Venture Capitalists: Why and How They Invest in Startups

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My name’s Scott Bleier and I’m a corporate lawyer and partner at the law firm Morse, Brown, and Pendleton in Boston, Massachusetts, where I focus my practice representing entrepreneurs, start-up companies, and venture capital investors.

Today we’re going to talk at a high level about venture capital investing, specifically why venture capitalists tend to invest in companies in the first place. Then we’re going to scratch the surface and talk about some of the different funding models that venture capitalists typically use with start-up companies.

What’s the market opportunity size?

So first things first: I’m not a venture capitalist, but, as a lawyer that works with start-up companies that receive venture capital financing, oftentimes startup companies will approach me and say, “Scott, what are some of the factors that venture capitalists consider whether deciding whether to invest in a company in the first place?”

I think we can distill that down to a handful of components that go with the decision-making of venture capitalists. The first one is: what is the size of the market opportunity for the start-up company? Venture capital firms typically want to invest in companies that can be significant players in larger markets, not in small niche markets.

What is the problem that you as a startup company are trying to solve? Is it a large problem that is a problem encountered by a lot of individuals and potential consumers down the road? Size and market opportunity are very important for venture capitalists when deciding whether your business is a viable business to invest in.

Competitive Advantage

Number two, what sort of competitive advantage do you as a startup company have? Venture capitalists love to invest in companies that really have a head start on the competition, whether it’s some sort of proprietary intellectual property that you have or perhaps intellectual property that you have patented so that you can foist off competition from other competitors. Do have an innovative sales and distribution channel that is really setting you apart from the rest of the pack? If you can show that you have an advantage over your competitors that’s going to allow you to grow more quickly and more efficiently than other companies, it’s a major check in your column in terms of your ability to be able to raise money for venture capital firms.

How strong is the management team?

Next, how strong is the management team or the founder team? At the end of the day, a venture capitalist is not only investing in a business and the business idea, they’re investing in you, the entrepreneur and the founder. Start-up companies can go through peaks and valleys and twists and turns. Venture capitalists want to make sure that they’re essentially betting on the right horses and in a race to the finish line. So, the strength of the management team can be something that’s very attractive to a venture capitalist. The management team profile, the personalities, and the makeup of the interrelationships amongst the cofounding team are important factors for venture capital investors considering investing in a startup company.

Customer Validation

Lastly, customer validation is very important. At the end of the day, companies exist to create users and customers to sell products to. If you already have some customer validation and you’ve already started selling some of your products, that’s going to be compelling evidence for a venture capital investor to take a chance on you. It’s always easier to show something to someone as opposed to tell them something. Rather than saying, “If I only had $1,000,000 in my bank account from you, Mr. or Mrs. Investor, look how I’ll be able to grow my company,” it’s a more compelling argument to say, “Look, despite having little-to-no investment capital, look what I’ve been able to achieve. If only I were to have some additional investment capital account, look at how I’d be able to scale and grow my business.” Again, early customer validation is a very positive mark for a startup company looking to raise venture capital investment.

Published Data

Having spoken just a bit about the reasons venture capital investors decide to invest in startup companies in the first place, let’s talk really quickly about what some of the published data is saying about the number of the companies that are receiving venture capital financing in the United States. The published data suggests that in 2015 there was about $72 billion invested by venture capital firms in the United States, and those went to about 4000 different companies. Bear in mind, that’s not all startup companies. That incluldes private companies at all stages of development, from very nascent stages with seed financings to more mature companies that are having series C or D financings.

In the aggregate, about $72 billion was invested across 4000 companies in 2015. In terms of a breakdown by industry, about 55% of that money was invested in technology companies, and about 45% of that money was invested in life sciences companies.

There are regional breakdowns available from publicly available data that you can look into. I work on the East Coast in the Boston area. About 10% of that total money was invested in the Boston area in 2015, about six or seven billion dollars with more or less the same breakdown between life sciences companies and technology companies. Hopefully, that gives you an idea of the order of magnitude in terms of the number of companies that are getting financed and the amount of dollars that are actually being invested in companies.

About Scott Bleier

Scott’s practice is focused on the representation of entrepreneurs, emerging technology companies, and venture capital investors. Scott specializes in corporate and securities law; private financings; and mergers and acquisitions.

Scott regularly speaks on entrepreneurship, startup companies, and financings, delivering presentations to entrepreneurs, investors, and lawyers at the Cambridge Innovation Center, Swissnex Boston, the American Bar Association, and the MIT Enterprise Forum. Scott currently chairs the Venture Capital Transactional Issues sub-committee of the Business Law Section of the American Bar Association.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

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