How to Identify if Your startup Qualifies for a Venture Capital Investment?

The number of startups that received investment from venture capital funds in Latin American countries increased significantly from 94 ventures in 2013 to 2,570 in the first half of 2023, according to the latest report by LAVCA¹. This evidence shows an exponential growth of 27X over the last decade in regional startup investments.

This growth is evident in the media, where there is increasingly more news about startups receiving thousands or millions of dollars in investment, reaching unicorn status², and participating in shows like Shark Tank in Latin American countries such as Brazil, Mexico, and Colombia where these projects are showcased for potencial investment.

However, there is limited information available about the characteristics of startups that manage to get financed through the venture capital industry. An industry that not only includes venture capital funds, but also startup accelerators, and angel investor networks.

Therefore, the first thing we need to understand is, what is the dynamics of those who invest in startups? Unlike other types of investments, in the case of startups, the return of investment is very different, and extreme, and this return is determined by the risk of the investment.

In the venture capital world, the return of investment is described as the "power law", a phenomenon where most investments are lost totally or partially, while a small fraction generates most of the returns. This relationship is seen in the world’s best investment funds such as Y Combinator. The same distribution I’ve seen reflected in the results of all the investment funds that have published them, and even in the investments in startups in which I have been involved.

Now, let's look at a hyper-simplified example³ of the economics of a venture capital investment fund. The vast majority of venture capital funds typically operate within a 10-year framework. At the end of 10 years, they are expected to return at least 3X of the invested value to their investors, which would mean an annual return rate of approximately 12%. Based on industry statistics, in 7 out of 10 the investors will lose their investment while in 2 out of 10 they will recover the invested amount. So, what should be the return of the successful startups to achieve a 3X return of the fund if the same amount is invested in the 10 startups?

The result is 28X. The successful startup should multiply the invested value by 28 times. To achieve this, the startup should grow at least 28X in a period shorter than 10 years, and if it raises additional investment rounds it will have to grow more than 28X to prevent the dilution. Finally, it must be acquired or make an IPO so that the fund can have the cash return needed to distribute to its investors.

To achieve that at least one of the ventures in the investment portfolio can return 28X the invested amount, the criteria when investing is that each of the 10 investments have has the chance to achieve that level of extraordinary return.

On this aspect, evidence shows that startups that can achieve that kind of return have very particular characteristics:

• They are based on technology, mostly software technology
• They have scalable business models
• They have strong competitive advantages that make them difficult to replicate by competition
• They must be able to expand to sufficiently large markets
• They have an extraordinary team in all areas of the business, which allows them to grow exponentially for 5 to 10 consecutive years.

In the following link, you can see the most updated list by CB Insights with the startups that have reached unicorn status classified by technology and industry.

In it you will find aninfographic where you can observe that Internet, software, and fintech startups groups have the largest number of unicorns, while hardware startups are a minority, and 100% of unicorns are technology companies.

If your venture is not technological, does not have a scalable business model, does not have a strong competitive advantage that can sustain over time, or does not have the possibility of growing in a large market, do not get discouraged, you can still succeed but you will have to look for other sources of financing, as it is unlikely to obtain investment from a startup accelerator, angel investors, or venture capital funds.

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¹ The Association for Private Capital Investment in Latin America

² Companies that, without being publicly traded or acquired by a third party, achieve a value of 1 billion dollars or more.

³  This is an extremely simplified example because we are not considering the management costs of the investment fund or the carried of the fund.