Barry Brennan, Founder & MD of CapF9 Ventures
Unlocking the Money Tree: 8 reasons why a VC might hate your business and what you can do about it!
I’ve met numerous founders frustrated at their lack of success in getting funding from VC firms. Sometimes it’s hard for founders to get good quality feedback from VCs on why their company is not the “right fit.”
On the other hand, you will often hear VCs speaking about their own “pattern matching” when they assess new investments. Each VC has positive and negative fact factors drawn from their own previous direct experiences, their specific investment thesis, the market outlook at that time, as well as their preferred mental and business models. However, there are certain enduring patterns, or “Danger Zones” (to reference the legendary Kenny Loggins), that VCs often find particularly challenging when making an investment. If your startup falls into one of these Danger Zones it doesn’t mean you won’t attract VC investment, but you will have to work harder and smarter to find the right VC.
First, let’s look at 4 broad tactics founders should keep in mind when seeking venture capital funding. Next, I’ll lay out the 8 Danger Zones and provide actionable tips founders can use to increase their chances of getting funded.
Engage early and often with VCs throughout your fundraising cycles
Even if you fall into the Danger Zones (listed below), do engage with VCs early in your fundraising process but with eyes wide open about the specific challenges of your business. VCs like to get to “know” the founders and the earlier you engage the better. However, you need to be prepared and have a clear vision and ambition for your enterprise at this stage. VCs are looking for outsized returns. This comes from great founding teams with real vision tackling large opportunities. Warm introductions improve the likelihood of good engagement with VCs--these can come from contacts at their portfolio companies, for example.
Understand the metrics that matter for your business
VCs always look at metrics. While it is harder at seed or pre-seed stages to show traction via metrics, founders need to have a clear understanding of the metrics that matter for their business. You need to demonstrate a clear understanding of the unit economics of your business and the metrics that make your business work from day one and at scale. For example, for many software businesses, the Customer Acquisition Cost (CAC), Customer Growth, and Lifetime Value (LTV) of a Customer are three metrics you will need to understand and show progress in. At the very least, you’ll need to show you understand these metrics and why you believe you can set and meet ambitious metrics before you can attract investment.
Research a VC’s investment thesis before you engage with them
Save your (and the VC’s) time by researching the type of sectors your targeted VC is interested and active in. A cursory glance at the VC’s website or twitter account is easy to do, and if you can get access to Crunchbase or Pitchbook or related databases, you will also find the type of companies the VC has invested in. Try to personalise your approach if you can and find the right partner if there is a specialism within the VC team which is common.
Different geographical locations have different VC ecosystems
Each geographical location has different “flavors” of VC. While there is some evidence of VCs moving further from their home location to invest, in many cases VCs still invest locally (whether in their state, their country, or region). Covid has opened up this somewhat and we are seeing more investors move out of their geographies but this tends to be at later stages (Series A+). However, especially at pre seed and seed stages, many investors are, and act local. In that regard, the Danger Zones identified below can be even more challenging for founders in locations with less-developed VC ecosystems or in locations with a small number of VCs. I happen to live in a great, but small, ecosystem (Ireland) and see these issues all the time. Smaller ecosystems tend to have fewer investors and, for example, smaller markets can be tough for consumer companies trying to show that they can scale to larger jurisdictions. Larger ecosystems are more likely to have VCs willing to invest in some of the Danger Zones below. Each ecosystem also has its own character. This can be a result of a strong university with expertise in certain technologies, for example, or a cluster of previously successful founders from a particular sector. This can make funding more accessible in that particular location from local VCs. Research your ecosystem by speaking to founders and advisors in your ecosystem.
Now let’s look at some more specific Danger Zones. I want to make it clear that these are general red flags. Usually, dealing in generalities is a terrible thing--I get that. But knowing the general lie of the VC landscape before you jump into the fundraising swamp makes sense. There are always outliers that buck the trend, but if you don’t know what VCs generally hate, you can’t get them to like you!
Danger Zone #1: You are addressing a small market
In short, VCs need large Total Addressable Markets. The objective for the VC is to create a portfolio of investments with the knowledge that a significant proportion of these investments will fail (the “Losers”). Losses on the Losers need to be more than compensated by large and outsized gains on a small number of Winners. These Winners need to return an extremely high multiple on the original VC investment. In that context, you have to convince the VC that your business is capable of returning a high multiple of investment. High valuations are a function of actual, or future high revenues and relevant market multiples. If the market you are addressing is small and potential revenues small, the VC math simply does not work. This is one of the reasons market size slides are one of the most important slides in your pitch deck.
