“Your startup is not venture-backable.” What does it mean?
You’ve spent months, or even years, building and validating a product, onboarded a few hundred users, and are preparing for your first fundraising round. But regardless of whom you reach out to, the feedback is the same: it’s not venture-backable (or some other similar term). What a bummer. But really, what does that even mean?
Firstly, there’s no concrete definition for being “venture-backable,” and interpretations vary. In my view, not being venture-backable means: “You can’t grow as much and as quickly as we expect.”
VCs are fixated on massive growth rates. They take risks to invest in companies with the potential for significant growth and disruption, hoping to see a substantial return on investment (ROI) in a relatively short period. When they say your business isn’t venture-backable, it implies they don’t see it fulfilling their growth criteria.
Let’s delve into some typical reasons why a business might not be considered venture-backable.
1. Small market size
When evaluating a potential investment, venture capitalists meticulously consider the size of the market. A fundamental question they ask is whether the investment is truly worth it. This is not just about your company’s ability to grow and potentially dominate the market — which in itself is a best-case scenario. The critical factor here is the actual size of the opportunity at hand. How much revenue could your company realistically generate if it captures a significant market share? Is it $10 million a year? $100 million a year? For VCs, these figures might still fall short.
The allure for VCs lies in scaling businesses that can tap into markets worth hundreds of millions or even billions. They are looking for ventures that not only promise significant returns but also have the potential to disrupt or create large markets. It’s about finding those rare opportunities that can deliver outsized returns on their investment.
Therefore, if your business operates in a niche or limited market, it might struggle to attract VC interest. The total market size needs to be substantial, even when your probability of success is taken into account. VCs often seek businesses that, even if capturing only a small fraction of the market, can still generate considerable revenue.
2. Small market population
There are instances where the financial value of your market is significant, yet the actual population size within that market is limited. Take, for example, a luxury service such as a helicopter rental business catering to VIPs and business tycoons. While each transaction may be highly profitable, the challenge lies in consistently finding and retaining a sufficient number of customers. This scenario represents a market that is not only hard to penetrate but also demands more elaborate and costly marketing strategies.
In such niche markets, scaling the business rapidly becomes an arduous task. Venture capitalists often shy away from these situations because they typically seek rapid, scalable growth. Slow-growing markets, despite their high per-customer value, may not align with the aggressive growth targets and quick returns that VCs usually pursue.
3. Long Sales Cycle
Your growth potential is also impacted by your sales and onboarding process. How long does it take to onboard a new customer? Is it automated, or does it involve manual work?
Imagine developing an AI tool designed to generate management reports for companies. This tool would likely require integration with various software and tools on the client’s side to access their raw data. If each integration demands a manual, bespoke approach for every new customer, it significantly ramps up your onboarding complexity.
This not only risks alienating potential customers due to the cumbersome process but also diminishes the appeal of your business in the eyes of VCs. They typically favor startups with scalable, efficient processes, and this manual, time-intensive approach runs counter to that preference.
4. Perceived value in a competitive market
The value provided by some businesses is immediately apparent and unquestionable, like the convenience offered by using Uber’s app to get a ride within minutes. However, not all businesses have this clarity of value.
For many, especially in industries with intangible products or services, demonstrating their value swiftly and unequivocally is challenging. For example, assume you have an AI tool to capture some data points from employees and give their managers a report on how engaged an employee is so managers can improve the engagement of their teams. This is a very important topic, and every manager agrees that low employee engagement leads to high employee turnover, and employee turnover is a waste of money and time. But how can you predict the impact of your solution on your client’s bottom line? How much lower would the turnover rate be if a company used your tool?
This is particularly more impactful in markets where several companies offer similar solutions, making it difficult to distinguish which one is superior. In such cases, the inability to clearly showcase value can slow down sales and limit growth potential, which is unattractive to venture capitalists. Often, both customers and VCs in these crowded markets gravitate towards the more established, well-known options due to the Bandwagon effect/bias.
5. Long term feasibility
Consider the rise and plateau of blockchain businesses and NFTs. Not that they’ve died, but they are not creating the same buzz that they used to. Investors, having witnessed similar patterns, can differentiate between fleeting trends and genuine opportunities. Businesses built on emerging technologies without a clear future might find it difficult to attract investment. Investors hate to see their investments evaporate into thin air in a year or two.
Note: This primarily pertains to typical venture capitalists, not the exceptionally high-risk-taking VCs often found on the West Coast. These latter investors are known for their readiness to invest in a wide array of (usually high risk) ventures, frequently seeking rapid returns, sometimes aiming for a 10x return within a short span of one to two years.
6. Reliance on other businesses
If your business model relies heavily on another company’s platform, such as developing a WordPress or Shopify plugin, venture capitalists might view this as a drawback. This dependency limits your autonomy, especially in areas like pricing, which becomes contingent on the policies of the host platform. This interdependence can introduce significant risk to your business.
However, it’s important to distinguish between dependence on core business platforms and on infrastructure providers. For instance, hosting your service on AWS doesn’t imply a dependency on AWS, as it simply provides infrastructure. This type of arrangement offers flexibility, allowing you to switch to alternatives like Google Cloud Platform (GCP) or Azure if needed. This contrasts with developing a product like a Shopify plugin, where your business becomes intrinsically tied to Shopify’s ecosystem.
In the context of OpenAI’s GPT API, I view it as an infrastructure component. It shouldn’t be the primary value driver of your business but rather a tool to enhance it. Creating a service solely dependent on the ChatGPT API, like attempting to replicate ChatGPT itself, is generally unattractive to investors. If the primary API your business relies on ceases to exist, your business faces existential risk, which is a significant concern for investors.
Final Point:
A startup not deemed VC-backable can still be a viable business, potentially with a high capacity for generating revenue. The label ‘not venture-backable’ doesn’t imply that your business lacks merit; it just indicates a misalignment between its potential and investor expectations. To make your business attractive to venture capitalists, addressing the issues in your business model or execution is key, though it’s important to recognize that this might not always be feasible or worthwhile.
Alternatively, pursuing a growth strategy independent of VC funding could be a viable option. Success in the business world doesn’t mandatorily require venture capital investment.
What other factors do you believe contribute to a startup being labelled as not venture-backable? Share your insights in the comments section.
