Like most VCs, we often review dozens of deals each week. We have developed a funnel that enables us to quickly eliminate those that do not fit our general investment criteria (e.g. industry, stage, model).
The deals that survive this initial culling process are subjected to much greater scrutiny and due diligence. This process includes a thorough review of the deck, financial statements, and projections; discussions with founders, customers, and other investors; and, a review of third-party information relevant to the company, its product, and industry. Companies are eliminated from further consideration during various stages of this process, and, in the end, we ultimately invest in a small percentage of the deals we review.
When we decide not to invest in a company, we always take the time to explain to the founders the reasons for our decision. The purpose of this article is to provide a review of the 11 most common reasons why we choose not to invest in companies, in hopes that some founders might find it helpful in improving their chances of raising capital:
- Lack of transparency/candor. If we detect that a founder is not being forthright, we immediately lose interest. Venture investing is based on relationships, and being opaque makes for an inauspicious beginning of a relationship.
- Nothing proprietary/defensible. If a company doesn’t have something that is proprietary that makes it defensible against potential competitors, then its success will lead to its downfall. What do I mean by that? Without a moat, the company’s success is easily replicable. The more success it has, the more competitors it will attract. But if it has a secret sauce — which could include technology, processes, knowledge, relationships, etc. — its odds of sustained growth are far greater. And while first-mover advantage is helpful in the early stages, it usually doesn’t mean much in the long run (e.g. Myspace).
- No proven, scalable paid marketing channels. We like to invest in companies where our capital can be used to fuel revenue growth. If a company has not yet identified cost-efficient marketing channels that are scalable, then they are more likely to burn through our capital experimenting and testing to find them. We prefer to invest in companies that have already done at least enough of this initial testing so that they can use our investment to scale the channels that are working. And we have a strong preference for founders that intimately understand paid customer acquisition and don’t reply to our questions about growth by saying: “We’re hiring a growth hacker.”
- Don’t know your Key Performance Indicators (KPIs). We find that there is a direct correlation between the depth of a founder’s knowledge of the company’s KPIs and the company’s success. First, founders must demonstrate that they understand which metrics are important to their business. Second, they must demonstrate that they are properly measuring and calculating those metrics. Finally, they must know which levers to pull to affect each KPI and which KPIs need to be tweaked in order for the business to succeed.
- Short runway. When we invest in a company, we like to see that it will have at least 12 months of post-close runway. Raising money requires a lot of time and effort and distracts founders from growing the business. We want the company to have adequate resources to enable the team to focus on growth without having to worry about quickly raising another round. Also, the next round becomes much easier to raise if a company has demonstrated 12 months of improving KPIs and growth. In order to calculate post-close runway, founders must know the current cash burn and must have formulated detailed projections of how they will spend the funds they are raising, as well as how much cash they will be burning each month post-close. This calculation can be done assuming: (1) zero revenue, (2) current revenue with zero growth, or (3) reasonable revenue growth based on historical trends.
- TAM is too small. We often see companies that have innovative, sometimes ingenious, solutions to a problem faced by a relatively small group. In order for a company to achieve exit velocity, it needs to be addressing a large enough market to make its upside revenue potential meaningful to an acquirer. If a company can’t demonstrate to us that the size of the market that its solutions address is reasonable (for us, that is usually north of a $1B-per-year market), we usually pass.
- Pre-revenue or pre-ship. We find that there is a disproportionate decrease in investment risk relative to the increase in valuation when a company makes its first sale. In other words, the risk decreases more than the valuation increases once a company graduates from pre-revenue to building and shipping a product for which someone is willing to pay. Thus, we think it prudent to invest after a company has made this first sale and has shown some early evidence of product-market fit.
- No vision. We like to invest in companies whose founders have a clear vision for how to grow the company to 100x its current size. While getting there will certainly require the company to deviate from this vision, not having a vision makes it infinitely more difficult. A North Star keeps founders on track even in the craziest storms.
- Don’t intimately understand your competition. Companies often tell me “we have no competitors.” I generally find this difficult to believe and push back with: “How is your target market currently solving the problem you intend to address? That’s your competition.” Beyond this rudimentary knowledge, founders should thoroughly understand the solutions being offered by their competitors, what market segments they are addressing, and how they are selling. A company’s potential customers will be comparing the company’s product against other available solutions and sharp founders will have properly positioned the product for success. Not being extremely knowledgeable about these other options and differentiating your product accordingly is a recipe for failure.
- Lopsided founding team. Products need to be built and products need to be sold. These tasks require vastly different skill-sets that are rarely possessed by the same people. We prefer to see a founding team with experience in a variety of disciplines, from engineering and development, to sales and marketing. Having all disciplines baked in from the founding of a company helps ensure that it creates both great products and products that can be sold. Yes, companies can hire talent in areas in which they are deficient, but then, that deficient area is not really part of the company’s DNA. Plus, it’s always preferred if the folks managing the hired hands have experience in the relevant area.
- No skin in the game. We want to see that founders are 100% dedicated to the company before we jump in. At a bare minimum, they need to be working full time on the business. Ideally, they have also invested a relatively significant amount of their own money in the company as well. Paul Graham wrote that once founders take steps such that it becomes “unthinkably humiliating to fail,” they quickly become “committed to fight to the death.” We agree.
This list is not exhaustive, but hopefully it gives founders a helpful checklist to make sure they are addressing some of the most common reasons why we (and probably other early-stage investors), pass on deals. And by the way, if you’re doing all of these things right, we’d love to hear from you.