In this series, supported by Nexit Ventures, we today take a look at investment criteria that venture capitalists use to grade startups. While these are sure to slightly differ from company to company, you'll be very well off understanding the implications and criteria Nexit Ventures uses to grade their potential investments. There are six points that investors usually look at and we'll take a look at each of these in detail. The criteria are management, market potential, exit potential, business model, technology and finance.
Before we dig into these points, we have to understand how venture capitalists work on a slightly broader term. First of all, the VC business is a business of hits, homeruns, great companies becoming huge. Investors make their money back on a very few great investments, but these are usually the world class type. These homeruns can be achieved by targeting aggressively to the top of the world, investing into the very best companies only, but then again - investing very early on and spreading the investments into many enough companies.
Management, in other words the team. This is the single most important part of the investment criteria that investors use to grade their potential investments. In teams, Nexit Ventures, looks into both the depth/quality of the team, but also into how diversified they are. Teams need to have various skill sets. There needs to be a clear business focus, but also a very deep understanding of the industry the company works in.
Naturally, other aspects of entrepreneurs are also graded and looked at; how well are the people in the team prepared to work in the face of high risk and uncertainty, how well are they organised to pursue the opportunity, how dynamic is the team if they need to change course and so on. One of the ways entrepreneurs can look at this is that when investors look into early stage companies, there is seldom anything else to support the investment decision than a strong and a qualified team.
2. Market potential
Another very clear and obvious criteria for investors. Since VCs look into high potential areas where they could exit their investments at a higher valuation - the demand for the company's services need to be supported by a strong market.
There are a few things regarding the market investors look at on top of the obvious size of it. These issues are for example the growth and/or internal dynamics of the market, the level of competition, access to the market, what distribution mechanics work in the market and what at what stage is the market - timing is essential.
3. Exit potential
Again, if you're an entrepreneur - you need to have some idea of the a potential exit in mind, if you go looking for venture money. Basically, there are two ways to go about this - IPOs and M&As. IPOs or initial public offerings is the act of taking the company public to a stock exchange. M&As are a lot more common these days and mean mergers and acquisitions. Larger companies constantly buy smaller startups to either gain market share, revenue, technology or other important assets they may see valuable in your company. Have a look at our previous article in the series to understand what creates value in a high tech startup.
4. Business model
Business model defines to venture capitalists one thing - how well are you able to make money from your venture. Investors basically look at two things when it comes to business models; the scalability of it and how well you can protect and differentiate it.
Scalability is the basis for any venture capital really. It means that you're able to create more revenues without increasing the costs in the same proportion. Thus, consultancy businesses are seldom able to attract venture money (and it almost never makes sense) as their business models do not scale. Differentiation and protection means that you're able to build in unfair advantages and different kinds of customer lock-ins to keep your business ahead of the competition.
If you're a technology startup, investors will also value you on your technology. This was also partially covered in our previous article, creating value in high tech startups. Investors will be looking at your technology team, how you protect your IPR, what kind of a role the technology plays in the equation (how much are you requiring consumer behaviour to change for example) and if there is any technology risk involved (any unsolved areas of the technology that are needed for the solution to work at large).
6. The Finances
Finally, the last criteria is the financial status of the company. There are four smaller points to look at and they are the use of the funds, financing terms, financial risk and the potential of a 10x return on investment.
The use of funds is important, because investors want to see how you'll be using the funds to grow your business. If you're paying debt away, it's probably not a good idea for an investor to be investing in your company. Financing terms are important and vary from investor to investor. These will be covered in more detail in the term sheet and are seldom one of the key points in the negotiations.
Financial risk means what kind of risks are involved with the current investment. These can be for example, if the company needs further financing to complete the R&D of its products, will there be a risk that market conditions will change and the company will need more funding, etc. Finally, the question on where all venture capitalists make their money - will the exit potential of the investment be many fold?
If you're able to prepare for these areas and questions presented in the above six points, you'll be well prepared for negotiations around financing your startup through venture capital. While these criteria and their importance may vary from company to company - they are somewhat general for all venture capital companies in the industry.
This post is part of a series of posts supported by
Nexit Ventures is a mobile venture capital firm focused on wireless technologies and services. Leveraging its extensive network in the global mobile marketplace, Nexit invests primarily in Nordic and US-based earlystage companies with products and services for a global market. For Nordic mobile companies, Nexit provides a bridge to Silicon Valley markets and exit opportunities.
Image by PJ Chmiel