Fundraising Venture Capital

Startup Handbook:

How to raise money from VCs

I want to explain why venture capitalists give 21 year olds $30,000,000 to pursue startup ideas.

What's going through their heads?

What specifically are investors looking for today?

Fo rcontext, most of my day is spent introducing founders to investors:

• I run a seed fund: Julian.capital
• I built VCSheet.com to help founders find VCs
• I run SeedChecks.com for founders to meet well-known angels

The first thing founders should know: Most seed VCs want startups that can reach a $1B+ valuation. Their investing lens revolves around that outcome.

I'll show you how to help convince VCs of your $1B pathway.

But, first, why $1B in particular? It's because it's typically needed to make VC portfolio math work: Let's say a VC fund makes twenty $1M investments. Say 19 startups go nowhere, which will often happen, and 1 goes from a $15M valuation to a $1B exit. When accounting for a 60% dilution from future funding, the return is $26M to the fund. So a single $1B company gives a 1.3x return on the fund's capital.

If a fund's lifespan is fourteen years, which isn't uncommon, a 1.3x isn't great.

So VCs are hoping for more than "just" a $1B+ outcome. And they want multiple such exits. In short: Seed VCs need huge outliers to make up for the odds: most of their investments will die.

(In reality: It's more common to see, say, 12 startups go to zero, 7 return 1.5-4x the initial investment, and potentially one return a lot. But I'm keeping the math simple.)

So, how does a startup reach $1B these days?

Typically, you need enough revenue multiplied by your sector's (e.g. D2C, fintech) average valuation multiple. This revenue-to-valuation multiple varies by competition, trends, and time, and is effectively set by public markets.

For example, you might have a $40M revenue business, but if you're selling shoes, you're therefore a D2C startup, which has lower revenue multiples than SaaS. So with, say, a 4x revenue multiple, you're "only" worth $160M.

There's another force affecting your valuation: If a public company similar to you makes $100M/yr and has a market cap of $1B (a 10x revenue multiple), then that may affect you.

But $100M/yr is a high threshold. Few companies in history have reached that. And this is why most startups fail to be suitable for VC.

What are the alternative funding paths for founders? There exist alt VCs who invest for greater equity, and maybe even profit share, but expect smaller net returns.

But there aren't many of those. And so most people are left to raising funds from friends and family. I like that approach, and I think it's the right path for most people. More people should run their startup as a bootstrapped lifestyle business.

That is so much better than feeling growth-at-all-costs VC pressure for most people.

Anyway, let's say you do need VC capital in order to get off the ground. In that case, how do you convince VCs you can be worth $1B?

Here's what VCs often look for.

Depending on the investor's style, they may index either on your startup's market pull or team quality (if not both). You have to convince VCs that you have both, in addition to other factors, but let's start with these two.

Market pull

What's market pull? It's the condition where your startup is so compelling at its price point that the market pulls it out of your hands the moment it learns of it. In contrast, there's market "push" where you have to slog to convince people of your product's ROI—as it's not self-evident.

Here's the good news: At seed, it's okay if you don't have market pull yet. Because VCs often invest on the belief that market pull will materialize in the near future. Meaning, most are okay with betting on where the world is going.

Four factors can cause market pull to emerge:

1. Consumer behavioral changes (eg. keto diet becomes trendy)
2. Regulatory changes (eg. weed becomes legal)
3. Technological innovation (eg. batteries become cheaper)
4. New distribution channels (eg. TikTok emerges)

I list the businesses most likely to experience market pull here. That page is a must-read for better understanding this concept.

VCs are trying to predict these trends to identify which ideas will experience market pull.

So, our first takeaway for pitch decks: If you don't have market pull yet, your pitch should explain why tailwinds will produce market pull for you in the future.

VCs don't mind waiting for market pull because if an idea looks weak today but great in the future, then future value won't be fully priced into the startup's valuation, and VCs can invest at a lower valuation. Valuation is often critical, especially at seed. So let's talk about that for a moment.

Aside: Valuation

The lower the valuation, the more the VC makes at your $1B+ exit, and that's why good VCs care about seed valuation. In fact, if they invest in you at a low enough valuation, they don't even need you to hit $1B. A $300M exit could still return their fund if they invested low enough. This is why VCs might be much more likely to invest in you at $10M than $25M.

Lowering your valuation is therefore a lever you have during fundraising.

Market pull

Anyway, back to market pull. It's worth repeating: convincing that there's present or future market pull is critical. In fact, many investors are tolerant of product and team risk, but have very little appetite for market pull risk.