So, if your company is a niche solution with a niche offering and your Total Addressable Market is small, you have a potentially existential problem when it comes to attracting VC investment. To be clear, many, many companies are addressing small markets all the time. In fact, the vast majority of small and medium enterprises are in this category, but they use their own capital to get off the ground and profits to grow. They are not VC-backed. Examples of businesses that struggle here include artisan food companies, businesses addressing a very localized need, niche concepts in small markets or businesses built around a single person/personality. These are often non-scalable and will really struggle to attract any VC investment.
What can you do about it?
Find a bigger market: if you really want to seek VC funding, assess whether your product or solution can point to a different market or adopt a different route to market.
Explain that this is step 1 of a larger journey. Try to build a story to explain that this is just the first step for your company and that you have a pipeline of other products or solutions that can help build additional revenue streams to create a larger market.
Demonstrate that you are creating a new market with a view to convincing the VC that simply looking at existing market data is not the right way to assess the opportunity. This can be a tough one for many businesses, but it’s not impossible. Airbnb is an example of a company that famously created a huge new market beginning with the idea of sleeping on the couches of strangers!
Danger zone #2: You are a consumer-facing business (B2C)
Many VCs simply will not invest in B2C businesses. Some VCs will say this upfront, others will not say it at all. Why? VCs like to keep their options open (just in case)!
If you are a B2C business, you will need to be prepared to work harder to get VCs over the line. Building a consumer business can be an enormously costly and risky endeavour and can take years to get real traction. This means large investments are required, which increases the investment risk as you will likely need to rely heavily on follow-on funding. If your business needs a lot of funding to be successful, then dilution of the ownership percentages for early investors (including VCs) is inevitable. This puts significant pressure to improve business metrics between each fundraise and this can strain valuation discussions between raises. Building a consumer-facing brand takes time. Time, large investments, and future unknown requirements are not easy bedfellows for VC firms.
What can you do about it?
Find VCs that specialise in B2C businesses. They are not always easy to find but they are out there and you will find discussions with B2C VCs to be a breath of fresh air since they “get it.”
Pivot to B2B2C (i.e., your business sells to other businesses who in turn sell to consumers instead of selling directly to consumers). I would guess that a huge number of inbound B2C companies in incubator and accelerator programs eventually pivot to a B2B2C model in the end. For one thing, many accelerator mentors and prospective investors will encourage B2C business in this direction! The reason is that this ultimately reduces investor risks: a B2B2C business model often involves larger contracts with larger businesses rather than hundreds or thousands of transactions with many consumers. B2C founders may resist this pivot (at first), but it can be logical (at least as an initial route to market) and it can be on a roadmap to a final B2C vision. That said, I always like to say “never take advice from an investor who doesn’t invest” so always be careful whose counsel you take!
Target angel investors. In the absence of finding a specialist B2C VC, it may make sense to seek out angel investors rather than a VC, at least in the early stages for B2C businesses. You may have a chance to prove some metrics and gain traction, and this may get you over the line with the VC firms subsequently.
Crowdfunding platforms can be ideal funding sources for B2C businesses so this is an alternative funding route I would recommend exploring. These platforms also provide potential end customers and advocates in your new investor base.
Here’s a warning for any B2B businesses that might look a bit like a B2C business: If your business is somehow at risk of this misread, I would literally type in bold that “this is a B2B business” early in your pitch deck. Pitches only get a quick perusal sometimes and could fail the B2C test if a VC skims incorrectly!
Danger zone #3: Your business is a double-sided marketplace
When an investor looks at a double-sided marketplace, they see every investor risk doubled! Twice the chance everything will go wrong. You must attract customers on both sides, have two go-to-market strategies, build two different interfaces, and get sufficient and balanced traction on both sides to make the marketplace effective. Double this up with a consumer-facing element (i.e., a B2C marketplace) and you are in VC Danger Zone “squared.”
Marketplaces are notoriously difficult to get off the ground with all the moving parts described above and more. They can be enormous consumers of capital, are often a long-drawn-out slugfest between competitors, and can be a “winner takes all” proposition. It’s especially challenging for founders in smaller ecosystems with limited VCs to launch these kinds of B2C marketplace businesses. Also, just because you launch a double-sided marketplace in a small market doesn’t mean you will be successful in a second one. You might have to do it all again!
What can you do about it?
Find marketplace VCs. They are out there, but they are not that easy to find and often only in larger markets.
Prove your business case in a particular niche and raise funding against the metrics in this niche. If you can be laser-focused on achieving a small part of your bigger vision, this may provide the data investors need to believe in the bigger opportunity.
