We come across many amazing and thriving tech companies in our day-to-day practice, which one could think of as great investments. However, Venture Capital (VC) is a “crazy” high risk, high gain asset class, with very specific characteristics, that only fits with a small subset of these. Conversely, many amazing companies are better off without venture capital.

If you think about it, VCs take on serious risk when they invest in startups that have a very limited track record, a business plan that may rely heavily on a concept or a prototype, and little in the way of assets. This is, oh so different, from established companies that produce sales, profits and cash flow – where one can take comfort in a history and going concern, can measure value, and even take some form of security.

Let’s face it, it is not easy for a General Partner who needs to rely on the meteoric rise of at least a few startups in their portfolio, and then use a portfolio risk-mitigation strategy in order to come out with the 25-35% return per annum over the lifetime of the fund expected by their Limited Partners. To make it harder, their investments are only realised towards the back-end or even after the end of the usual 10-year fund lifetime, given that an investment exit could come through a secondary sale of shares to a new investor, but is much more likely to only come when there is a general exit through a trade-sale or an IPO.

So how do VCs make a go of it? It is though an almost religious approach to evaluating companies, which they almost all share, and boils down to the following must-haves:

1. Competitive Advantage/Moat – a distinct advantage over competitors in the market with barriers to entry for potential competitors
2. Large Market – a market that can generate at least $1 billion in revenue
3. Ability to scale – the value proposition must be able to be delivered at scale
4. Strong growth – evidence of strong early revenue growth to validate market acceptance (metrics depend on the stage)
5. Management Team – entrepreneurs that really know their space, ideally are not first-timers, and are hugely ambitious

These factors are like a mantra, and If there is the even slightest doubt in any one of these, it is an immediate “pass”. VCs receive so many pitch decks, that they can afford to be highly selective.

The startups they back therefore need to have the potential for huge success, which only a small percentage will actually achieve. They will be pushed hard to grow fast through successive funding rounds (see our article VC funding and the foie-gras effect) and towards the exit door, before the competition can catch up.

It is all a bit crazy, but it works, at least most of the time, although obviously harder with the current investment “slowdown”. It is easy to see why many amazing tech companies do not, or do not want to, fit into this investment class.