A common reason why VCs don’t invest in a lot of startups is that the opportunity isn’t what we call “VC Backable”. This piece of vague feedback is common across the industry, but more importantly, I think it’s crucial for entrepreneurs to understand what this means. It very well may shift your fundraising strategy, or how you think about your business entirely.

A good place to start is by understanding the goals of a VC fund.

A venture firm’s ability to make a return on the capital it invests is key to this entire discussion. But just how hard is it to make money in venture capital? And how much money does a VC need to make? Let’s answer these questions first from a macro perspective than from a fund-level perspective.

In finance, there is a concept called the Capital Market Line. A simple chart that plots different asset classes on a risk/reward plane. See below:

Coming into Focus – Howard Marks

We all know that startups are risky. But what the capital allocation line tells us is that venture capital (which rests beyond private equity on the capital market line) is a high-risk, high-reward asset class.

So, what does this mean? If we look at VC portfolio return data from Angel List, we can see how “high risk, high reward” manifests itself:

Angel List

This chart shows us that most early-stage funds return somewhere between 1-2x the capital invested… Which is a sub-optimal rate of return. Keep in mind that this 1-2x return is happening over a 7–10-year lifespan, so more times than not – Limited Partners (LPs), who invest in VC funds, are better off investing in a different asset class if they are purely seeking superior returns. The challenge in venture capital, however, is that not all investments are equal. If every single company a VC invests in returned 3x that would be great! But that isn’t the case. So, what does a real venture fund look like?

Rhino Ventures

Rhino Ventures here in Canada publicly shares their fund performance. The 2015 vintage fund on the left really highlights how not every investment is equal. In this case, 50% of the portfolio is valued at less than 2x and while it certainly helps to not have many write-offs; the bulk of the returns came from just a few investments… According to their blog post, the overall fund has a return multiple of 7.1x (as of Q4 2020). Which is a top-performing fund by VC standards.

The takeaway here is that venture capital is just another asset class for investors to allocate capital towards. Performance matters, so VC investors want to deliver outsized returns compared to other investment alternatives. Let’s take a look at the performance of a few investment options:

Top & median venture fund performance data courtesy of Pitchbook

Look at the top performing venture fund in our table above – coming in at 40.10% annual return which is almost 4x what you could have made in the S&P 500. This is what we call outsized returns. The median venture fund on the other hand didn’t do that much better than the S&P 500. After accounting for increased risk and illiquidity (an LPs money is locked up for 10 years in a VC fund), you likely would have been better off investing in the S&P 500 vs. the median venture fund.

So, how does this all tie back to you, the entrepreneur?

Let’s quickly summarize where we are: The goal of a VC firm is to generate outsized returns for its investors. To do this, the fund has to make high-risk, high-reward investments. With the understanding that most portfolio companies will only return 1-2x, and the bulk of returns will come from just a few investments.

So as an entrepreneur, the key question you need to ask yourself is: “Does my startup, despite all the risks, have the potential to be one of these outlier companies for an investor?

To help answer that question, consider the following:

1. Market size

Market size often comes up in meetings with investors because it helps determine the size of the pond you might be fishing in. A total addressable market (TAM) of say, $100 million usually isn’t enough to get VCs interested.

So, for an investor, TAM = the size of the opportunity your company is going after. It’s important to be thoughtful when calculating the size of your TAM. If you’re using the headlines from Grand View Research or Markets & Markets reports you’re going to be wrong, and investors see right through that.

Of course, companies that create new markets (Airbnb, DoorDash, Uber, etc.) might find this challenging. But there are proxies you can use. For example, Uber first estimated their TAM based on the Taxi industry. Airbnb could have done the same with the hotel industry. Jared Sleeper has a great article on how you can explain your TAM to investors.

2. Is the market large enough to support multiple $1 billion + companies?

This is key. Remember, VCs are looking for massive outlier opportunities. There are very few winner-take-all markets, but VC investors want to ensure that there is a path for the company to reach the level of valuation that they need.

Recall that since most investments only return 1-2x the capital invested, the few companies that perform very well need to generate strong returns for the entire fund. This is why investors look for companies that can achieve valuations in the range of hundreds of millions to billions of dollars.

3. Do you as the entrepreneur even want to go down this path?

Funding from VCs sounds great because it solves your near-term problems. But do you really want to grow into a $1 billion+ company? Be honest here – lots of mentors / advisors / others might say “I’ll intro you to VCs, you need capital to scale, etc.” but once you take that money your signed up for the $1 billion + ride. And if that’s not what you want then I can almost guarantee you that the money won’t be worth it.

There is nothing wrong with building a business that doesn’t scale to VC-level outcomes. In fact – I’d almost argue that non-VC businesses are just as critical if not more critical to the economy. Besides, the opportunity for you + your employees to be successful doesn’t rest on being a billion-dollar business… Over the last several years there have been new funding models popping up. For example, ClearCo & Pipe are two companies looking to change the landscape of business funding that don’t require equity.

So to summarize, throughout this post I wanted to highlight two things: 1) How VCs think about their investments and why such large outcomes are required. And 2) How this ties back to you as the entrepreneur. Both from the opportunity-size standpoint (is it possible to generate outsized returns via investing in your startup) and the more personal one (do you even want to go down this road?).

Hopefully, this sheds some light on why an investor might be saying “I don’t think this is VC backable” – Often times we are big fans of the business, but we just don’t see it being able to generate the returns we need.  