Lock down one side of the marketplace. If you already have supply or demand figured out, then adding the second side of the marketplace as the next step in your proposition is a less risky endeavor for investors. This could be because you are an incumbent in the marketplace, and it means you present investors with at least a partially de-risked proposition.
A business-to-business (i.e., no consumer side) marketplace may be more fundable. This kind of marketplace removes the consumer element and can make the company more investable.
Consult the experts. Sarah Tavel, GP at The Benchmark, has written a fantastic series of articles called “The Hierarchy of Marketplaces I, II and III.” Blas Moros also has an excellent piece called On Platforms. Every marketplace founder should read and reread these resources!
Danger zone #4: You are a hardware business
In investment hell, there is a graveyard full of investors who have literally lost their shirts investing in and losing that investment in hardware startups. This is deeply ingrained in the psyche of many VCs, sometimes from personal experience. For many VCs, hardware is just a straight no-go Danger Zone. Issues here include the challenge of the one-off nature of the revenue, the risks around production and supply chains, and the high working capital requirements
What can you do about it?
Find a hardware VC. Again, there are a small number of VCs out there who do invest in hardware. This is especially true for sectors like healthcare, for example, where there is an active medical devices investment community with investors who understand the investment journey and time-to-market for these types of devices.
If you can build a recurring element of income into your business, this can help open investment possibilities significantly. (e.g., Nespresso makes more money on recurring purchases of coffee capsules than machine sales.) Embedding a software as a service component or another recurring model into technical hardware can be attractive for certain VC investors. An investor I really like in Chicago, Nick Moran of New Stack Ventures, not only hosts a great podcast (The Full Ratchet) but has a specific investment thesis around hardware businesses with an embedded recurring revenue model.
Partner with your hardware supplier to de-risk the production elements of the business so you can focus on sales and other challenges of scale.
Crowdfunding is often a good source of investment for many hardware projects, particularly consumer-facing hardware products.
Danger zone # 5: The wrong team with the right idea
Jerry Colonna, the former VC investor and author of books such as Reboot, is known as the “CEO Whisperer”. He writes about the importance of “radical self-inquiry,” which involves the process of unmasking oneself to examine oneself in the mirror. Each founding team should complete an audit of their own strengths and weaknesses and be brutal about it. Investors will spot your weakness a mile off, while you will have to prove your strengths. If you know your weaknesses, you can then (a) prepare for the inevitable VC questions on these weaknesses; (b) address the weaknesses by taking action (e.g., hiring new people or adding a founder to the team); or (c) do nothing at all. For anyone determined to take option (c), please reread this paragraph before proceeding!
Even if you have everything right in terms of product and proposition, if there are serious weaknesses in your team composition they can be fatal to investment from a VC. Building a great business requires getting the execution right and a combination of many skills. Success depends on having world-class talent and a great founding team. Oh, and honesty, transparency and integrity are absolutely essential attributes. Non-negotiable. If you stray in these areas (and get caught), then no VC or other investor will fund you.
What can you do about it?
For solo founders: think about bringing a co-founder on board or (at least) bolstering your team or explaining clearly your roadmap of hires. VCs often express reservations about investing in solo founders. There are some notable exceptions here but the reality is that starting and growing a business to scale is extremely hard. Few founders have all the skills (and stamina) necessary to do everything needed on their own, so bring others on your journey. If you can convince great people to work with you on your journey, you can convince great investors, too.
For 100% technical teams: get a hustler/salesperson on the team. Products do not sell themselves. Selling is a real skill and a somewhat underrated skill by founders without sales experience. Believe me, VCs do not underestimate the importance of being able to see the product or solution you are pitching. Unless you are a med-tech or biotech startup with many years before commercialization, you will need to think about sales upfront. Without sales, there is no cash. Without cash, there is no company. You need someone to own this part of your business and tell this part of your story.
For spin-out academic teams: there are a couple of issues here. First, if you are an academic founder, you need to decide if you are willing to leave academia and move into your startup full time. You simply have to have an answer here. It comes up all the time and tenure is a tough thing to trade for startup life, so be honest with yourself and your investors about this. If you won’t leave your university post, you will need to bring in a CEO or other team members/founders to grow and scale the business. Second, academics may lack commercial experience or sales skills. This can be a glaring gap in spin-out teams and you should address it.
For teams that can’t explain what they are doing: every now and then, I've met a team that just doesn’t seem to get what an investor is looking for. There can be lots of reasons for this, for example an excessive focus on the technology with little analysis of the market or route to market. In 2016-17, there was a splurge of startups leading with blockchain in their pitches (as in the first pages of the deck). These startups had to be repeatedly told that it is not your specific technology that matters, it’s whether you have the right technology providing the right solution to a big enough problem. Getting decent advice really can make a difference here, so get good advising/coaching on your deck or a board member with previous fundraising experience to help you hone your message. If you can’t tell your story properly, don’t be upset if a VC doesn’t hear it the way you want.
