Source | LinkedIn : By Prajakt Raut
The word ‘startups’ is currently used to describe technology companies or technology enabled companies that have the potential to get funding from angel investors or VCs. However, using that definition for a startup narrows the possibilities that the entrepreneur can pursue as a business because the kind of companies that VCs can invest in is a very small subset of the many kinds of businesses that entrepreneurs can pursue.
While many ventures can be good businesses for the entrepreneurs, they need not necessarily be a good investment for VCs. And to understand why that is so, it is important to understand the business model of angel investors and VCs.
- Possibility of an ‘exit’ is critical: Investors make money when they sell shares they hold in your company. NOT when they buy the shares by investing in your company. So, unless there is a reasonable chance that they will be able to sell the shares to someone else – next round investors, strategic buyers or, in very rare cases, IPO, there is no reason for the investor to invest, even if the venture becomes a reasonably successful business.
- There must be a reasonable chance to get more than 10x returns: Because many of the ventures they invest in will fail, unless the few successful ones return 10 – 20 times the amount invested, the investor won’t make money on the overall portfolio. [If you have time, click here to read more on this]
- Market leadership is important: To get 10-20 times return on the amount invested, the venture must achieve a commanding position in a potentially large market … else the next round of investors won’t have any reason to buy the earlier round investor’s equity at a significant premium. So, even if a venture is a reasonably profitable company, but not in a reasonably dominant position, the investor will not be able to sell shares (certainly unlikely at a good premium) even if the business is a reasonably satisfying one for the entrepreneur.
- Scale is important. Else the numbers just won’t work for the investors to get a decent return on their investment.
And therefore, the only kind of businesses that angel investors and VCs can invest in are businesses that can scale up massively and who can have a dominant position in a very large market and in which they can sell their stake to someone else for 10 – 20 times the amount they had bought the stake at. Not all businesses will qualify on these criteria, even if the venture is a reasonably happy outcome for the entrepreneur. So, when entrepreneurs start with VC funding as a focus for their business, it narrows their choices to a small sub set of possibilities rather than a large number of possibilities that an entrepreneur can pursue if VC funding was not a criterion.
A restaurant or a handmade shoe making company or a boutique or a furniture store or a jewellery brand or an ad agency or a manufacturing unit, or indeed any legitimate business that the founder is happy doing and satisfied with the financial outcomes is a good business. But these, and many other businesses, may not qualify for venture capital. And that’s OK.