When it comes to funding your startup, creating FOMO for your fundraise (fear of missing out) can be a powerful tool to attract investors. FOMO is the feeling that you’ll miss out on something great if you don’t act now. And when it comes to investing in a new company, investors never want to miss out on the next big thing.

As a founder, it’s essential to understand investor motivations when it comes to fundraising. And one of the most important rules is this —  venture capitalists (VCs) need big returns. That’s because VCs are in the business of taking substantial risk to generate outsized returns for their investors. And the way they make money is by investing in companies that have the potential to become global successes.

This is where the power law comes into play. The power law states that a small number of startups will generate the majority of returns. Studies have shown that just 6% of startups will make up 60% of all venture capital returns. So, if VCs are looking for significant returns, they’re looking for that small number of startups that will generate most of those returns.

Example of the Power Law

Angel List 

For this reason, it’s important to pitch a big vision when you’re raising money from VCs. They’re not interested in funding small companies that will only generate modest returns. They want to invest in companies that have the potential to become huge businesses. And the only way to convince them of that potential is to pitch a big vision of what your startup can become. That big vision will help in creating FOMO in your fundraise. After all, who wants to to miss out on that?

Finding the right investors

As a founder, one of the most important things you can do is to ensure that you spend your time wisely regarding your fundraising efforts. This means finding the right investors and building investor relationships that will not only provide the capital you need but also be able to offer valuable insights and connections.

There are a few key factors to keep in mind when searching for potential investors:

• The fund’s size – Make sure the fund is large enough to support your round of funding. You don’t want to waste your time approaching investors who won’t be able to provide the amount of money you’re looking for.
• The lead/no lead – It’s generally best to work with a lead investor, as they will be more likely to understand your business and can help drive the deal towards a close. However, if you’re struggling to find a lead investor, don’t be afraid to approach non-lead investors as well.
• The fund’s theme – Does the fund focus on investments in your industry or sector? If not, it may be challenging to get them on board.
• The lifecycle of the fund- Is the fund nearing the end of its life cycle? If so, they may be less likely to take on new investments. Each fund typically has a 3-5 year investment period. 
• Relevant portfolio companies – Does the fund have any direct competitors to your startup as part of its portfolio? If so, it could make it harder to get them on board.

Automating and personalizing your fundraising pipeline

Creating a great fundraising pipeline is essential for any business, but it can be time-consuming and difficult to do manually. Fortunately, there are ways to automate and personalize your pipeline to make the process easier.

One way to automate your fundraising pipeline is to use a tool like Zapier. Zapier can help you connect different software applications and create triggers that automatically add tasks to your pipeline. For example, you can create a trigger that adds new contacts from your email list into your fundraising pipeline.

Another way to personalize your fundraising pipeline is to tailor the properties and stages to your specific business. This will help you track progress and ensure you raise money at the right pace for your company. Additionally, consider using free investor databases like Crunchbase or NFX Signal to help you find potential investors.

You can easily automate and personalize your fundraising pipeline with a little effort. By doing so, you’ll save time and make sure that you are raising money efficiently.

Template for reaching out cold + email intro blurbs

What is the best way to reach out to potential investors and build up relationships? What are some good email intro blurbs that can be used?

When reaching out to potential investors, it is important to be concise and clear about what you are looking for. Investors typically see hundreds of opportunities a year, many of which generally just aren’t a fit. Intro blurbs should be short, sweet, and to the point. You should also include a call to action in your email so that the investor knows what you want from them (meeting, deck review, etc.).

Following up with potential investors is key to success. Sometimes, investors will not respond to your initial email. However, if you follow up promptly, you may be able to get their attention. Creating FOMO in your fundraise campaign will create a sense of urgency for potential investors to reply.

Visible has some great templates & tips for cold out-reach success. 

How to leverage FOMO by creating momentum:

Your initial pitch to investors needs to show (at least at a high level) the roadmap to your startup becoming a massive success. 

So how do you make sure you’re doing it right?

For starters, think in terms of acts, not slides. Just like a good play or movie is structured in acts, your investor update should be divided into three distinct sections.

In act 1, make your case; you’ll lay out what you’re building, what it can become, and why now is the time to invest.

In act 2, de-risk your approach; you’ll address any concerns investors might have about your ability to succeed by detailing what you’ve done to increase the odds of success.

And in Act 3, broaden your case. This is where you’ll make a case for why investing in your company is a good financial decision and a way to positively impact the world.

Remember, your goal is not to present a bunch of data or information in slide form. Your goal is to tell a story that will engage and excite your investors and leave them wanting more.

When it comes to setting meetings and beginning the process with investors, it is key to continue building momentum. Even when you start having active meetings with a handful of firms.  

To do this effectively, you need to stack your meetings. That means reaching out to firms in sets of five and then refining your pitch based on feedback from the first eight or so meetings. Doing this will ensure that you’re always presenting your best case and create a sense of FOMO among investors who don’t want to miss out on the next big thing. If you stop actively pitching new investors – you might find yoursel with a empty pipeline if the ones your talking to now end up not investing. 

So go out there and start crafting your story. And remember, when it comes to pitching investors, it’s all about creating momentum, generating FOMO, and building investor relationships. Do that, and you’ll be well on your way to success.

Watch the full webinar and Q&A here: