How venture capitalists make investment choices

For entrepreneurs looking to raise capital for their start-up businesses, early-stage investors such as angel and venture capitalist investors can be awfully hard to find, and when you do find them, it's even tougher to get investment dollars out of them.

But angels and venture capitalists (VCs) are taking on serious risk. New ventures frequently have little to no sales; the founders may have only the faintest real-life management experience, and the business plan may be based on nothing more than a concept or a simple prototype. There are plenty of good reasons why VCs are tight with their investment dollars.

Still, despite facing enormous risks, VCs do fork-out millions of dollars to tiny, untested ventures with the hope that they will eventually transform into the next big thing. So, what things prompt VCs to pull out their checkbooks?

With mature companies, the process of establishing value and investability is fairly straightforward. Established companies produce sales, profits and cash flow that can be used to arrive at a fairly reliable measure of value. For early-stage ventures, however, VCs have to put much more effort into getting inside the business and the opportunity.

Here are some key considerations for a VC when evaluating a potential investment:

Quite simply, management is by far the most important factor that smart investors take into consideration. VCs invest in a management team and its ability to execute on the business plan, first and foremost. They are not looking for "green" managers; they are looking ideally for executives who have successfully built businesses that have generated high returns for the investors.

Businesses looking for venture capital investment should be able to provide a list of experienced, qualified people who will play central roles in the company's development. Businesses that lack talented managers should be willing to hire them from outside. There is an old saying that holds true for many VCs – they would prefer to invest in a bad idea led by accomplished management rather than a great business plan supported by a team of inexperienced managers.

(For more on finding great companies, check out Evaluating a Company's Management.)

Demonstrating that the business will target a large, addressable market opportunity is important for grabbing VC investors' attention. For VCs, "large" typically means a market that can generate $1 billion or more in revenues. In order to receive the large returns that they expect from investments, VCs generally want to ensure that their portfolio companies have a chance of growing sales worth hundreds of millions of dollars.

The bigger the market size, the greater the likelihood of a trade sale, making the business even more exciting for VCs looking for potential ways to exit their investment. Ideally, the business will grow fast enough for them to take first or second place in the market.

Venture capitalists expect business plans to include detailed market size analysis. Market sizing should be presented from the "top down" and from the "bottom up." That means providing third-party estimates found in market research reports, but also feedback from potential customers, showing their willingness to buy and pay for the business's product.

(To learn the motives that drive companies into the arms of an acquirer, read Why Successful Business Owners Sell Out.)

Investors want to invest in great products and services with a competitive edge that is long lasting. They look for a solution to a real, burning problem that hasn't been solved before by other companies in the marketplace. They look for products and services that customers can't do without – because it's so much better or because it's so much cheaper than anything else in the market.

VCs look for a competitive advantage in the market. They want their portfolio companies to be able to generate sales and profits before competitors enter the market and reduce profitability. The fewer direct competitors operating in the space, the better.

A VC's job is to take on risk. So, naturally, they want to know what they are getting into when they take a stake in an early stage company. As they speak to the business's founders or read the business plan, VCs will want to be absolutely clear about what the business has accomplished and what still needs to be accomplished.

• Could regulatory or legal issues pop up?
• Is this the right product for today or 10 years from today?
• Is there enough money in the fund to fully meet the opportunity?
• Is there an eventual exit from the investment and a chance to see a return?

The ways that VCs measure, evaluate and try to minimize risk can vary depending on the type of fund and the individuals who are making the investment decisions. But at the end of the day, VCs are trying to mitigate risk while producing big returns from their investments.

(To learn about some ways to prepare for and manage risks, see Identifying and Managing Business Risks.)

The rewards of a spectacularly successful, high-return investment can be spoiled by money-losing investments. So, before putting money into an opportunity, venture capitalists spend a lot of time vetting them and looking for key ingredients to success. They want to know whether management is up to the task, the size of the market opportunity and whether the product has what it takes to make money. Moreover, they want to reduce the riskiness of the opportunity.