A VC State of Mind: What Drives their Investing Decisions?

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SaaS startup founders can often lose focus while struggling through funding-related problems, and while the fundraising circuit may feel tedious and draining, the reality remains: without capital, you won’t be able to build and grow a viable business.

A key consideration is that more often than not, there’s a disconnect between founders’ and VCs’ mindsets — something that founders need to understand if they want to outperform the competition in the crowded VC funding space.

But before we dig into the minds of VCs, it is important to first understand some of their primary motivations.

Big Risks, Big Rewards?

While some VCs bank on smaller startups in need of funding for growth, the slower rate at which they will gain back their doubled or tripled ROI is often a deal-breaker for many investors. Unless they see an exit pathway that will generate large returns, they’ll be reluctant to invest in your idea.

This largely has to do with the structure of VC funds. Typically the person or people leading the fund are not actually the primary investors, in terms of the capital itself. Rather, they are making investment decisions on behalf of a number of other (often institutional) investors. This means that when you make a pitch to a General Partner at a VC firm, you’re pitching to someone who makes their money as a percentage of the investment return. So, if you earned $120 million from a $100 million investment, the VF fund itself is not getting the full $20 million – they’re probably only getting around $3-5 million, while their Limited Partners receive most of the profit. This is why you’ll need to generate substantial returns in order to appeal to a VC investor.

Not to mention, VCs need big stakes. They usually hold on to 10-15% for a seed fund in a company to maximize their returns. Anything lower than that would mean a higher overall exit value is needed as there is a serious risk that the entire fund will not be returned.

FOMO as a Psychological Driver of VCs

Just as people often pursue the latest trends and fads, VCs have an innate fear of missing out on potential deals that may bring massive ROI to the table. Nothing scars a VC more than having passed on an opportunity that turns out to be the “next big thing.”

For this reason, VCs are always eager to ensure that their investments are well-positioned to capitalize on breakout ideas and technologies. Gigi Levy-Weiss of venture firm NFX shared his own experience about “the deal that got away:” “I said no and, other than losing a potentially amazing financial outcome, I also missed out on being part of a phenomenal journey,” he recalls.

However, this fear of missing out does not mean that investors are making random, arbitrary decisions — there are certain strategies they use to identify the most valuable deals from the large volume of opportunities that reach their desk. Here’s a peek into some of their tactics, as broken down by CB Insights:

  • Tracking investor activity. A known practice among VCs is to look at deals that their associates have passed on, and give those opportunities another look. Just because one investor failed to understand the value proposition of a company doesn’t necessarily mean that there isn’t a meaningful opportunity for successful investment. This is especially true when considering that different VC funds have different investment objectives, areas of expertises, and portfolio needs. As the saying goes, “one person’s trash is another person’s treasure.”
  • Monitoring the investment pipeline. Sometimes, VCs will pass on an idea not because of the validity of the business plan or the success of an idea, but simply because there’s a misalignment between a company’s growth phase and the investor’s needs. Some investors prefer brand-new startups, to maximize potential returns. Other investors are looking for more mature companies that have already achieved stable revenues, and simply wish to expand. Understanding how your startup’s current growth phase aligns with investor need is key to securing the funding you need.
  • Lineage tracing. This involves tracking missed Series B and Series C deals, identifying where they came from and who the investors involved in the deal-making were. VCs will then build relationships with these investors, and compare the deals they’ve traced with the ones they’ve already seen. 

Bonus: FOLS (Fear of Looking Stupid)

FOMO is not the only psychological driver of VCs — there’s also FOLS, or fear of looking stupid. 

Gigi Levy-Weiss cited some examples of some not-so-wise moves VCs make that could cost them billions in the long run:

  • Investing in a field where a top fund has already invested in a competitor (e.g. investing in Company XYZ’s competitor after Company XYZ has already raised massive amounts beyond initial targets)
  • Investing in a company that competes with a highly successful company (relevant particularly to a number of SaaS companies as competition can be fierce in this sector).

Combine FOMO and FOLS, and the result is a “high safety, low price” VC mindset. VCs often take their time researching your company in order to minimize risk. They are looking for low-risk companies with high growth potential — but framing your company as a FOMO-inducing opportunity is an important way to stand out from the crowd. 

Final Thoughts

VC psychology is important for founders to understand, so they can raise the capital they need. Once you’ve mastered the psychology behind VC investing, you can open up doors that may have previously remained closed.

Want to learn more about the VC mindset straight from thought leaders in the SaaS space? Register today for the 2021 Ascent Conference happening from October 6 to 8!

 

Photography by Daria Nepriakhina via Unsplash.

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