The word ‘startup’ is currently used to describe technology companies or technology-enabled companies that have the potential to get funding from angel investors or VCs. However, using that definition for a startup narrows the possibilities that the entrepreneur can pursue as a business because the kind of companies that VCs can invest in is a very small subset of the many kinds of businesses that entrepreneurs can pursue.
While many ventures can be good businesses for the entrepreneurs, they need not necessarily be a good investment for VCs. And to understand why that is so, it is important to understand the business model of angel investors and VCs.
The VC Business Model
Possibility Of An ‘Exit’ Is Critical
Investors make money when they sell shares they hold in your company. NOT when they buy the shares by investing in your company. So, unless there is a reasonable chance that they will be able to sell the shares to someone else – next round of investors, strategic buyers or, in very rare cases, IPO, there is no reason for the investor to invest, even if the venture becomes a reasonably successful business.
There Must Be A Reasonable Chance To Get More Than 10x Returns
Because many of the ventures they invest in will fail, unless the few successful ones return 10 – 20 times the amount invested, the investor won’t make money on the overall portfolio.
Market Leadership Is Important:
To get 10-20 times return on the amount invested, the venture must achieve a commanding position in a potentially large market … else the next round of investors won’t have any reason to buy the earlier round investor’s equity at a significant premium. So, even if a venture is a reasonably profitable company, but not in a reasonably dominant position, the investor will not be able to sell shares (certainly unlikely at a good premium) even if the business is a reasonably satisfying one for the entrepreneur.
Scale Is Important
Else the numbers just won’t work for the investors to get a decent return on their investment.
And therefore,…