When I’m trying to better understand and analyze an investment opportunity, there are several questions I like to ask: What customer pain point is the company trying to solve? How is the company solving that pain point in a differentiated way? And who exactly is it solving the pain point for?
Typically, getting answers to those questions helps me to assess a business and quickly get up to speed on its model, market, and solution.
Of course, there are many facets to truly understanding and qualifying an investment opportunity. Asking just three questions alone isn’t enough to paint a complete picture. All the more so given that the information that venture capitalists use to complete their analysis often varies from firm to firm and sometimes even partner to partner within the same firm.
Nevertheless, there are three common issues that, if discovered, are often deal breakers that will send many VCs running for the hills:
1. High Customer Concentration
Investors need to know how much of your company’s revenue is being driven by how many customers. Understanding customer diversification is very telling because it:
— Helps us assess the repeatability of your go-to-market strategy. If your business has a small number of customers, it may be an indicator that you’ve been unable to develop a scalable sales model.
— Provides signals about the overall size of your market opportunity. If you have very few customers and are only adding a handful of new ones each quarter, it makes us question how many target customers are actually out there for you to acquire.
— Allows us to assess our risk. If one customer is driving 50 percent of your revenue today, what will happen if that customer decides not to renew when its contract expires?
Now, investors do understand that no startup or growth-stage business is going to turn away big deals or customers. And we also recognize that those big customers can sometimes unfairly skew the customer concentration number. Our goal with this data point, however, is to gather some insight into the business’s ability to outgrow that concentration and mitigate customer loss.
2. High Customer Churn Rate
This data point is particularly relevant for B2B software-as-a-service (SaaS) businesses because a high churn rate is often deadly for those types of companies and greatly reduces the overall value of the business.
After all, the whole appeal of investing in a recurring revenue SaaS business is the long-term visibility and predictable nature of a company’s revenue. High churn rates negate that appeal. If a business loses a high percentage of its customers, its sales force will have to work just to replace that lost revenue, rather than focusing on new customer acquisition to grow beyond the prior year’s sales.
High churn also presents another problem for investors: Is the company capable of providing a viable solution to its target market? And, are there better alternatives out there that are causing customers to abandon ship in droves?
As you begin to seek venture capital, managing churn should be a primary focal point. There are several questions you can ask to better understand the causes of customer churn, including:
— Did your outgoing customers find a better product?
— How were they using our solution?
— Was our customer success team actively helping them?
— Did they not see value in our solution?
— Did we overpromise our capabilities to get the sale?
— Were they not the right customer to begin with?
By answering these questions, you can work to make positive changes to your churn rate before presenting those numbers to investors.
3. Significant Previous Money In
Every investor looks at this differently, so take the following advice with a grain of salt. At OpenView, we like to look at how much money an investment opportunity has already accepted to get it to its current stage, and what effect those dollars have had on its capitalization table and balance sheet.
Ultimately, too much previous money invested (or money invested at a ridiculously high valuation) poses three critical issues for new and existing investors:
— If your business has raised a significant amount of money and struggled to reach a certain revenue point, it sends up a red flag to investors that you might haven an inefficient sales and marketing strategy.
— Previously raised money at outrageously high valuations can cause fractures between founders, early investors, and new investors. The new investors, after all, will be looking to achieve a very sizeable outcome to hit their return target, which can harm early investors or shareholders’ opportunity to secure the amazing exit returns they were hoping for.
— If your company has raised too much venture capital, it’s likely that the founding team’s equity stake has been diluted significantly. Additionally, if the business has a large amount of preference on it, it could be very difficult for common-holders and option-holders to envision an exciting outcome.
Outside of equity funding, too much debt on a business can also create additional issues for investors. First and foremost, principal and interest payments inevitably hamper a high-growth company’s ability to invest in other growth areas (sales, marketing, product development, etc.). And because that debt needs to be paid down at some point (either through cash flow, raising new equity, or from exit proceeds), the total pot of dollars available to equity holders is reduced.
Are You Ready for VC Scrutiny?
There are, of course, many deal breakers that didn’t make this list, and each investor you run across is likely to have its own unique non-starters.
That said, the three issues above will be key diligence points for almost all investors as they try to dig into a company’s previous performance and potential for growth. For expansion-stage entrepreneurs, I think it’s critically important to be aware of these issues and try to optimize your business for them as you prep for fundraising.
The more you can effectively manage customer concentration, customer churn, and previous money in, the better your chances will be to land the capital you need from the partners you want in order to take your company to the next level.
Ricky Pelletier is an Associate at OpenView Venture Partners, a Boston-based venture capital firm focused on investing in expansion-stage SaaS companies.