As an entrepreneur, it never even crossed my mind to think about how investors decide which companies to invest in. Lots of investors blog generically about how they invest in great teams, big markets, maybe some traction, yadda yadda yadda. Regardless of the VC — whether it’s a big VC that will lead your seed, series A, series B, etc. rounds or a small micro VC that will only write a small seed check — they all generally think about the same characteristics of your company. They may have differing theses on these characteristics and form different conclusions, but they all look into the same things.
Except one.
There is one criterion that micro VCs must consider when deciding to invest in a company. And no one talks out loud about this.
Whether or not a company can get downstream capital from other investors in the future.
A micro VC, by definition, writes small seed checks and doesn’t do any follow-on investing. This means that once they have written their check, the firm cannot carry the company further. Certainly they could help with advice and introductions — but not with money.
There are exceptional cases where a company will never need to raise again after a seed round and will still be able to continue its growth, but this is a bit of a rarity. A micro VC must consider what will happen if a company is not able to raise beyond the seed check. Will the company go under? Will the founders be so tenacious that they will keep ploughing through no matter what?
This makes it difficult for micro VCs to make contrarian bets – investments in companies that few or no other investors will touch. Most micro VCs will pass outright. Contrarian investments are often companies that are in:
- Competitive markets
- Markets that other investors hate
- Unusual markets that most investors don’t think about, think are small, or think are insignificant
At 500 Startups, we are not really doing follow on investments these days, and so when I meet a founder and have conviction to invest, I have to believe that he/she will be able to raise beyond my small check. I’m pretty upfront with a founder in telling him/her that I think it will be difficult for him/her to raise further. Often, I’d want to know what would happen if he/she were not able to raise beyond my check.
Personally, I’m comfortable making a contrarian bet — even as a small investor who isn’t able to write a follow on check (after all, Google was like the 8th search engine in a super crowded space…). BUT, I have to have a lot of conviction that the company has above-and-beyond more tenacity and survivability than what I would expect from other companies AND that the outcome, if all went well, would be more lucrative to my firm than alternatives. Essentially, I’m expecting them to prove out equivalent progress to their fast-growth peers and sit out one round of funding, hoping that the next set of downstream investors will pick them up after proving out more.
Competitive markets
If I’m making a bet in a competitive market where there are multiple alternatives, usually, I’ll drill into the details, differences, and nuances of the product and user experience a lot more than, perhaps, a company in a more empty market. It’s these details — this experience — that often makes all the difference.
It has to be a BIG difference, not just incremental, in order to win in a competitive market. Sometimes it’s not the product or the user experience that makes this 10x difference — sometimes it’s in the business model — but I’ve found it usually ends up trickling down to the user experience as well.
Markets that other investors hate
Markets tend to be cyclical. One of my pet peeves is that markets go in and out of favor – usually for no good reason (though not always). Usually what happens is that investors have poured too much money in a given space, and then a few high-flying companies in that space end up going belly up. Then, everyone else up-and-coming in that space suffers because investors are no longer excited about investing in more companies in that space.
Unfortunately, if you’re in one of these spaces, there isn’t a whole lot in your control. It will simply be harder to raise money. It doesn’t mean you have a bad business – it just means that there may be less investor appetite for your business at this time. The good news is that all of these markets are cyclical, and so your business may come in favor with investors in a few years again.
Unusual markets
I think this is changing but still has a ways to go. If you’re serving a customer base that either few investors understand or understand as a lucrative or big opportunity, then investors may just pass outright. In the past, this has been more of an issue because a lot of investors have traditionally had a similar worldview. With newer investors and firms emerging with different perspectives, you may be able to find someone with a similar thesis if you look hard enough.
All-in-all, if you have a company that falls into one of these categories, you should know that micro VCs, in particular, will need to find more conviction than usual in order to invest in your company. They simply cannot carry you beyond their initial check and rely so much on downstream investors to help their companies in the later stages.