Rejection is a part of life, but the amount of rejection a founder faces in fundraising can be demoralizing and an emotional roller coaster. Often the reason an investor passes on investing isn’t because of you, and that rejection is not rejection of your startup. After doing early stage investing for three years, here are things I wish I knew as a founder when it came to building a VC-backed startup:
#1 Big Markets
To build a successful startup, one thing a founder needs to get right is to build in a big, growing market. Every startup needs momentum. It’s so much easier to find momentum if you choose large, growing markets. For the founder this produces amazing tailwinds to help get to product market fit.
However, how big is big to be considered a VC-backed company? Large markets are billions plus for VC-backed companies because of VC math. In VC Math, even a 100x exit , which could be great for the founder, may not make money for the VC because they only take a percentage of the profits. [a]
This is why investors look for billion-dollar-plus addressable markets. A VC knows that 95% of startups fail, so they bet on the startups that have the potential of becoming multi-billion-dollar companies.
The recommended way to size up a market is to look at the Total Addressable Market (TAM). This means the total dollars addressable to you as a startup. This method is also referred to as “bottoms-up”. The easiest way to calculate this is:
# of potential customers * average dollar amount per customer/per year = $$ = TAM
And hopefully your TAM is in the multi-billions. [b]
#2 Paint the Upside
The largest mistake a VC can make is underestimating the upside of a startup.
Anu Hariharan, YC Partner and previous partner at A16Z, talking about investing in DoorDash.
There are so many reasons to say no, but VCs only win by saying “Yes”, and “Yes” to the right ones. No one gets points for calling out failures, only winners. This is where you as the founder can paint the picture that if your startup succeeds, it will be as big as Amazon, Cloudflare, Google or EPIC - you’ll own a large part of a growing market.
But how do you do that when you’re still in the early stage? Highlight these most important aspects:
Progress/Traction: How does the investor know this is something people want? Revenue growth
Unique Insight: What you know that competitors don’t know?
Team: What is the superpower that enables your team to execute better than others?
Why Now: Sometimes timing is obvious, but when it’s not, it’s great to highlight
Vision: When this becomes $100B company what does it look like and how will you get there?
#3 It’s not you, it’s them.
Yes, you can fix your pitch and yes you can work your process, but some things you cannot fix - like how VCs are incentivized. [c] I really wish I knew this as a founder, and realizing that rejection from investors was not because we didn't build something great, in a large growing market with a great upside.
VCs manage someone else’s money
I used to think that VCs had all the power because they decided whether or not to give our startup money. I also thought that they were just insanely rich (hahah), so they had full control over the money they invested. But, I found out quickly that VCs raise money from other people called Limited Partners (LPs). These LPs tend to be institutional funds, university, and endownments who are trying to manage pension funds. Remember: Everyone has a boss.
When I was at Kabam, one of our VCs had an LP meeting and hoping to have some of these LPs visit their portfolio companies. Our company opened our doors to host. Imagine my surprise when the person who was an LP (or likely representing the LP) was a young professional just out of college managing a pension fund in Europe. I couldn’t believe that my investor’s investor looked so different than what I had envisioned, and our investors too had to also hustle for money to invest in us.
VCs are effectively money managers paid to invest in startups. They aren’t all knowing and definitely cannot be your boss. In fact, you really don’t want them to be your boss because they would be horrible at it. They have fiduciary responsibility to invest their money wisely [d]. VC’s make 20% of the profits and a 2% management fee yearly for the life of the fund. This means that their salary is based on how much they raise, and a nice return is based on how well their investments do. Their fund performance impacts future ability to manage and invest more money. [e]
So, sometimes rejection is not personal as the decision is dependent upon problems specific to VCs like the ones below.
Shots on Goal and The Power Law (VC Math)
The size of the fund dictates the size of each check and the number of checks that can be written. Each check represents a “shot on goal” or a chance to invest. Often, VCs will invest 20-30% of the fund within the first 2-3 years and save the rest for follow-on [f].
I recently spoke to an Investment Partner at a top-tier Series A VC Firm and they said that while they mainly do A’s, they also do seed. I asked how many deals each partner can do a year, and they said “1-3 deals, inclusive of seed”.
VC Math is also referred to as “The Power Law” [g] This means that 1-2 investments will “return the whole fund” and make money for the LPs. I highly recommend taking a look at how Elizabeth Yin explains why VCs are Obssessed With Unicorns (aka billion dollar companies)
VC is one of the few businesses where you can be right in a big way only once and be tragically wrong all the other times -- you will be successful.
Now that you understand how VCs make money, you can see that there are many reasons why an investor says no that may have nothing to do with you:
The VC may have already invested most of their fund
The VC may have just invested in a direct competitor
The VC couldn’t convince their partner (every fund has a different process, so be sure to ask about their process!)
The VC may not be interested in your market (which you can find out before meeting)
The VC may not be interested at your stage (which you can find out before meeting)
And because an investor always wants to keep the door open to invest, oftentimes they won't tell you the real reason, or sometimes they don’t know. And, this is why many give this advice to founders raising money, listen to the “no”, but not the reason.
If you are a founder raising money, and an investor says no, don’t listen too hard to the reason because oftentimes it’s not you, it’s them. And if you want to increase your chances of closing the check, make sure you are building in large, growing markets and painting the upside.
Above all, always help them see the upside of the business and of working with you.
I recently re-quoted this to my investor friend about the parting thought you should leave an investor:
“There is a high likelihood this will fail, but if it doesn’t, it will be big.”
To which she replied:
“There is a high likelihood we will enjoy working together, AND this will be big.”
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