Why? Whereas product and team can be iterated on over time, market risk is a brick wall—if no one wants you, it doesn't matter how well you execute.

Here's an exercise for assessing market pull for your startup idea:

1. 1. Find 100 potential customers that are representative of your total audience.
2. 2. Ask each to rank your startup idea out of 10 on how likely they are to pay a cash deposit to use it.
3. 3. Count the percentage of respondents who say 9 or 10. In my experience, only 9s and 10s matter. Don’t be misled by 7s and 8s—these aren't high enough to confirm conviction.
4. 4. Consider the percentage of respondents who say 9 and 10 as a proxy for how much of your total audience you could convert. Be realistic about audience size.
5. 5. See if you can get those 9s and 10s to actually pay a deposit. If so, you're onto something.
6. 6. Rinse and repeat for each idea you're considering.

This is simplified, but it's often useful during startup ideation. (For really novel ideas that people have to experience to believe, this exercise is less useful.)

Team quality

Beyond market pull, VCs index on team quality. In fact, perhaps 1/3rd of the VCs I know index way more on team than market.

Assessing a team's quality often comes down to diligencing whether the founders are forces of nature. Accordingly, here are criteria some VCs look for:

1. 1. Founder-market fit: Are the founders adept at the skills and customer empathy needed to make this idea succeed? For example:

   A. If this is a consumer startup, the founders may need strong product and UX sensibilities.
   B. If they’re B2B, they should be able to hustle through an enterprise sales slog.
   C. If they’re govtech, they should intimately know the sales process and possess a strong rolodex.

2. 2. Are they premeditative? Premeditative means they strategically think through decisions instead of YOLOing. They don't impulsively run at full speed without studying first. For example, do they know why historical attempts at their startup idea failed, what the learnings were, and where the landscape might go?
3. 3. Bias toward action: When the best decision is clear to the founders, do they pursue it without needlessly deferring?
4. 4. Do the founders think and express themselves clearly?
5. 5. Can the founders excite others to join the journey? Can they "sell?"

VCs assess most of these factors by talking to you across 2-4 calls and reference checking.

They pick up on cues fairly well—as this is mostly what they do all day.

Let's recap where we are so far:

• Most VCs look for $1B+ outcomes. The lower the valuation, the better.
• VCs build confidence in that potential $1B+ outcome by focusing on market pull and force-of-nature founders.

Convey these two points in your pitch—above everything else. In fact, do not end a pitch call without doing everything you can to reassure investors of those two factors. Don't trust them to ask the right questions that will let you talk about these. Many are lazily just checking boxes. Take control and impress them.

That said, even if you nail these factors, you're still likely to be rejected by most VCs. Why?

Why VCs pass on good deals

Why do VCs pass on so many good, $1B+ potential deals?

Often for two reasons (that they may not be transparent with you about): either they're not motivated to do the research to confirm your idea and space are as interesting as you claim. This happens a lot. VCs are lazy.

Or, while you might be very compelling, the VC has simply seen other startups that are more compelling—and there's only so many checks they can write.

Meaning, it's not so much about you as it is about them.

This is why VCSheet.com is so important (and free). It shows you which VCs invest in your sectors so you waste less time pitching those that are too lazy to learn it. VC Sheet also shows you VCs' publicly-available email addresses.

However, if you do pitch really well, you can absolutely get VCs who don't know your space (and aren't constrained to invest in certain spaces) to drop what they're doing and learn everything. This is what I try to do.

VCs will often fail to tell you these reasons candidly. When they're lazy or they think that you're just not as compelling as the other deals they've seen, they generally give you some other excuse to save face and avoid being confrontational.

Now, here's the other major reason why VCs pass: concern over competition. VCs fear that your competitors are better than you, or that tangential companies will line-extend into your space and suffocate you.

This is reasonable. In markets where there isn't enough room for many big winners—because there isn't enough market demand to split—competitive analysis is critical.

Fortunately, VCs are quite tolerant of old incumbent competitors—more so than competition from young and hungry startups. They know that old companies often can’t compete with the speed, iteration, brand, and adaptability of startups.

Regardless, this is why you must cover your competitive landscape in your pitch. This is the third most important factor after market pull and team quality. I've seen three counter-positioning techniques:

1. Do something no one else is—and get a big head start
2. Do something incumbents cannot do without hurting themselves
3. Be such strong, force-of-nature top 0.1% founders that VCs don't care about competitors—because they think you'll out-execute them

Let's expand on those points, because it's so critical that you convince VCs you'll beat your competition.

