What Startups need to understand about Venture Capitalists

Recently, a friend of mine built an app for resellers. He has been working on it for quite some time. It has been 1–2 years since he has been building the application. Now that it’s nearing completion, he’s begun looking for investments. Now, there is a good chance he won’t successfully raise funds despite checking most boxes. Why is that?

Most startups do not understand the VC mindset. In his book, The Venture Mindset, Stanford professor Ilya Strebulaev goes deeper into how VCs think. While most of his book discusses frameworks organizations can use, startup founders looking to raise funds need to understand some core fundamentals about how VCs think.

Here are a few key things startup founders, especially in the early stages need to understand about Venture Capitalists.

Most VCs are ‘Value Investors’

This is core to a VC’s thinking. I would go so far as to say that the mindset of a retail investor in a stock market is the same as a VC. Let’s take a look at what a stock market investor looks at (this does not include traders or those performing intraday trades):

1. Most investors try and understand the business they are investing in. For instance, if I am investing in Tesla, I will need to know the nature of their business. This will involve my understanding of their customers, business model, team robustness, and most importantly their potential to grow. All of this information can be gleaned from either their website or annual reports (if published). Most publicly traded companies are required to publish these details for public viewing.
2. The second aspect requires a mix of qualitative and quantitative aspects. In some cases, investment analysts look at performing a DCF (Discounted cash flow) valuation. This involves making assumptions about revenue projections, discount rates, cost of capital, and so forth. Some prominent investors like Charlie Munger do not like the DCF while others look at multiples and make comparisons with similar organizations. I will cover financial modeling in another post.
3. Continuing from comparisons with other companies, investor Mohnish Pabrai has an interesting approach. In competitive markets or red oceans, he looks for a ‘moat.’ In simple terms, a moat refers to a company’s competitive advantage and how it sets itself apart in markets that would otherwise seem competitive.
4. Based on the above pointers, a Value Investor (as coined by Benjamin Graham) looks for a reason to say ‘No’ as opposed to looking for a ‘Yes.’

Now, let’s try to draw parallels with a Venture Capitalist

1. A VC needs to understand macroeconomic conditions, the Total Addressable Market (TAM), and most importantly — have an investment thesis on a specific industry. I’ve written about building an investment thesis before.
2. When listening to a pitch, a VC always looks for red flags and reasons to disqualify as opposed to investing. This means, that a VC is always looking for a reason not to invest.
3. A VC’s first instinct is to always understand the management team/company founders. For some VC funds, the founding team’s credentials are important. This is an important metric for me since founder-market fitment is critical.
4. In ‘Zero to One’, Peter Thiel talks about how monopolies win the lion’s share of the TAM. However, most startups need to understand the concept of ‘Monopolistic Competition.’ In simpler lingo, this term roughly translates to competitive advantage or a moat. Let’s take the example of my friend’s app. On the surface, his app is the same as market leader Meesho. However, a few adjustments and tweaks (i.e. his moat) have made enough difference for him to convince himself that funds can be raised and customers can be acquired.
5. I have come across many VC analysts who continue to employ the DCF method to value startups. Although this can lead to significant risk due to a lot of financial modeling assumptions, it remains the most effective way (in my opinion, of course) to value startups. The priorities however are different at each end of the spectrum. While startup founders would look at negotiating a higher valuation, a fund manager will always look at the intrinsic value and try to negotiate down to this value.

Based on these aspects, it is safe to assume that most fund managers and VC analysts are value investors.

VCs look beyond the Pitch Deck

I have written at length about this. A pitch deck is composed of three core aspects:

1. The problem statement and the proposed solution.
2. The founding team or the people who are going to solve that problem and why.
3. Financials and any early metrics that validate the pointers above.

While a pitch deck is important at an early stage, VC analysts will always look at a larger due diligence. A pitch deck might get you a meeting or through the door, but having a sound financial model (not exaggerated), a solid GTM, and a few options for PMFs is what entices early-stage investors.

An idea doesn’t get you through the door anymore

If you are a startup founder in the early stage, there are 2 ways to validate your idea or product. The first is to do some primary research. This is the preferred method since this generally leads to the first set of customers. The second is to get the customers and skip the primary research part. In my friend’s reseller application, he would need to do the latter. However, if you are working on an idea and looking to get some validation on what product you need to purchase, it is critical to have primary and secondary research in place.

To conclude, this post is intended for startups who are finding it difficult to raise funds from VCs. While it does take a lot of effort to raise money and the process involves speaking to several VCs, it is important to understand how a VC thinks before approaching a fund.

Disclaimer(s)

1. This isn’t financial advice. Far from it actually. It is intended to be a playbook with some of my learnings over the years.
2. I don’t make guarantees and hence cannot guarantee that this playbook might work.
3. This post is completely my opinion and does not reflect my partners, employers, or any portfolio companies.