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Insight Series: 3 criteria venture capitalists use to make investment choices

Venture Capital

It’s typical for early-stage businesses to face a time when the ability to commercialise and scale its offering becomes critical for longer-term success. Commercialisation and scale span multiple business considerations, from manufacturing, distribution, sales, and marketing to hiring talent, buying technology, and investing in capital equipment. To do it well is rarely cheap. To avoid it means business failure.

While accessing capital can be a daunting prospect for founders and leaders of early-stage firms, one viable path to fuel commercialisation and scale is venture capital. It’s a popular source of funding for smaller businesses. The latest KPMG Venture Pulse report revealed 2020 was a bumper year for venture capital funding in Australia, with a record US$1.6b invested, up from USD$1.48b in 2019[1].

Venture capital is a form of private equity financing that investors, venture capitalists (VCs), provide to early-stage companies. VCs make speculative investments in companies that don’t yet have the proven revenue returns or steady performance metrics of more established firms. Investing in unproven businesses brings risk to investors but backing the right company can bring VCs extremely high returns. Recent examples of Australian companies that have generated excellent investor returns include 99Designs, Airwallex, and Nuix.

Saltire Capital Partners frequently advise early-stage firms seeking access to capital. A common question that comes up in early discussions is Are there criteria VCs use to decide whether to invest in a business? 

The answer is a resounding “yes”. While there is variation between markets and industries, most VCs vet at least three core criteria during the pitch process and surrounding meetings:

Competitive advantage 

A firm’s competitive advantage is the secret ingredient that lets it perform better than the competition and keeps customers coming back because of the value it provides. That secret ingredient may be the ability to deliver a good or service to market faster, better, or more affordably than competitors. It may be a unique product, protected by a patent or intellectual property law. It might also be proprietary technology, particular expertise in a team, or an innovative method to reach customers. Whatever a business’s competitive advantage, it must be difficult or impossible to replicate. Competitive advantage is also linked to the market opportunity size: a firm with a competitive advantage in a vast market is more appealing to investors than a differentiated firm in a narrow market because bigger markets mean more customers and greater scope for profitability.

The calibre of the management team 

Investors are known to comment that they’ll “bet on a jockey, not the horse”. In other words, VCs inspect the calibre of the management team behind a venture, as much as they look at the business. VCs want to know the management team has the right character, skills, and motivation to deliver on their promises. Every person on the team must have a clear purpose, know their role, understand what they contribute, and be committed to sharing success. Obvious connections and rapport across the team are highly valued because VCs want confidence the team can work efficiently together and pivot in a new direction if needed.

Don’t stress if the management team doesn’t come with formal qualifications. Teams with proven success and hands-on experience are often more attractive to investors than teams with degrees from leading universities but no actual work experience.

Financial outlook 

VCs invest money to make money. The typical investment size in Australia is on average $250,000 in seed investment with $2m – $5m in Series A onward investment. Generally, most VCs seek a 20.0x – 30.0x return on funds invested. To assess your company’s potential to generate returns of that scale, VCs will scrutinise the financial outlook of your business. VCs want to know the size of your market: is it big enough to support revenue projections to deliver the necessary returns? Are you thinking big enough? A VC will analyse how much money is needed to accelerate growth, where funds will be spent, when the business will become profitable, what kinds of returns are likely, and in what timeframe. A VC will also examine control of your company. Will funding require you to give up control, or retain control? Most businesses don’t deliver returns overnight, but VCs nearly always want a return on their money soon than later, so expect to model your company’s run rate, profitability, EBITDA, and more over time.

For early-stage companies needing capital Saltire Capital Partners selectively helps with introductions to VCs, hosts exclusive networking opportunities, and guides on pitch development.

Contact us for details on how to connect with the right venture capitalist for your business.

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