The Reality of How Investors Find Black-Swan Startups

Originally posted on N2 Technology on the 10 March, 2021

Approximately 100 million businesses are launched every year, and an estimated 6.8 million of those are applying for funding. However, the odds of raising that money are slim; out of 3,000 inbound applications at Andreessen Horowitz, 200 are looked at seriously, and only 20 get funding. That’s only a 0.66% chance of actually receiving any funding. And even after then, chances of a startup becoming successful averages at just 8%. Combine that, and startups have a 0.05%, or 1 in 2,000 success rate. Definitely a slim pickings scenario. Yet, even with so many options for VCs, deal sourcing remains arduous and time-consuming.

Venture Capital has been a vital source of financing for high-growth startups over the past 30 years. Amazon, Apple, Facebook, Google, Microsoft, and Whole Foods owe their early success, in part, to the capital and coaching provided by VCs. In fact, in 2015, it was recorded that 20% of market capitalisation and 44% of research and development spending came from public companies that received VC backing. It suffices to say, VC funding has become an essential driver of economic value. So why - when there are so many great entrepreneurs and innovations surfacing every year - are so few companies making the funding cut?

Arguably, it’s the process. Starting right at the first, most vital hurdle. Deal sourcing is somewhat archaic, heavily relying on traditional, claustrophobic, and limiting localised networks that are repeatedly delivering the same results in an echo-chamber. VCs predominantly conduct deal sourcing manually, with little data and no standardised financial assessment criteria. And on top of that, many VCs are competing aggressively to find the best talent, with the best ideas, in an overly saturated market.

“The average time between funding rounds from Seed to Series A is 22 months, Series A to B is 24 months, and Series B to Series C is 27 months.” - Carta

What VCs are looking for in a startup

According to HBR, 95% of VCs place founders as the most important factor when deciding to pursue a deal. 75% believe the business model is most critical, 68% believe the market, 31% believe in the industry, and taking last place is the company’s valuation.

These prioritising factors are also supported by Andreessen. He believes that there are three primary aspects to look for when culling businesses:

• A huge market

• Differentiating technology

• Incredible people

If the market is too small, there won’t be enough demand - regardless of how great the product or service is. If the technology is too similar to others on the market, it can be too difficult to break away from competitors. And without incredible people, neither of the two aforementioned criteria matter. According to VCs, founders who possess courage and genius are the two most important traits to look out for. Not giving up in the face of adversity, being determined to succeed, learning from mistakes, and out-of-the-box thinking has led to successful navigation of extremely challenging markets.

How deal sourcing works

In its most basic form, deal sourcing is the process of entrepreneurs with good ideas and no money, finding investors who have money, but no ideas. A VC’s first task is to match with startups looking for funding. This is called ‘generating deal flow’.

According to Harvard Business Review’s Survey, more than 30% of deals come from VCs former colleagues or work acquaintances. 20% of deals come from referrals from other investors, 10% from cold email pitches by company management, and 8% from existing portfolio company referrals. Jim Breyer, founder of Breyer Capital and the first VC investor in Facebook says, “I’ve found that the best deals often come from my network of trusted investors, entrepreneurs, and professors. My peers and partners help me quickly sift through opportunities and prioritise those I should take seriously. Help from experts goes a long way in generating quantity and then narrowing down for quality.”

The limitations of local networks

However, these findings reveal just how difficult it can be for entrepreneurs who are not connected to the right social and professional circles. As the old adage goes; ‘it’s who you know, not what you know’. This disadvantages entrepreneurs who don’t fall into the “white men” category - says, HBR.

This pathway ultimately neglects founders of colour, females, and those who live outside of the traditional hub regions such as London, Boston, Silicon Valley, and Beijing. These networks constrict our connections to analogous people from where we live and who we’ve worked with. This is dangerous for two fundamental reasons; one, if you’re only operating within a small proportion of society, how can innovators or startups be found outside of their applicable realms? And two, as Sarah Kunst, Managing Director of Cleo Capital, says, “If you’ve been under-promoted at every job you’ve ever had, your title might be several levels below your work experience, and your peers might not be in C-suites where they could hire you or appoint you to boards. If you’ve been underpaid, you may not have the free cash flow to join exclusive clubs or angel-invest, and those missed network nodes add up to incalculable losses in career and net worth.”

