Unveiling the Secrets: What VCs look for in Early-Stage Startups

Tiliter co-founder Martin Karafilis pitching to investors at UNSW Founders 10x Demo Day

Venture capital (VC) investors play a pivotal role in fuelling the growth of many early-stage startups. Not every company they invest in will be a unicorn but VCs are in the business of helping to birth billion-dollar ventures. So it’s important to prove you have the strong potential to become a unicorn within 10 years of launch.

VCs need to believe all startups they invest in will achieve growth of 3.3x to recoup money for their shareholders. But in reality, what they’re really hunting for is the future Canvas and Atlassians - companies who experience what they call ‘hockey stick growth’ within the first 5-10 years.

In this article, we delve into the minds of VCs, unraveling the key factors they consider when evaluating and investing in early-stage startups so you can better tailor your pitch and increase your chances of securing that all-important early investment.

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What VCs look for depends on the stage of the startup and area expertise but there are some non-negotiables when it comes to selection criteria. When evaluating potential investments, VCs look for these key factors that indicate a company has what it takes to be successful:

Exceptional Founders: The Driving Force Behind Success

VCs understand the importance of founders in steering a startup toward success. They seek entrepreneurs who possess a deep understanding of their industry, exhibit resilience, and demonstrate a strong passion for their venture. Founders with relevant experience, a track record of success, and a growth-oriented mindset are more likely to secure investment. This is also called founder fit - they ask themselves, does the founder(s) have the unique expertise and experience in this specific market to execute this business model better than anyone else?

Market Potential: Tapping into Lucrative Opportunities

VC firms seek markets with considerable growth potential, disruptive technologies, or untapped niches. Startups that can offer solutions to existing problems or address underserved markets tend to attract significant attention from venture capitalists. What’s most attractive to VCs (although increasingly rare to find) is an uncontested market space, or "blue ocean," where competition is limited or non-existent. Rather than battling for market share in crowded "red oceans," startups following the Blue Ocean Strategy aim to create new markets by offering unique value propositions and innovative solutions. Venture capitalists are attracted to startups that can effectively differentiate themselves from competitors, break traditional industry boundaries, and unlock untapped customer demand.

Competitive Advantage: Standing Out from the Crowd

Having a unique value proposition and a sustainable competitive advantage is critical for startups seeking venture capital. Investors look for startups that possess a clear differentiation strategy, whether through proprietary technology, intellectual property, network effects, or innovative business models. A strong competitive advantage enhances a startup's prospects for long-term success and scalability. You’ll often hear the term “moat” used, meaning how will you build a moat around your startup to protect its competitive advantage? Will it be a patent? Great customer service and a high customer retention rate?

Scalability: Fueling Growth and Expansion

This is arguably what sets a VC backable startup apart - can it grow and how fast? VCs seek startups with the potential for extremely rapid growth and scalability. They analyse a startup's business model to ascertain if it can effectively scale its operations, capture a significant market share, and generate substantial returns on investment - without needing to open countless funding rounds in the future. Startups that demonstrate the ability to achieve economies of scale and leverage their initial success into further expansion are appealing to VCs. Scalability is why so many VCs invest in SaaS businesses that traditionally have low barriers to scale.

Traction and Milestones: Demonstrating Progress

This is often what founders worry about most when going into a VC meeting because investors closely evaluate a startup's traction and milestones achieved. Positive indicators, such as high user engagement, revenue growth, improving gross margins, low customer acquisition costs (CAC) and high customer lifetime value (CLTV) ratios, strategic partnerships, or product development milestones, reflect the startup's ability to execute its business plan and validate its market fit. Startups that can demonstrate tangible progress are more likely to attract venture capital funding. Most VCs will ask when you expect to earn your first $1 million in revenue, then when you will earn $1 million a month in recurring revenue. Ultimately VCs need to believe you will get to a $1 billion valuation in less than 10 years.

Addressable Market Size: Potential for Substantial Returns

The size and growth potential of a startup's target market are incredibly important to VCs and they expect you to have done your homework. They seek markets that are large enough to offer substantial returns on investment, providing a viable exit strategy. Startups targeting niche markets should demonstrate the potential to expand their addressable market or tap into adjacent markets to attract investor interest. Startups who use a top-down approach in estimating their market and just estimate their serviceable obtainable market (SOM) will be 1% of the total available market (TAM) in their first year can expect a grilling from VCs.

Business Model Viability: Sustainable Revenue Generation

Investors thoroughly analyse a startup's business model to evaluate its viability and revenue-generating potential. They assess the startup's monetisation strategies, pricing models, and revenue streams to ensure they are robust and aligned with the market dynamics. Startups with diversified revenue streams and a clear path to profitability are more likely to attract venture capital investment. What to know what the magic words are for an investor? Recurring revenue. If there is a way to introduce subscriptions to your offering ASAP or prove that you have a solid plan to do so will put you in good stead.

Addressing Gendered Questions: Navigating Bias in VC Interactions

It is an unfortunate reality that male-identifying and female-identifying founders often face different lines of questioning from investors. Gendered questions, consciously or unconsciously posed, can perpetuate biases and hinder female entrepreneurs' ability to secure funding on an equal footing. Male founders frequently encounter inquiries centered on their growth strategies, market potential, and vision for scale. Conversely, female founders may face questions that disproportionately focus on potential risk, personal circumstances, and their ability to manage both family and business commitments. While VCs may not intentionally be gendering their questions to founders, it’s important to keep this inherent bias in mind and prepare for possibilities. This is a two-way relationship and if you feel you are not being treated fairly, it’s ok to push back in discussions with VCs.

Exit Strategy: Paving the Path to Investor Returns

This is a hotly contested one. Some VCs are adamant you must have an exit strategy in mind before seeking investment while others would prefer you spend your time focussing on building a unicorn. But it’s best to be prepared regardless. An exit strategy outlines the plan for investors to recoup their investments and generate returns. It is crucial for venture capitalists as it provides a clear path to liquidity. Common exit strategies include initial public offerings (IPOs), acquisitions by larger companies, or management buyouts. Many VCs seek startups that have a realistic and feasible exit strategy in place, indicating a thorough understanding of the market landscape, potential acquirers, and timing considerations. A robust exit strategy showcases a startup's long-term vision, potential for scalability, and ability to generate substantial returns for investors. Startups that can articulate a compelling exit strategy align their interests with those of venture capitalists and increase their chances of attracting investment capital.