VCs Reveal Their Top Criteria for Funding a Startup

VCs Reveal Their Top Criteria for Funding a Startup

Venture capitalists (VCs) receive hundreds of funding applications from startups every year. With so many options to choose from, VCs have developed a rigorous set of criteria to quickly assess which startups are worth investing in.

The Founding Team

The number one thing VCs look for is an excellent founding team. As one VC put it on Quora, “We invest in people, not ideas.” A startup could have the most groundbreaking idea, but without an effective team to execute on that vision, the business will fail.

VCs want to see that the founders have relevant expertise, industry connections, and a strong track record of execution. According to research on startup funding criteria, over 90% of VCs said the team was the most important factor in their investment decisions. Specific things VCs look for include:

  • Relevant experience: Has the team successfully built a company before, especially in the same or similar industry? Do they have experience working at top companies that equip them to succeed?
  • Technical capabilities: Does the team have strong engineering talent to build the product? What is their track record of shipping high-quality products on time?
  • Business and sales abilities: Does the team understand the fundamentals of business, like finances, marketing, pricing, etc? Do they know how to sell? The best ideas won’t succeed without solid business execution.
  • Commitment and grit: Is the team working on this full time? Are they willing to dedicate everything to making the business work? Founding a startup takes immense personal sacrifice.

Market Size

In addition to the team, VCs carefully evaluate the startup’s market opportunity. As one VC said on Quora, “We’re looking for big markets. Ideally $1 billion or more.”

VCs focus on massive addressable markets because that’s where the biggest potential payoffs – and financial returns – are. Even a small slice of a billion-dollar market can mean huge revenues. Specific elements VCs consider include:

  • Market size: How big is the total addressable market, in dollars? Is it growing or declining?
  • Competitive landscape: How crowded is the market? Who are the major players? Is there room for a new entrant to capture share?
  • Customer demand: Do customers urgently need this product or solution? Will they pay for it? Understanding real market pain points is key.
  • Business model: Does the product lend itself to a compelling business model? Can the company generate recurring revenues through subscriptions, etc.? This impacts how easily the company can scale.

Traction and Metrics

The third critical element VCs evaluate is traction. They want to see that the startup has already gained some customer adoption and has momentum in the market.

As one VC explained on Avvo, “We don’t expect startups to have much traction, but we need to see some level of customer validation, even if it includes pre-orders, crowdfunding campaign results, or conversations with prospective customers.”

Specific traction metrics VCs look for include:

  • Revenue growth: What are the startup’s current revenues? How quickly are they accelerating? High and rapidly growing revenues suggest strong product-market fit.
  • User or customer growth: How many users or customers does the startup have? How quickly has this grown over the past few months? Rapid user growth signals that customers derive real value from the product.
  • Engagement and retention rates: Are existing users actively engaging with the product? What percentage of customers churn each month? High engagement and retention rates indicate the product successfully meets customer needs.

Product/Market Fit

In addition to evaluating traction, VCs probe into product/market fit. Product/market fit means the startup has built a product that effectively meets market demand.

As one VC explained on FindLaw, “We look for startups where the dogs are eating the dog food – where customers are deriving so much value from the product, they can’t live without it.”

VCs assess product/market fit by speaking directly with current customers and users. They ask questions like:

  • How urgently do you need this solution? How badly does it pain you not to have it?
  • How does this product meet your needs or solve your problems?
  • Would you recommend this product to colleagues or friends?
  • On a scale of 1-10, how disappointed would you be if you could no longer use the product?

Defensibility Against Competition

VCs also want to see that startups have a sound strategy to defend themselves against competitors. Since successful startups often spur other companies to enter the space, founders need to showcase their sustainable competitive advantages.

As one VC noted on Quora, “We look for proprietary tech, exclusive partnerships, or innovative business models that can’t be easily copied.” Other elements that build defensibility include:

  • Patents: Does the startup have patented intellectual property, like algorithms or data models? Patents prevent competitors from replicating unique IP.
  • Proprietary data: Does the startup own or have exclusive access to unique datasets that competitors can’t access? This proprietary data powers better products.
  • Switching costs: Will customers face high costs to move to competitor products? Things like data migration and retraining employees on new systems create inertia.
  • Network effects: Does the product become more valuable as more users join the platform? Network effects lead to self-reinforcing growth that is hard to displace.

By demonstrating sound competitive defenses, startups can provide VCs confidence that the company will retain its market position even as new entrants emerge.

Clear Monetization Strategy

Finally, VCs need to see a viable path to profitability. They pay close attention to the startup’s monetization and revenue model.As one VC advised on Avvo, “We need to understand how this becomes a money-making business. Sell us on how this will make enough profit to deliver strong investment returns.”Key elements VCs evaluate related to monetization include:

  • Revenue model: How will the company generate revenues? Common startup models include subscriptions, commissions, licensing, advertising, and more.
  • Profit margins: What are the unit economics like? How profitable is each customer? High margins and negative churn are attractive.
  • Customer acquisition costs: How much does it cost to acquire each customer? Can this be done profitably at scale? Low CAC indicates an efficient model.
  • Payback period: How long does it take to recover the costs of acquiring a customer? Faster payback periods mean faster growth.

By showing a viable path to profitability, startups demonstrate that their business can sustainably scale into a high-growth, high-margin enterprise. This convinces VCs that their investment will pay off.

The Bottom Line

VCs reject over 99% of the funding applications they receive because most startups fail to meet the rigorous criteria around team, market, product, traction, defensibility, and profitability.However, while VC criteria sets a high bar, thousands of startups successfully raise funding every year after proving they have what the best investors look for. With a strong team, large market, compelling product, promising growth, competitive defenses, and realistic monetization strategy, startups can secure the backing they need to scale into market leaders.

Resources

Quora: What do venture capitalists look for in a startup?

Avvo: What VCs Want: An Investor’s Perspective on Startups

FindLaw: What Do VCs Look for in a Startup?

Quora: What unique things do VCs look for in startups before investing in them?