In the competitive startup world, success is never guaranteed.
As most startup founders and venture capitalists would probably agree, there is no surefire way to build a successful business, no matter how good, unique, or practical an idea is.
There are, however, small steps and smart decisions that, if done right, can make a startup much more likely to succeed.
Obviously, though, this is not to say that investors should just jump right in and trust their gut when deciding which early-stage startups are worth financing.
Founders and investors look for certain patterns and possible strategies in a business plan.
Founders and investors look for certain patterns and possible strategies in a business plan. Share on XThese don’t guarantee success, but they do make it more likely that the plan will work.
In this article, you’ll learn the art and science of picking successful startups.
This should make it easier for you to get funding and run a business that is consistently profitable.
Evaluating Startup Founders
The first thing to do is choose a venture to invest in.
This is a very important part of the process because it involves not only evaluating the business model but also building a relationship with the founding team.
But how does one do this?
Being a venture investor with operational experience makes it easier to connect with founders.
Having prior operational experience is super helpful, and it makes an investor show empathy towards the founders they invest in because they understand how hard it can be to build a business.
Empathy in this sense isn’t limited to being able to “listen”—it’s also about designing and recommending solutions and directing them to the people who can help fix a problem or improve a situation at a company.
Operational Experience Is Vital for a Startup Investor
Being successful in the venture capital industry involves some level of luck, but success is also rooted in a lot of other factors, such as empathy, or being able to view things from a founder’s perspective.
Even if an investor has no operational experience, they can still succeed if they’re a “naturally empathic” person.
That said, operational experience is not an assurance for picking winning startups.
In the end, it’s not enough for an investor to have been in the same position as the founder to be able to evaluate the business.
Founding Team Dynamics
The process of evaluation also has much to do with the founders or founding team and their overall perspective on the new venture.
For instance, investors should be on the lookout to see whether or not the company’s founders are experts in the market in which they are targeting to launch their product.
What competitive advantage do they have, or what do they know about their market that very few people or no one else does?
Jake Zeller has talked to many entrepreneurs over the years, and he once mentioned how, as an investor, he deems it a bad sign when he talks to entrepreneurs and finds that he knows the market and potential strategies for their company better than they do.
Zeller also thinks it’s good for startup founders to be experts in a topic or niche they’re pitching for, because it gets him excited and gives him a new perspective on whether or not it’s a good niche to get into.
Co-founder splits can be detrimental to the success of the company, so Zeller also takes co-founder relationships into consideration to try and gauge how well or badly they would work together in the future.
He does this by ensuring he gets to meet them together in a room, say through a pitch meeting, to observe them and see if they’re talking over one another, contradicting what each other says, or generally demonstrating a strong and good working relationship.
In addition to knowing the market well, the team is also an important part of deciding which startups to fund.
Many investors believe that funding a great team is better than funding an idea with a huge market opportunity.
Many investors believe that funding a great team is better than funding an idea with a huge market opportunity. Share on XMeanwhile, in an episode of the podcast “We Study Billionaires,” startup investor and entrepreneur Jason Calacanis said that leadership is also something that he looks for when investing in startups.
According to him, certain people are born leaders, inspiring those around them to embark on a fruitful journey.
But an entrepreneur’s personality and the fact that they hold themselves to very high standards don’t mean that they’ll be successful with their startup.
Instead, Calacanis says being a good leader requires being open to developing new skills like being modest by listening to the feedback of those around you, focusing on motivating your employees, and ultimately bringing them towards excellence.
Understanding the Startup’s Business Model
The business model of a new company is probably just as important as the people who started it. It shows how profitable the business will be and how much it will grow.
This phase should be one of the highest priorities for aspiring founders looking for ways to find adequate funding, as no matter how good an idea or a technology is, the business model can largely make or break a pitch during early meetings.
Clearly, this is because investors are looking for the right balance between how feasible and developed a project is and how quickly they could make money from it.
This is why it is so important for a business model to include good data from solid research that shows how it would compare to its competitors.
So, founders can figure out what their different strategic options are, how their product or service is different from what’s already on the market, who their target customers are, and what risks and challenges it might face.
Seasoned start-up investors who receive hundreds of emails a day from hopeful founders might already be familiar (perhaps all too familiar) with this topic, but those looking to get into the venture capital industry will certainly find what’s ahead useful.
University Lab Partners, an independent, non-profit platform, has put together seven business models for different kinds of businesses.
