Functions and Frameworks is dedicated to helping business owners innovate

Sunday, April 5, 2015

Reasons for New Venture Funding Rejections and How to Avoid It

Whenever you read a business publication today, it would most likely contain articles on venture capitalists, how they find great opportunities and the ventures they fund. It would also showcase success stories and how entrepreneurs landed themselves with venture capital and soared to wealth in a short period of time. And by doing so, it paints a picture that getting funding from venture capitalists is easy while in reality, only a few young companies would get it. 

Timmons & Spinelli (2009) explained that venture capitalists rejects 98% of the opportunities presented to them by young companies. Due to the high risk involved, venture capitalists are very picky. The reasons for the high rejection rate are due to a very stringent screening criteria these venture capitalists use in order to select opportunities with high propensity for commercial growth. 

The reality is that most ventures do not qualify and therefore rejected because of one or more of the following reasons: 

1. The business proposals are not in their preferred industries. 
2. The business proposals have not displayed the potential for growth. 
3. The entrepreneur are not referred by the right person and many other reasons. 
Most venture capitalists like to invest in ventures after the potential has been proven and the risk reduced. They do so by screening every proposal with specific criteria that was based on good business sense. 

Understanding the Mind of Venture Capitalists

Macmillan, Seigel & Narasimha (1985) administered a questionnaire to one hundred venture capitalists to determine the most crucial criteria that they use to decide on funding new ventures. The study shows that above all criteria, the quality of the entrepreneur ultimately determines funding decision. Five of the top ten most important criteria had to do with the entrepreneur’s experience or personality. And the business plan aids the venture capitalists to understand the product or service, the market and the competition and how the entrepreneur fits in the entire picture. 

The study also indicated that venture capitalists assess proposals systematically in terms of six categories of risk that needs to be managed. The six categories are: 

1. Risk of losing the entire investment – the prospect of 10 times return within 5-10 years are relatively insulated from the threat of total loss of the investment. 

2. Risk of unable to bail out if necessary – entrepreneurs who are familiar with the industry knows how to bail out and be able to do so if necessary. 

3. Risk of failure to implement the venture idea – Ventures in which the entrepreneurs have clear idea of what they are doing, who have developed a functional prototype, and which product has a demonstrated market acceptance are more cushioned from product and market development failures. 

4. Competitive risk – a venture with a proprietary product that has little threat of competition within 3 years and an existing market is clearly competitively insulated. 

5. Risk of management failure – The entrepreneur must be capable of intense sustained effort, knows the market thoroughly, and reacts well to risk.

6. Risk of leadership failure – aside from the other factors, the ability to lead is something every venture capitalists consider prior to funding. 

Reasons for Rejections 

Understanding the criteria at which venture capitalists disqualify opportunities is key in creating great business proposals. In order to do this, the study showed 10 essential criteria rated by the respondents.

Ten Criteria Most Frequently Rated Essential

According to the same study, the researchers have identified characteristics of “critically flawed” proposals, which a combination of any of the two would result to rejection.

Percentage of Venture Capitalists Who Would Reject Proposals Which Fail Two Criteria

To interpret, let’s take combination 1 in the list. 84% of the sampled venture capitalist would reject the proposal because it failed two criteria as shown above. And as you go down the list of combinations, you can see the rejection rate. And if we apply to this to the real world, most likely we will experience the same rejection ratings as described in the research literature and findings.

Having the Right Team Matters

Also, looking closely, it would seem that at least one criterion in each of the combination described above is about the entrepreneurs’ character or experience.. In order to mitigate the potential of refusal due to personality or lack of experience, the entrepreneur must ensure that he/she can assemble a team who can compensate for these flaws.

The succeeding graph below came from the same study showing the percent preference of the venture capitalists in terms of team composition. More than half said that each new venture should have a balance team essential. Regardless how the other factors are attractive, most venture capitalists would reject a proposal if this were not met.

Required Venture Team Composition

How Young Companies Can Overcome This

In order to increase the chances of success in securing funding, my research led me to a realization that all the roadblocks for acquiring financial resources points to the elements of Timmon’s model – Opportunity, Team, and Resources.

The case studies and research done by other people still points to the basic foundation of Timmon’s model and how venture capitalists screen all aplicants for funding. It talks about finding the right opportunity using a set of criteria such as growth potential, rate of return on investment and exit strategy.

It also talks about the element of a team and how venture capitalists puts a lot of weight in the character of the entrepreneur and his recruited team members whose skills, expertise and experience compliments that entire venture.

Lastly, this topic is all about securing financial resources which is the third element in Timmon’s model. I learnt that this component of the model if secured via venture capitalists is highly dependent on the two elements. If the entrepeneur deosn’t have the right opportunity and has a mediocre team, the chances of rejection is extremely high.