No standardised financial assessment

Few VCs use standard financial-analysis techniques to assess deals. The most commonly used metric is simply the cash returned from the deal as a multiple of the cash invested. Following that, the Internal Rate of Return (IRR) is the most commonly used metric. The reason for a lack of standardised assessment methods? VCs believe that success is quantified through the exit return, rather than estimations of near-term cash flow. As J.P. Gan of INCE Capital explained, “successful VC deals take a long time to develop, mature, and exit. We very much focus on potential return multiple rather than on NPV or IRR at the time of investment. IRR is only calculated after the fact when there is an exit for our limited partners.”

Overwhelming inbound traffic and superstitions

Most investors have so much inbound application traffic, sifting through large amounts of data without the aid of tools and a standardised assessment method constitutes a staggering task - further reinforcing reliance on trusted networks, as well as wasting time and resources.

However, much like Serena Williams attributes her success to the way she ties her shoelaces, investors have been known to over-analyse a successful deal in order to replicate the process exactly. They look to draw correlations to non-essential aspects and justify behaviours with the intent to create an identical outcome. These beliefs usually last less than a year and are later replaced by a new superstition. As Warren Buffett wrote; “nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball.”

Entrepreneurship inexperience

Many entrepreneurs with the greatest ideas have limited fund raising experience. Therefore, they have little context and appreciation for how much time must be sacrificed to source an investor. As Forbes says, the uncomfortable truth for entrepreneurs is that ideas are cheap… That doesn’t mean you should give up too quickly. If founders don’t have a network and are new to the business, it takes time. There will be a lot of no’s before the checks come.”

Ultimately, founders have a business to build, launch and run. Wouldn’t time be better spent fulfilling meaningful tasks, rather than seeking investors with a very low success rate? Fortunately, there are platforms like N2 Technology that do the heavy lifting. They continually place startups on applicable investor and VCs’ network radars - all the time.

Finding alignment

Even when a potential partnership is found, both parties’ visions must align. Investors look for companies that fit into their portfolios and how their experience and expertise can best help the founding management team. The problem for investors is that the best startups with inspiring entrepreneurs have intense competition to fund them. It’s important, therefore, as a founder, to work with an investor who offers more than the highest bid. Entrepreneurs must consider:

• The style and type of management an investor will provide,

• Someone who trusts in the vision,

• Has a valuable network,

• Has experience within the appropriate industry,

• Fits the companies’ brand and culture,

• Can provide adequate time and commitment.

Conclusion

In a time where technology is propelling us forward, and at a rate never been seen before, why are we stuck 30 years in the past? Phenomenal entrepreneurs are going unnoticed - or found too late - simply because they’re not mixing in the ‘right circles’. Entrepreneurs are not getting the education they need to play the funding game, and investors are recapitulating irrational procedures instead of relying on the credible data available. With Silicon Valley becoming overly saturated, and Covid-19 breaking down geographical barriers for business, “you can no longer look only in your own backyard for startups, innovation, and the talent that power them. Venture capitalists, used to looking close to home, need to broaden their horizons and think, look, and act globally,” says HBR.

Fortunately, times are changing with the help of technology, and the VC deal sourcing landscape is undergoing an overdue revolution. Effective methods for sourcing the best business opportunities with top talent have evolved. Over the last decade, matching investors with appropriate companies and leaders have matured. Reliance on traditional methods are being obviated by technology, automation, and data harvesting. Now, there are platforms that can identify, quality, and match best-suited startups and investors through clean data that is validated. Gone are the days of endless spreadsheets. We welcome more time to do the things that matter!

To find out more, please head to N2 Technology.