7 Factors VCs Look for in Tech Companies
Did you know that there are about 75,600 tech startups in the US as of 2024? In comparison, by the end of 2023, there were only 3,417 venture capital firms. A limited pool of VCs is tasked with evaluating and shortlisting startups for investment. Because of all this competition, securing funding from VCs is extremely challenging for tech startups.
VCs want a clear plan for scaling operations based on a validated proof of concept. They often consider businesses that can scale quickly and efficiently through technology or innovative processes.
Hence, tech startups need to cover all bases when seeking funding from VCs. To help you do so, in this article, we will guide you regarding the seven most important factors from a VC’s perspective. Read on to know more!
How VCs choose tech companies for investment?
VCs employ certain criteria to decide which tech companies to invest in. Investment philosophies vary among VC firms; some concentrate on particular industries, while others avoid sectors they deem saturated.
Some of the factors that you must pay attention to when seeking funds from VCs are:
Capable and Experienced Team
In a tech startup or any startup for that matter, the factor that has the most influence on the success or failure is its founding team. These are the people you count on to refine the business idea, develop the prototype, find the right market for the product, form strategic partnerships, and establish distribution channels. They are also responsible for finding talented employees to add to the team.
The founding team must be equipped with the skills, experience, and mental strength to keep the startup going through the various challenges a startup faces.
In tech startups, the skills of founding teams tend to be concentrated on the technical side. We tend to see a high concentration of programmers and engineers among tech founders. While this may work until the prototype is developed, someone must figure out the go-to-market (GTM) strategy. Initially, the startup could get away with outsourcing some of the finance-related tasks but eventually, it would need someone who can lead finance-related operations to ensure cost efficiency and tax compliance.
Hence, there needs to be a healthy skillset balance among the founding team.
Product-market Alignment
Product-market fit is achieved when the product meets the needs of the market being targeted. If a tech startup makes it to this stage, it will have repeat customers. If the startup is operating on a subscription model, it will see a rise in the ratio of subscribers to freemium users.
Achieving product-market fit significantly reduces the risk for tech startups, making them a more secure investment.
After this product development milestone is achieved, the startup can move towards scaling up production, refining the product over time, and marketing the product to a wider audience.
However, if the product-market fit is not achieved, there will be doubts about the commercial viability of the business idea.
If the product lacks the required features or does not have an appealing design, the product-market fit could be achieved by further developing the product. However, if the product is trying to solve a problem that the target audience does not need to be solved, then, it will be difficult to find repeat users, let alone find paying customers.
Unique selling Proposition
Competitive advantages are especially important for tech startups. A lot of funding is required by tech startups for research and development (R&D). So, if their products and services are easily replicable, it would be challenging to recover the R&D costs.
Hence, tech startups must secure unassailable competitive advantages arising out of intellectual property rights (IPRs), strong brand power, network effects, and exclusive partnerships.
For instance, even though the Dvorak keyboard layout is considered the fastest for English typing, the QWERTY layout dominates the market because of network effects.
When a startup has unassailable competitive advantages, its growth is sustainable, it can charge a premium in comparison to its competitors, and the scalability and profitability are increased. Another benefit is that the investors will have more exit opportunities since the startup can be expected to survive for longer.
Streamlined cap table
A simplified cap table has clear ownership structures, a limited number of stakeholders, a lack of complex securities, and presents key information in an organized and detailed manner. Cap tables are the starting point for dilution analysis, an important exercise for investors.
VCs would like to check the anti-dilution rights of other investors and your employee stock option pool. If an investor has anti-dilution rights, they will be the first party to be offered new shares in future funding rounds. This right could dilute the percentage stake being offered to the VCs. Also, the employee stock option pool size represents the potential dilution from equity compensations.
Other issues that VCs would like to identify from cap tables are:
- Concentration of equity and voting powers with early investors and founders
- Difficulties in identifying parties with the most influence due to convertible securities
- Complex ownership structures involving numerous classes of shares
- Outdated employee stock option pools
Strategic Partnerships
Many tech startup products are not directly used by individuals. Instead, these products are integrated into websites and business processes. For instance, Cloudflare’s website application security services are used by various platforms but not many internet users know about it.
Another example of such tech products would be Plaid. This company facilitates communication between financial services companies, banks, and credit card providers.
Such tech companies could not grow without strategic relationships. For instance, Plaid has partnered with companies from payments, banking-as-a-service (BaaS), card issuing, credit, crypto, consulting, digital banking, investments and wealth, payroll, climate tech, data security, and personal financial management (PFM) industries.
Market dynamics and growth rate
When a VC is shortlisting tech startups to invest in, typically, the first thing they look at is the industry and market segment they operate in. In recent years, AI companies like xAI, OpenAI, Scale AI, and Cyera have raised the most funds. The forerunner of the AI movement, OpenAI, recently raised $6.6 billion in a funding round.
These companies were able to raise such enormous funding because AI is a nascent industry with a large market opportunity that was previously untouched.
However, just operating in a high-growth potential industry is not enough to convince VCs to sign a cheque. During a funding round, VCs will verify the market opportunity based on the following factors.
| Factor | Description |
|---|---|
| Total addressable market (TAM) | This is the total demand in the market the startup is trying to target. |
| Serviceable addressable market (SAM) | This is the total demand in the startup’s product segment. SAM is a part of TAM relevant to the startup’s product segment. |
| Serviceable obtainable market (SOM) | This is the part of SAM that a startup can realistically capture. |
Expandability and Market entry
The idea behind funding rounds is to inject funds into a startup at different stages given that it meets certain performance criteria. Eventually, the startup is expected to reach a critical mass where it has enough momentum, customer base, and market presence to sustain itself. At this point, VCs and other startup investors hope to make their exits either through initial public offerings (IPOs) or buybacks.
However, to reach critical mass, the business idea must be scalable and commercially viable.
When you meet with VCs, you must present a clear and detailed plan for scaling your operations. This plan should outline the key steps you intend to take, along with a comprehensive list of requirements, including the necessary talent, funding, technology, and strategic partnerships.
You must also present how the unit economics of your tech startup will change with scale and other developments.
Eqvista – Your partner in funding success!
When VCs are scrutinizing an investment opportunity, they first look at the team’s capability, temperament, and combined skill set. Then, to ensure commercial viability, they will verify if the tech startup’s product has achieved product-market fit. Since tech startups require expensive R&D investments, VCs will want to invest in ones that have unassailable competitive advantages. Otherwise, the R&D investments will be difficult to recover.
If a tech startup connects various players in a value chain or supports other products, it must build strategic relationships and this is something VCs like to verify. To assess the market opportunity, VCs also review factors like total addressable market (TAM), serviceable addressable market (SAM), and serviceable obtainable market (SOM).
Another critical factor considered by VCs is whether the tech startup’s product is scalable enough to reach critical mass and commercially viable. This determines the tech startup’s exit potential.
A factor often overlooked by tech startups is the state of the cap table. Maintaining a simplified, organized, and detailed cap table can go a long way in sealing the deal with VCs. This is an area that Eqvista’s cap table management software can assist in.
We provide features like round modeling, financial reporting and compliance support, and shareholder portals to enable smooth and effective equity management. Contact us to know more!
