Ten Reasons Why Pre-Seed Investors Might Say No
Ten Reasons Why Pre-Seed Investors Might Say No
When it comes to decision-making, Venture Capital can be an opaque industry. At Octopus Ventures, we’ve gone some way towards shining a light on our decision making process, while our area of interest — backing the people and companies with ambitions to change the world — is at the front and centre of everything we do.
Still, in the early stage of pre-seed investments, when a VC has nothing more to go on than a small team, a basic product, and an indication of the potential outsized market opportunity, it isn’t always clear how and why some companies get backing and others miss out.
In defense of VCs, especially those focused on early-stage companies, a huge number of pitches cross their desks every day. Because of the sheer volume of deal flow they manage, they’re always looking to trim the list. With Octopus Ventures’ new commitment to backing pioneering companies early — with the first cheque, in some cases — I’ve put together a list of the eleven reasons investors might say a quick no, or dig into your business model with further questions. If you can address these points before you make your approach, you’ll do a lot to build confidence in your idea.
- Start up Fund Fit: This one is obvious: do your research, save your time and energy, and if your business isn’t a fit for a fund — don’t make contact. Some funds, for example, simply don’t invest in hardware, cannabis, or psychedelics. Others won’t support startups who are pre-product, or don’t invest in certain geogrphies. Whilst there might be a few exceptions to the rule on these “outright no’s,” generally this is one of the first criteria VCs turn to when looking to trim down their list — unless there’s something exceptional, and proven, about the start up.
- Solo ‘Non-Technical’ Founder: This isn’t as common a deal-breaker as it used to be, but it’s still likely to generate concern in any potential backer. This is particularly true when it is a single founder, and they cannot build the early versions of the product. Unless you have a proven track record as a founder, convincing VCs that you have what it takes to do it alone is going to be a challenge. Demonstrating that a solo founder can build the solution, and has clear plans to onboard a team, will be essential if VCs are going to jump at this opportunity – but some will still say no for this reason.
- No product/MVP/demonstrated market pull: While some pre-seed investors are happy to back nothing more than a great idea and a team, it’s still quite rare. Investors want to fund something that has signs of early growth, and proof that it’s continuing. Show proof points that the market appetite for your solution is mounting — and all you need to do is supercharge that growth with funding. Mitigate the risk further by showing early indications that customers are keen for the solution (even if it isn’t fully ready yet) and that your team has the chops to build it.
It’s also important to remember that speed of execution is essential to investors – especially at the earliest stages. If you’ve been working on an idea for a long time (a couple of years or more) and you can’t show signs of meaningful progress, this could be a red flag (there are, of course exceptions to this – and legitimate reasons for delay. Covid is a great example).
- Poor founder-problem/market fit: You might hear more about the product-market fit, but in the world of pre-stage funding, it’s founder-market that matters. Because it is so early, VCs don’t expect founders to have found product market fit. In fact, at this stage, most founders are still building an initial version of their product. If there’s no congruence between your previous professional or lived experience or skillset and the problem, you’re setting out to solve, it’s likely that a VC will pass. Because there aren’t many solid data-points to go on, early-stage VCs pay far closer attention to team – so it needs to be clear why yours is certain to be the winning one.
- Crowded Market and No Differentiation: If you’re in a crowded market, with lots of VC-funded competition and very little to make your business stand out, it is likely that VCs will pass straight off the bat. IP and brand are both key differentiators. One exception to this rule is when a crowded market is filled with one or two incumbents. If a start up is building a radically different solution in this niche, one that incumbents will struggle to imitate either because of their size, or because incentives for them to are not aligned, VCs will be interested — and you should highlight it in your pitch.
- Scalability Implications: While evaluating the Business Model of a company, there are scalability implications that might prompt a quick no from VCs. Perhaps your solution has a hardware element that makes scalability more difficult when compared to a software product. Or maybe your business model has a long sales cycle: selling to government, or large corporations that have complex internal supplier onboarding processes with little incentive to switch to an “unestablished” start up. Any of these factors may prompt VCs to dig further into the opportunity, to work out if it’s worth it in context. Make sure you’re direct and upfront in communicating how your start up can reach $100m ARR in five years.
- Unit Economics: The basic anatomy of any successful business is that revenue far exceeds your costs. If you can demonstrate an early indication that you can acquire a high volume of customers cheaply and quickly, and monetise them sustainably, investors are sure to be interested. On the other hand, if a business model hints at high customer acquisition costs – as we see with many consumer app models today — coupled with high churn and low margins, backers will see this as a red flag that could result in either a quick no, or additional questions.
Pure consumer apps are notoriously tricky to monetise. They often rely on critical network effects or scale to unlock monetisation, usually via third-party data plays, or consumer subscriptions. Until then, most of the growth is financed with equity funding. The risk that backers — and founders — have to balance is that the business may run out of money before reaching the crucial threshold, especially if it isn’t solving a painful problem.
- Short Runway: This is really subjective, but most investors want to be part of a funding round that gives the founders enough runway to achieve strong milestones for the next round. This is even more critical in the current fundraising climate. Anything less than a 12-month runway could raise eyebrows, as it might hint that the startup is raising too low and could run out of money, or that the business isn’t capital efficient. Navigate this by planning your fundraising round size to give enough runway to focus on building the business, and hitting strong metrics even in an uncertain macroeconomic climate.
- Competing Portfolio Company: If an investor has a similar start up in their portfolio, it’s possible there’ll be enough of a conflict of interest to deter investment. This isn’t a hard rule: some investors are happy to invest in companies who do similar things in different geographies, have different go-to-market strategies or who target different customer segments.
- Valuation Too High: The VC investment model is based on the power law, meaning that only some of the startups in its portfolio will return the required multiples for the entire fund. Their investment is based on the assumption that a start up is able to hit those fund return profiles.
A start up with a high valuation will also need to demonstrate high exit outcomes, if it’s going to return the multiples the fund needs. Some VCs are more valuation sensitive, because of the % ownership requirements they need for the fund profile. These will likely pass on any start up that doesn’t meet their thresholds with their investment amounts considered. Of course, there are always exceptions. The best start ups sometimes seem “expensive.” But still, an excessively high valuation is a common reason for investors to turn a business down.
- It’s not you, its them: Finally, there are myriad reasons an investor might pass that have nothing to do with you. These include timing, market concerns, and administrative bottlenecks. It is tough to hear a lot of noes as a founder, and sometimes it can be difficult not to take things personally. But unfortunately, they do happen; just remember that a lot of the time, it has nothing to do with you.
These are a few of the key reasons I see institutional investors passing on pre-seed stage funding rounds. As I hope is clear, there are always exceptions — however these points are still well worth thinking about as you bring your world-changing idea to the backers who could offer the means to scale.
If you’re working on something at this early stage, and you’d like us consider it, you can get in touch to tell us all about your business here