How VCs Get to 'Yes'
At least a few times a week, entrepreneurs ask me, “Is it too soon to raise money?” This might be in the context of a company trying to raise its seed round or a company further along and receiving my feedback about a series A, B, or C round. Another question I often get is, “What do I need to accomplish to raise money from Investor X?”
There are some rubrics that arise from time to time about what it means to be ready to raise a round. For example, there is sort of a magic number for SaaS businesses to achieve $100,000 MRR, which is usually a good benchmark for raising a decent VC-led series A or B. But overall, I think this question is difficult to answer.
No matter where you draw the line, there are cases of companies that have raised capital way earlier with way less meat on their bones. And at the same time, there are companies that had way more meat on their bones but still struggled to raise money.
Here is my framework for how I--and I think many investors--think about how prepared a company is for funding. Think of this as sort of a sequel to my seed VC decision tree.
As an investor, I am thinking about every opportunity in terms of my conviction around the team, product approach, and market opportunity. The final factor is typically deal terms and pricing, but usually that gets figured last. I’m smashing that all into some measure of “conviction” on the vertical axis.
At the same time, for any given company, there is a “burden of proof” that is required to get an investor to the point at which they'll want to invest. These are all proof points the business is working, and can range from actual financial metrics to even subjective things such as how industry experts and potential customers perceive the idea.
The kinks in the curve show the major milestones for most business. The first kink is going from product-discovery to true product/market fit. The reason it’s a sharp kink is that when you clear that threshold of “proof,” the conviction needed for investors to get interested drops significantly. The same thing happens when you go from product/market fit to having an established, repeatable, business model, and growth.
This is the second kink in the curve. It oversimplifies things of course, but generally speaking, seed rounds happen before product/market fit has been achieved, series As (and some Bs) happen between PMF and determining the business/growth machine, and Cs happen once the machine has been built. The sad faces fall anywhere beneath the curve, which basically represents when investors say “no”.
A “no” happens when the burden of proof for the company is too high, given the investor’s conviction. You will notice that between the kinks, the curve is relatively flat. This illustrates the fact that when investors lack conviction, the “proof” they need to say “yes” is usually unreasonable. Put another way, an investor with just a little less conviction than one who would be willing to say “yes” has a much higher burden of proof.
This is why sometimes entrepreneurs feel like “keeping investors up to date” just results in goals being pushed back. This is also why entrepreneurs are almost always puzzled when they ask an investor, “What would we need to do to get you interested?"
VCs pretty much reside in the unhappy area beneath the curve. They consider thousands of potential investments each year, and the conclusion almost always is that our conviction around the opportunity relative to the proof don’t jive. Even for companies far along, the valuation is the great equalizer. An investor may love the team, product, and market, and be impressed by the proof points, but still think it’s not a reasonable risk/return at a particular price.
If you assume that the startup market is approaching efficiency, which is increasingly less debatable, then the pricing of a deal should get bid up to a point that is almost too expensive, except for the investor with the most conviction. A quote from Mark Zuckerberg around the time Facebook was approached by Yahoo for $1 billion offers another perspective.
When recalling the board conversation about turning down the offer, Peter Thiel described Zuckerberg’s logic this way: ”[Yahoo] had no definitive idea about the future," he said. "They did not properly value things that did not yet exist, so they were therefore undervaluing the business.”
In a way, VCs that pull the trigger on an investment think this way almost every time they do a deal. They commit to a future that is undefined, at a stage most think is too early, and at a price most think is too high. This is also why I remind founders that fundraising is about “searching for true believers, not convincing skeptics.” Skeptics are further down the conviction axis, and due to the slope of the curve, the burden of proof to get them over the hump is simply impractical.
As a side note, this is not true for what some VCs call “proprietary deals." The idea here is that some entrepreneurs work with a VC for an amount that many VCs would love to invest, but because of a pre-existing relationship, that VC wins the deal below market price. This can happen occassionally, but I think it is less than 20 percent of deals that get done.
This post originally appeared on robgo.org and has been reprinted with the author's permission.