Venture capitalists (VCs) play a crucial role in the American economy by financing startups. Every day we read headlines about the successful organizations VCs have backed — like Google, Whole Foods, Facebook, and Apple, to name a few — but most people don’t know much about how the process works or how venture capitalists find companies.
Welcome to the first blog in a series of articles to demystify the process. Over the upcoming weeks, we’ll explore all the details about how venture capitalists find companies and even come to buy them. From finding and evaluating potential companies to best practices after the investment and organizations that can help you along the way, we’re going for the deep dive.
Whether you’re a newbie recently contacted by a family member who hopes you’ll invest in their company, a long-time VC, or an entrepreneur hoping to attract an investor’s attention, this series is a must-read. We’ll talk about how VCs hunt for deals, assess opportunities, add value to portfolio companies, and operate their firms.
Let’s begin with a look at how professional VCs do business. Let’s focus on those who make a living every day and how venture capitalists find companies in a variety of industries and scenarios.
What VCs Really Do
Like wizards in Oz, venture capitalists seem to move about in cloaked secrecy. With the number of startups that fail (70% of them will, just within the first ten years), we can’t blame them. No one wants their name associated with a major wreck like WeWork, which we’ve covered before. But with great risk can come tremendous rewards.
In the broadest sense, venture capitalists connect entrepreneurs with ideas with the funding they need to move forward. So as an aspiring VC, you need access to plenty of cash and a mind for numbers. But you’ll also need imagination and a tendency for overthinking. After all, you’ll be partnering money with an entrepreneur who may have tunnel vision and a sense of ownership regarding their “baby.”
If you know you have what it takes, then let’s find out where venture capital firms find prospective matches.
Where Do Venture Capitalists Find Companies to Work With?
The first task a VC faces is connecting with startups that need funding. In the industry, we call this “generating deal flow.” According to an article published by Harvard Business Review, Jim Breyer — the first VC investor in Facebook and founder of Breyer Capital — says high-quality deal flow is essential to solid returns.
The big VC firms rely on a few different resources for leads and potential matches. Per Harvard Business Review, only about 10% of the deals they make result from a direct pitch from an entrepreneur, and 30% of their deals come through peer-to-peer referrals.
Online resources and matchmaking databases exist (and we’ll talk about them in a moment), but the experts do a lot of networking in the industries they find appealing. For an aspiring VC, that could mean:
- Attending trade shows and industry events
- Chamber of Commerce activity
- Joining professional organizations
- Constant research, including buying subscriptions to industry publications
It’s impossible to be a master of all things. The point is to get your finger on the pulse of a specific industry, as the pros don’t hand out money to every entrepreneur that asks.
Websites and Services That Help Venture Capitalists Find Companies and Evaluate Them
Thanks to the beauty of the internet, there are dozens of online resources entrepreneurs and VCs can use to get acquainted. They include:
The list doesn’t end there. Just spend some time on your favorite search engine to get more ideas. Social media should also be part of your toolkit.
Of course, you don’t need to choose one specific sector in which to work. But in the early stages, confidence helps.
Choosing a Speciality Sector
So the first questions to ask yourself are:
- Which industries do I understand well?
- Which companies or inventions could blossom quickly with a cash injection?
Now, a deep understanding of a particular industry doesn’t guarantee success. In fact, a fresh perspective and “outside-the-box” ideas can be far more valuable to all sides of a company: the entrepreneur, prospective customers, and the VC. But a basic knowledge of how a business works can be invaluable.
Also, some industries are extremely difficult to break into unless you have a solid background. Healthcare, for instance, is a rapidly growing sector with all kinds of future potential. But these companies face so much regulatory oversight and inherent insurance risks that a minor slip can be crushing.
Retail can be highly challenging, too. Between eCommerce websites, big box stores, and an uphill battle against heritage brands like Johnson & Johnson or Stihl, the company you choose to invest in must be a real winner with something genuinely fresh and valuable that will be hard to knock off for a while.
Finding the Right Company to Invest in Without a Third-Party Subscription
Maybe you’re not interested in joining a platform with every other unicorn hunter out there. Perhaps you’d rather try this on your own. So, how do you look for a company and evaluate it? First, look for signs that an organization is growing and would welcome an outside investor.
Signs That a Company Is Poised for Growth and Could Use an Investor
Let’s think about this from a Main Street point of view. You’re an aspiring VC and would like to invest in local organizations in your hometown.
Start by watching the companies that interest you. You’re looking for signs that a company is poised for growth. Venture capitalists find companies by:
- Looking at their website traffic and social media activity for ballooning activity
- Monitoring job postings for that company to see which positions they’re advertising for and how often
- Experiencing their product/service in person; try their new ice cream product or play their new video game, and ask others to do the same.
Once you’re confident that a business is about to boom, arrange a meeting with the entrepreneur to get a feel for them. But not every startup and VC will be a good match. Some companies are asking for hundreds of millions of dollars and very little involvement from the VC. On the other hand, some startups need expert help and counseling. Ask yourself: can you provide the industry insights they need?
When meeting with an entrepreneur, you must be transparent about your firm, your perceived future involvement, and your investment strategy. It helps to have a website or blog that explains your goals and methods and provides details to prove you are an authority in this field or sector.
Now, one of the most frequently asked questions about this process is how to value a company. In the following article, we’ll take a deeper dive into valuation methods before, during, and after the sale of a business. But let’s set down a framework here.
Introducing Valuation: Learning to Determine What a Business Is Worth
Before investing in any business, you must attempt to understand what that company is worth and what it could be worth in the future.
What Is Valuation?
Investopedia says it well, “Valuation is the analytical process of determining the current (or projected) worth of an asset or a company.” Several techniques are used for doing a company valuation, and we’ll explore those in our next piece. For now, know that an analyst placing a value on a startup looks at the composition of its capital structure, the management team, the prospect of future earnings, and the market value of its assets, among other things. Sometimes, the value and activity of competitors are used as a reference point.
Two Main Categories of Valuations
Two primary categories of valuations are:
1. Absolute Valuation Models
These models attempt to find the intrinsic or “true” value of an investment based only on fundamentals. This method focuses on quantifiable numbers: dividends, cash flow, and the growth rate for a single company. It doesn’t compare this startup with other companies in the industry. Per Investopedia, valuation models in this category include the following:
- Residual income model
- Dividend discount model
- Discounted cash flow model
- Asset-based model
2. Relative Valuation Models
On the other hand, you can compare the business in question to other similar entities. These methods involve calculating multiples and ratios, like the price-to-earnings multiple, and comparing them to the multiples of similar companies. For instance, when social media was in its infancy, investors like Jim Brewer (mentioned above) probably compared Facebook’s future to the day’s industry leader, MySpace.
Of course, from time to time, a startup will crop up that doesn’t have much data available for either valuation method. When MySpace was in its infancy, there was very little in the world to which it compared. Also, we’ve all heard the unicorn stories about garage-based companies like HP and Microsoft, which had little income and few assets in their early days.
The topic of valuations is worthy of an entire article, and that’s the next blog in this series. So stay tuned for that!