How founders should think about scale before pitching for venture capital

So you have started up recently, have just launched the product six months back, have a few paying customers, good margins and a clear plan for the next eighteen months! You recently got introduced to this venture capitalist through a common friend and are excited to meet and pitch for a seed round.

For the last couple of years as a venture capital investor, I have had a chance to interact with hundreds of entrepreneurs. Most of them were with solid ideas, great teams and a passion to build something out. 

One of the most difficult things that I have had to do is to say 'no' to a lot of ideas with great founding teams which had a solid underlying business, revenue and even path (sometimes imminent) to profit. Still, that business is not a great fit with the venture capital model. 

There has always been a lack of clarity in the mind of a lot of entrepreneurs about what exactly is a 'venture fundable' business and why do venture capitalists say no to profitable ideas while pouring millions of dollars into (seemingly) loss-making, cash guzzling businesses!

Most of the founders do not fully understand how the venture capital business model works, (although the share of founders, who understand it is much higher than what it was 5-10 years ago). I always recommend founders first understand the venture capital business before engaging with one. A lot of good reads are already available on this topic like these hackernoon articles in 2017 and 2018, so I wouldn't spend time rehashing it. What I really want to convey is a simple actionable framework that can help entrepreneurs to think through before approaching venture capitalists, especially from the perspective of scale.

A <TLDR> (too long; didn't read) from all the stuff that you will find about the venture capital model is that the returns follow power laws and hence first and foremost, scale matters. You will see venture capitalists can (and almost always will), take bets on seemingly difficult businesses (with a higher chance of failure) but the ones which can grow very large. Simply put, high risk but high reward models. 

Ten minutes into a pitching session, the first question is 'can this become large?' How large should you be thinking? That's the real (100) million-dollar question?

A rule of thumb that we follow is to try and answer 'can this business reach a $100 million, high quality annualised revenue, in the next 7-8 years'. If the answer is yes, you have got (our) attention!

Now let us dissect each aspect of this question and flesh this whole out a little, shall we?

1. Revenue: It's important to emphasise here on 'revenue'. This is not GMV, not GTV, not LTV. In case you are into an intermediary business, (for example, a marketplace), then you should think of this as the commission/take rate or gross margins. This is essentially the price, customers are paying for the value that 'your business' is providing.
2. High quality: This is super important! A good quality revenue is high gross margins (usually software margins 70 to 90%), strong predictability/repeatability (nothing like a long term subscription revenue model), good cashflows (generate positive cashflows with growth and you are golden). This is why SaaS (software-as-a-service) businesses are highly valued -- that is as high quality as you can get.
3. 7-8 years: Are you going to grow fast? Are the conditions (both business as well as market) conducive now for you to quickly scale? Most of the fast-growing businesses can do that because they ride some 'wave'. New technologies usually change customer behaviors and enable businesses to grow fast.

An important point to also think through is if capital is really going to help your business grow fast? As an example, most B2B businesses traditionally could not grow very fast because of structural reasons and so even though they were in a large market, they were not as attractive for investors. The SaaS wave has changed all of that, as now companies selling to even SMBs can scale very fast.

Having understood the question, before you answer a yes or a no, take some time to also nuance some finer points and visualise how your business and the market looks at scale.

First, it is critical to see if you are attacking a market where the 'target addressable market -- TAM' is large enough to support such a business. When looking at the TAM, most of the founders go with public data and a top-down approach. The usual jist is -- billions of dollars in market size and only a 0.1% market capture yields 100s of millions in revenue. This almost always doesn't work -- you wouldn't be able to find many valuable companies with 0.1% market share in a large market, it’s usually a larger percentage of a much smaller but highly targeted market.

While calculating 'TAM' I always encourage founders to do a 'bottoms up' market sizing to go with a top-down approach. It usually will start with you being able to define your core customer segment.The total universe of your core target customer and the price per customer will give a good estimate of the market size, at scale assume that there would be two-three large competitors eying for most of the market share and make reasonable assumptions.

It's important to also remember that the best of the companies always end up increasing the TAM! Especially if you are riding a wave, it is difficult to estimate the market size ten years in the future. Still, when you are looking to bet the best part of your productive career, it is prudent to start with a large enough TAM rather than depending only on expanding market size.

There are a lot of other things that go in while evaluating a business for an investment – team, competition, business model, technology and so on, but the deeper dive is contingent on crossing the line on 'team' and 'TAM'.

Now what if after this consideration, the answer to this question is a 'no'? In that case, you go with the good old way of building businesses -- profits and cashflows. Although this way is less glamorised, this is how most of the large businesses in India (and globally) have been built. They have been financed by conventional debt, public and private equity financing. Family offices and HNIs (with patient capital) are good partners for such a business in early days, a lot more options open up with a scale.

If the answer to the 100 million dollar question is a 'yes' for you, go ahead -- a lot of VCs including us at Kae Capital are waiting with (our) cheque books!

Gaurav Chaturvedi

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Gaurav Chaturvedi is a partner at Kae Capital. The post appeared first on LinkedIn and has been published with the writer's permission.