewhat similar – it started off with a technical asset (good quality, free p2p telephony) but as competitors caught up on the technical asset, its value had shifted to its user base – i.e. the fact that no one likes to move his buddy list to a different service introduces a high “switching cost” for the userbase, making Skype valuable.
Juniper, a router company, developed a new approach to Internet packet routing in the 1990s. Industry giant Cisco had been dominating the market with a routing technology that was based mostly on processing each data packet by inspecting it “in software” using fairly broadly usable CPUs, whereas Juniper developed specific ASICs (Application specific integrated circuits) chips that could switch certain types of packets directly “in hardware”, which made them much faster. This way, Juniper was able to sell much faster routers at a comparable price, and become a tremendously successful company. This company is an example of a business building its barrier around technology that was hard to imitate by its competition. (Please apologize for the simplified technical explanation…and feel free to correct me)
Moreover, consider that venture capital opportunities are high-risk, high return. Both Ebay and Juniper were not introducing small incremental changes, but entirely new models or approaches. No one knew whether they would be successful, but it was clear that if they would, they could become very large companies. - Team? Business Model?
Ok, so if there if you can build a great product, can you make money with it? Do you have the right team, or at least the foundation for the right team to make it happen? These are other key aspects that you’ll read about in every business textbook, so I won’t expand too much on it here. I may talk more about the business models on the web today in a separate post, though. - Disproportional leverage on the investment
Also remember that VCs are always trying to propel a company to a big hit with comparatively small capital investments, so there has to be an opportunity to strongly increase the company’s value based on the VCs investment. That’s why it’s important for the enterpreneur to show the VC what kind of milestones or significant progress can be reached with the investment. It’s also why -as an example- professional services firms are not typical VC investments – they scale very linearly, every new employee adds $x to the top line. However, in a software company for example, a small team can drive strong increases in revenue if they have discovered the right “formula” (i.e. product and business model).
Now if your business doesn’t match up with the points above, is it not a good business? Certainly not always! Several things could happen: For example, the VC just doesn’t get it. Happens to all of us. Trust me, I am happy for every enterpreneur who makes it even if I didn’t believe in his idea, and every enterpreneur deserves respectful treatment by the VC no matter what the business is like. (ii) Your business may end up being a money-printing machine on a moderate level or just take very long to grow, so it would maybe not generate a good VC return. That’s fine, it could still make you rich! There are many other possible reasons, but in any case it is important to remember that while businesses that VCs fund hopefully have some interesting characteristics, other businesses may still turn out great as well.
I have a list of some more questions I would like to talk about in subsequent posts, but please feel free to comment with suggestions.
Would you like to comment on this blog post? Get in touch with me and please do let me know where to find your comment. I'll update this post with the best of them. (Why?)