1. Do something no one else is.

Doing something hard that'll take other startups, say, two years to replicate gives you a head start to take over the minds and hearts of customers—and let network plus lock-in effects kick in.

Here are factors that may provide you with a head start: proprietary data, technological innovation, early regulatory approval, and more.

2. Do something the incumbent cannot.

For example, Google’s Android operating system is open. This is the opposite of iOS, which Apple keeps closed. As a result, Android carved out the entire non-iOS market for phone manufacturers.

Another example of doing what the incumbent cannot is livekindred.com (I invested). They're a competitor to Airbnb that does something Airbnb likely wouldn't: Whereas Airbnb charges nightly fees, Kindred charges a low annual fee then makes nightly stays nearly free. They do this by having members swap home stays with each other.

Airbnb is unlikely to replicate Kindred because doing so would annihilate the revenue model sustaining their massive market cap.

Other things VCs care about

VCs look for many other factors when investing, and certainly not all VCs invest the same way I've outlined here, but I'll touch on one last factor that I personally care a lot about: how you acquire users at scale.

As a marketer, this is where most founders I meet are weakest—and where you can stand out. In your pitch, I insist you explain what your scalable acquisition edge is. How can you acquire users at scale in a way that others cannot?

Product-led acquisition

One of the most compelling answers is walking through how you leverage product-led acquisition (PLA). To explain PLA, I have a quiz for you:

Which of the following channels is best for acquiring users?

Google Search · Instagram · Facebook · Quora · Amazon · Google Display · App Store · Pinterest · Snapchat · YouTube · Bing · LinkedIn · Affiliates · Influencers · Direct mail · Physical ads · SEO · UGC · Network effects · Thought leadership content · Referrals · Sales · Aggregators (e.g. Reddit) · Product-led acquisition · Speaking and events · PR · TV · Print · Radio · Community

The answer is…

... whichever cost-effectively scales for your startup.

But, alarmingly frequently, the best is product-led acquisition. PLA is when users naturally invite others while using your product.

For example, when you join Slack, you naturally invite your teammates and contractors so you can talk with them more easily. By doing so, you’re growing Slack’s user base for them—sparing Slack the need to spend money on ads.

Or, when you Venmo, Cash App, or PayPal someone money who doesn’t yet have an account on the app, there’s no way they won’t create an account to claim the $1,000 you’re sending them. Once again, you’re growing Venmo and Paypal for them by naturally encouraging others to sign up.

Many major tech startups of the last decade grew largely via PLA. Dropbox, Slack, Facebook, PayPal, Uber, Snapchat, Zoom, and more relied on users inviting others.

Y Combinator's Paul Graham phrased it like this:

"Don't start a startup where you need to go through someone else to get users." —Paul Graham

Here I explain the different types of PLA plus how to integrate them into your startup. I consider that a must-read for founders.

To be clear, I'm not saying you must grow via PLA, but I am saying it's one of the best ways to grow and it's one that VCs like because of its implied network effects and lack of reliance on third parties.

That's why I bring it up. VCs love it.

Putting it all together

Before I wrap, I want to dispel the myth that it's critical you have a warm intro when meeting VCs. Warm intros are better than cold, absolutely, but they're not necessary. Most VCs I know do in fact look at their incoming cold emails and skim them. Including me. Every day.

Indeed, VCs pass on the vast majority of incoming deals without much consideration—so prepare to be widely ignored—but many do skim to see if anything stands out for their interests. Because most funds, especially small ones, are not flooded with deals like you think.

This is why I suggest using VCSheet.com to find all the VCs who actually invest in your space. As mentioned, it's free.

Further, we built SeedChecks.com where you can submit your deck to 18+ well-known investors. There's no program to attend. No catch.

The vast majority of Seed Checks submissions won't get an intro, and now you know why: for all the reasons I've explained, VCs pass on the vast majority of deals, including many great ones, because they're not among the most likely companies they've ever seen to reach $1B.

It doesn't mean your idea isn't good or that you're not formidable.

Recap

For VCs to have conviction you'll be worth $1B+, many look for:

• Market pull and market timing
• Force of nature founders
• Ideal competitive landscape + counter-positioning
• Scalable customer acquisition strategy with an edge
• Big market with a scalable business model

Put quite simply: Are you among the most likely companies they've ever seen to reach $1B in valuation, taking into consideration how much revenue you must generate to be worth that much?

Now, all this said, should you even raise VC in the first place?