Why an investor rejection isn’t a knock on you

A few years ago, a friend asked me if I could forward an email to Abc VC.  I told him that since that Abc VC didn’t invest in my company.
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A few years ago, a friend asked me if I could forward an email to Abc VC.  I told him that since that Abc VC didn’t invest in my company, I wasn’t sure if Abc VC thought highly of me.

Now that I sit on the other side of the fence, I realized that my thinking was flawed.  In many cases, if a VC declines to invest in your company, it isn’t a knock against you (caveat being this is true unless you’ve acted really rude to them and/or their team).  In most cases, rejections happen well before even meeting a team, so that VC doesn’t even know you!

Here are a few reasons why an investor will reject you that has nothing to do with you.

1. Your idea is undifferentiated

Investors see thousands of businesses a year.  Your idea is the 50th social networking site this week.  Unless you have a differentiated angle and approach to the problem and/or significant traction, an investor won’t be able to understand why you stand out and why they should back your horse instead of someone else’s.  This is especially true at the early stages.

Note: by differentiation, I’m not talking about product or feature differentiation but outcome differentiation.  For example, if you’re creating a new Mailchimp competitor, you might think your product is differentiated if your product has better tracking than they do.  That’s a feature difference.  The outcome-differentiation is probably lacking; people use Mailchimp to increase revenue by selling more products and services via email.  So unless your feature can increase that outcome – and not just incrementally by 20% but a serious differential like 10x – it’s unlikely that a current, happy Mailchimp customer will want to switch to your product.  Think about it. If you’re using MailChimp and make, let’s say, $100 in sales for every send, it’s going to be a real pain in the neck to move to a new product. Your whole list is set up and everything for just an additional $20 per send.

Often as an entrepreneur, it’s hard to know whether your product is differentiated because you don’t know what other startups are out there.  This is something I personally faced when running my company LaunchBit.  There were and are so many freakin’ ad networks, ad exchanges, and ad platforms out there that LaunchBit was just undifferentiated.  A business like ours will have a really hard time raising money at the early stages, and if that’s feedback you are getting from at least 2 people, you may want to consider adjusting your plan and raise from angels and/or bootstrap for a long time.  It doesn’t mean it’s a bad business. In fact, it could be a very good business for you.  It just means VCs will shy away from it.

2. Your idea is not the right fit for the stage or industry.

Your idea is not a good fit per the investor’s thesis or mandate.  Sometimes this can be incredibly difficult to see. For example, a lot of software investors don’t invest in e-commerce companies (we do not.).  The products are physical things that cost a lot to store as inventory, and fundamentally, this makes e-commerce companies a very different profile from products that are entirely digital (software, software platforms that don’t house inventory, digital products, etc.).

A lot of investors call themselves “early stage” investors and aren’t good fits for pre-seed companies.  Many of these investors mean “series A” or “post seed” when they say “early stage,” even though they will do a handful of pre-seed deals with founders they already know or with successful serial entrepreneurs we’ve all heard of.

What I’ve found to be most annoying about the VC industry, as an entrepreneur, is that you can never pin down what VCs like.  This is because VCs are always hedging so they can see everything just in case there is that rare exception that they would potentially invest in outside of their thesis.  The best way to assess what VCs actually like is to look at their portfolio.  If a VC says that they invest without traction, you should find out when they’ve done so and whether it’s because they already had deep relationships with that team or because that team has incredible pedigree.  Play out the probabilities in your head of who will actually be likely to invest in a random company at your stage.

3a. Your business model seems flawed OR is not the right fit

I talked a lot about unit economics and sales cycles in my last post.  For me, I personally think very heavily about the unit economics of a business, and if I can’t get conviction around the potential customer acquisition, that’s an immediate pass for me regardless of the team, market size, or product.  I do understand that teams can pivot, but we are already so early in the lifecycle – often first check into a company – that I can’t count on pivots.

VCs look at unit economics in different ways.  For example, some VCs have such deep pockets that they can throw a lot of money at a company and wait out a long sales cycle. That’s not Hustle Fund.  We are currently a small fund, so when we back a company, we need to believe that we can help that company get downstream funding from other investors with deep pockets OR that the company can bootstrap its way to success.

In order to bootstrap your way to success, it largely means you need high margins and fast sales cycles.  These are companies that we can get behind as a lone ranger if we see hustle, focus, and a differentiated solution.

If you’re in a category where you have a long sales cycle or smaller margins, then I need to think that I can “sell” your deal to other investors, either people who will invest alongside us or after us.  We talk with and do try to understand what a lot of our early stage investor peers are interested in to help inform our decision.  The point is, when we are looking at companies with these type of customer acquisition qualities, we cannot make decisions in isolation.  We need to believe other investors will buy into you as well, even if we are still the first check into your company.

3b. The market size is not big enough

For a VC portfolio to work out, a VC’s winners need to compensate for all the losses of the losers plus much more to provide great fund returns.  Not only does the fund need to be net profitable, but it also needs to outperform other assets that our would-be backers could be investing in, such as other VC funds, real estate opportunities, the public stock market, etc.  No one really talks about how VCs differentiate themselves and what they need to deliver to their investors, but this is a big factor affecting how they invest in companies.

For a VC, it’s not good enough to have a winner “only return 10x” even though that would be a phenomenal outcome for a founder or even an angel.  Most VCs need their winners to return 100x (or ideally more).

This is why it seems that every VC is harping on billion dollar markets.  If you do not think you have that big of a business, VCs are not going to be the right people to raise from.  Angels might be a better fit.

For me personally, I think the problem with market-sizing exercises is that you just don’t know whether a market is big or not!  Airbnb is probably the poster child example of this.  At the seed stage, it seemed like a weird niche idea to sleep on someone else’s air mattress.  What is the market size for this?  Basically zero.  But sleeping on a bed in someone’s house is an alternative to getting a hotel room, and the hotel market is huge. It’s just very difficult to know whether the market size is big or not in the early days, especially for seemingly “weird” ideas.

This is why I don’t care to ask founders about their market size.  Their predictions will be wrong, and so will mine.  Moreover, even if a market is big, it doesn’t mean the company can grab a lot of that market share.  This is why I very much focus on a bottoms-up approach to analyzing a marketing and look at unit economics, sales cycles, and customer acquisition.  If the unit economics and sales cycles are rough, I don’t care how big the market is; it’s going to be a long and difficult slog to capture the market, and that means a very capital intensive business.  Then that goes back to the question of whether I think I can round up co-investors with me or downstream investors to fund this.

In short, these are 3 reasons why a VC might reject your business when they haven’t even looked at your team or anything else about your company.  It doesn’t mean you necessarily have a bad business; it just might not be the right fit for that particular firm or the VC industry in general.  In most cases (caveat being you were rude to someone on our team), when we decline to invest in companies, we would very much welcome seeing a different business that the founder starts later and would be honored if the founder wanted to take the time to refer a friend who is working on a different startup.

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