They must be used carefully to capture someone’s idea and brand in order to have a better chance of success.
Marketplace Model
First on the list is the Marketplace Model, a well-known design thinking model wherein a company or business fundamentally serves as a moderator between a buyer and a seller, possibly best represented by the e-commerce giant Amazon.
The plan is to invest money in a market niche that isn’t yet very crowded, or to bet on a pitch that will create an online space that caters to a very specific type of customer.
Bonus points if these customers are from an underserved sector that has been growing recently, because that makes it easier to reach or get a hold of the right people.
On-Demand Model
The next one is the On-Demand Model, which is basically when something is designed to supply a service that customers can get based on their need, or as the name suggests, on-demand.
The ride-hailing app Uber is one of the best-known examples of the new wave of business models, even though it is still evolving.
If you come across a business model like this, keep in mind that it can be leveraged, especially among the younger generation, who are largely attracted to apps that immediately fulfill their needs with only the click of a button.
Disintermediation Model
On the other hand, the Disintermediation Model is where a business eliminates the presence of a middleman in a supply chain so as to make a direct sale from the manufacturer to a customer.
The biggest advantage of this model is the significantly lower costs for the buyer, which can be beneficial for startups that are looking to produce and sell products.
A good example of this type of business are all of the new online mattress companies that have popped up within the last decade or so.
Subscription Model
Next is the progressively favored Subscription Model, where a company offers the continuous provision of a product or service via subscription instead of a one-time payment.
Most people nowadays probably have ongoing subscriptions with streaming services like Spotify or YouTube, and this is a testament to how exciting launching this kind of business is.
The key to this business is figuring out who the customers are, because most people who use this service will automatically renew their subscription.
But as an investor, keep in mind that the last few years have shown that competition for subscription-based services has also grown, making it harder to profitably penetrate this market.
Freemium Model
Another popular model among startups is the Freemium Model, where free (basic features) and premium (with additional perks and elements) services are offered through tiers.
Those who invest in a startup business that uses this model should make sure that the free and paid services are well balanced so that basic users will want to upgrade to a higher package.
Virtual Goods Model and Reseller Model
The last two models are the Virtual Goods Model and the Reseller Model.
The first is usually used by game developers to let customers buy intangible goods that only exist online.
On the other hand, the second is a tried-and-true and smart way to make money, since all you have to do is promote and sell a product that has already been made.
As an investor concerned about cost and loss, this model is helpful in that it decreases the need to hire salespeople as retailers and resellers are the ones who will reach out to customers.
With all of this, it should be kept in mind that no one true model is ever assured of success. As venture capitalists and founders start to work together, they should think about growth and development strategies using these business models.
Creating an Optimized Portfolio Strategy as a Venture Capitalist
With its ever-increasing allure these recent years, you might be new to venture capital and have decided to begin your journey into the VC industry with the thought that it’s just like any other asset class.
That is not the case. Many venture capitalists who’ve held roles in banking and consulting fail to see what sets this kind of investing apart from more traditional financial and investment enterprises.
In an article for the freelancing platform Toptal, trained treasurer and chartered financial analyst (CFA) Alex Graham wrote about what he referred to as the three core principles of venture capital portfolio strategy.
The first concept that he raised is that “venture capital is a game of home runs, not averages,” alluding to a venture capital investment having to be incredibly triumphant to strengthen a portfolio or the fund itself.
Venture capital is a game of home runs, not averages. Share on XThis insight, he explains, is crucial in the development of a venture capital portfolio, so as to be reminded that failed investments are irrelevant when every investment that one makes has a chance to hit a home run.
He expanded on this by dismissing the idea of a “strike-out” in venture capital, or, in simpler terms, “trying without success.”
Graham backed up his point of view with data from the US Department of Labor, which showed that only about half of businesses are still open for business after five years of starting up, and that number drops to just 20% as time goes on.
So, it’s not a surprise that he summed up his knowledge by saying, “You can either lose your money or hit a home run.”
Despite being naturally afraid of losses, the reality in venture capital is that one must be eager to maintain the mindset that strikeouts can happen but every investment still has the potential to be a home run.
After all, Graham said the science is sound in the sense that measuring a portfolio of venture capital returns at the fund level is driven only by a few superior or “home run” investments.
After getting all that information, the next question you might have is, “How can I improve my chances of hitting home runs to build my portfolio?”
The answer, according to Graham, involves both science and art.