Danger zone # 6: You have a terrible idea
Sometimes, perhaps a lot of the time, founders have terrible ideas. We all do. Terrible ideas are terrible investments. This applies to VCs and it applies to your time investment. It is a terrible idea to work on a terrible idea.
What can you do about it?
Pivot! Terrible ideas can become great ideas, but they usually involve a pivot or some new way of looking at the problem. This takes reflection and flexibility. If you are excessively rigid about your idea, this type of pivot can be hard but you have got to be open. Be especially cautious about sticking to your technology if that technology is not the right one.
Get proper external input and seek good advice as early as possible. Do not progress your idea in secret and spend many years building a product without checking whether anyone will want what you are building. Having a great idea is never enough. Executing a great idea is where the magic happens. You have to be able to explain to people what your idea is so you can be challenged about it.
Surround yourself with good friends, ask for feedback, and listen respectfully. Good friends will tell you the truth.
Danger zone #7: Zero traction or customer validation
For founders with zero traction, it can be difficult to get VC investment unless: you are in a particularly hot market like Silicon Valley; you are a founder with a track record (a previously successful startup); or you have found the Holy Grail (a difficult thing to do!).
The definitions of “seed” and “pre-seed” change from location to location, so founder experiences here can vary. The team is undoubtedly one of the most important components for an investor when evaluating a business. This holds even more true for early-stage startups. However, even with great teams, VCs likely want to see some evidence of traction/sales/product/customer validation before they will commit to funding.
What can you do about it?
Demonstrate some traction. Help the VC to help you. This can come in several ways. For example, if you do not know if you can attract customers, then build a basic website with a button asking potential customers to express their interest. This does not cost much and at least means you can gather some data to show potential investors.
Build a minimal viable product, even if it only does a small portion of what your ultimate ambition is. This helps prove that you can build a product.
Bring some customer or other data to the table proving your value proposition.
Give your product away and prove use.
Focus your pitch on the narrative of why you will be successful in the future and why there is a huge opportunity to exploit
Danger zone #8: Your cap table is “messy”
The capitalization table of a company (the cap table) lists the investors and shareholdings of the relevant investors who have invested in your company. You may hear investors say that a cap table is “messy,” and this can be fatal for your startup. This can occur for a number of reasons
You have too many small investors listed on the cap table, which can make approving transactions impossible and cumbersome
You as a founder have given away too much equity to external investors. The new investors will not see how they can invest without reducing your share of the company to a meaningless amount, meaning your interest and the interest of the investors may not be aligned
You have signed up to to poor documentation terms, for example giving away too much control to an investor, giving an unhealthy exit preferences or excessive returns to certain investors, or other legal terms that make it difficult for a new investor to come on board
You have given away significant sweat equity to early advisors
You have previous founders or team members on your cap table (i.e. with significant shares of the business) but they are no longer in the business
You have signed up to other prohibitive terms and conditions on previous incoming investments
What can you do about it?
Put a nominee company structure in place if you have too many individual investors. Investors are required to hold their shares through a specially formed nominee company which becomes the sole line as owner on the cap table. It can help solve the issue of too many investors on the cap table and importantly speed up decision making or approvals by investors.
Educate yourself up front. Understand the impact of giving away equity and what your funding journey will look like in the future and how this may affect founders’ equity.
Consider reverse vesting agreements and founders’ agreements to deal with founders who exit the business and clearly manage the allocation of equity between founders in the event of these exits.
Hire a good lawyer. As a “reformed / recovering lawyer”, you might expect me to say this. But this step is 100% necessary. Get a proper lawyer to document everything--and not your family lawyer, either! While I’m at it, get good tax advice, too.
Remember, it’s all about you!
It is said that interacting with VCs is like dating before getting married, and that the startup investment journey from day one to VC exit is longer than the average US marriage. In that regard, I’m also reminded of the famous breakup line “It’s not you, it’s me”. When it comes to VC conversations, however, it is all about you! You are making the approach to the VC. You can control the narrative, but only if you are prepared for the traps.
It is up to you as founder to recognize whether your company is in, or around, any of the above Danger Zones. As I have said, there are often ways of navigating the issues and there are always potential investors out there. However, it is critical to recognize that you are potentially in that Danger Zone before you can prepare properly. This will ensure your business looks like the very best possible version of itself and increases your chance of success when you do reach out to VCs.