Correlation Ventures did a study that showed how statistics and probability show that not even 5% of venture capital investments offer a return of more than 10 times the initial investment. Of those numbers, only a small percentage return 50x or more.
In other words, this scale means that investing in many startups creates better chances of hitting a home run.
More specifically, one needs to bet on 50 businesses for a 2% chance of landing a successful startup investment.
Now on to the art. Graham said that for venture capital firms, choosing which businesses to deploy capital in is more of an art than a science.
As was mentioned earlier in this article, there is no secret formula or solution that can be used to turn a chosen company into a success.
However, Graham listed down more conventional actions that some of the best investors in the world have mentioned or talked about when it comes to the practice of wisely choosing which among the sea of startup ideas is more likely to be a home run.
First is something that has been discussed previously in this article, which is betting on the team behind an idea.
Of course, if the empirical data does not help with the portfolio strategy, one can also put confidence in the more classic considerations, such as the people.
After all, an idea is born from a person, so the understanding and learning of a product’s DNA are best derived from a person.
Therefore, it makes sense that a startup with a winning team has a higher chance of success when an investor bets on it.
Graham also mentioned the value that investors place on a startup’s total addressable market, which is essentially how the company can show the whole opportunity for income that its product or service can gain within its market.
He noted that an entrepreneur who has deep knowledge about the competitors in the market he’s trying to penetrate is vital to demonstrating a clear plan for the business and establishing its ability to grow.
More aspects to consider when choosing a potentially lucrative startup to fund are those that have high operating leverage or those that show promise of aggressive growth without high costs, as well as those that employ unusual strategies by means of “unfair” advantage through a product, business model, or culture to go beyond or eclipse a predecessor.
Some examples of unfair advantages are Waze’s free geo-mapping made by users, Dollar Shave Club’s viral marketing of its high-quality razors for half the price of industry leader Gillette, and Dashlane’s decision to ditch traditional startup office setups and spend more money on new video technology that connects its offices in the U.S. and France.
Of course, there is also that thing to consider called timing, which is inarguably a critical part of the investment process.
Graham’s last strategy stressed how relevant follow-on investments are.
He described this as a venture capitalist’s ability and inclination to put more capital into the companies that are already in the portfolio and might launch other projects in the future.
As previously mentioned, not all investments will turn out to be profitable, and in fact, only a few will be.
This is where “follow-on” comes in, as becoming more tenacious with the “winners” of a fund augments its returns.
Despite this, Graham acknowledged that deciding when to make the move is easier said than done.
It is a risk that the management will have to take and a test of the “sunk cost” fallacy, but it also gives an opening for a possible advantage that can be capitalized on.
Conclusion
In this article, it has been said over and over that there is no way to avoid failing in the venture capital business.
Zeller said that around 40% to 50% of the companies that raised seed funding through their platform, AngelList, have brought back less than the capital invested in them.
However, he said these losses were compensated by the wins.
Among other things, patience is of the utmost importance because every day can bring a different kind of challenge or offer a new path for one’s plans in the world of startups and startup investing.
Meanwhile, Calacanis said he usually notes younger founders these days being ashamed of their startup failures, especially if their offering does not have a “product-market fit” or simply when customers dislike their product.
He argued that these startup founders, instead of trying to solve the problem by focusing on improving it, do everything but that, which of course does not make the product any better.
And since competitors are everywhere in the venture capital business, this situation is a recipe for failure.
However, he also emphasized the value of the phrase “what doesn’t kill you makes you stronger,” noting specifically that in some scenarios, “crises make the founder” in the world of startups.
He talked about the hard times Uber had to go through, which in the end showed how strong and resilient Uber’s founder was by getting the company back on its feet.
This is a great example of how success can be achieved backwards, and it shows how, in the competitive and warlike world of startups, those with the right mix of grit and creativity are more likely to do well.
This is a good example to end on because it sends a positive message to both aspiring founders who might be worried about failing if they started a startup and founders of young companies who might be worried about getting the next round of funding, as well as to venture capitalists who feel unprepared and overwhelmed by the idea of investing in ideas or companies that scream uncertainty.
As everyone knows, nothing is assured in the endeavors one takes. The only consolation in failure is that it makes for a great experience and allows someone to experiment further when a new idea is born.
The art and science of investing might be helpful to inform an investor’s decisions in the quest for achieving great heights in the venture capital industry, but a whole lot of it, as previously mentioned, still has to do with sheer luck.