Why your startup might not be suitable for VC funding

There are many reasons why VC’s pass on investment opportunities. Two common ones are that they don’t gel with the team or don’t have sufficient expertise in the target market. Today I’m going to focus on another reason for passing on a deal: market size. Even if a VC likes your team and understands the value that your startup brings to its target market, the market may simply be too small for your startup to become large enough to produce the returns which the VC needs.

Let’s go through some numbers to make things clearer. I will perform the analysis for a seed stage investor but you can repeat the exercise for later stage investors by changing the relevant variables. Let’s say a seed stage VC makes 10 investments at $1M each from a $10M fund. Common wisdom suggests that 1 out of 10 seed stage investments will succeed, but let’s say that this is a talented VC so he invests in 2 winners. Let’s also assume that 3 startups return the capital invested in them, and that the remaining 5 fail. If the VC holds the average investment for 5 years, in order to meet his 20% IRR target, the $10M fund size needs to grow to $25M. Since 3 investments at $1M each returned the capital invested in them and 5 failed, the 2 successful startups need to produce a combined return of $22M. This is equivalent to $11M per startup. Since the VC does not know which of his investments will succeed in advance, he needs to invest in companies which can realistically generate an 11X return on his capital. 
In addition, the VC needs to account for the impact of dilution in future funding rounds. If we assume that the average seed startup will need two more funding rounds, each diluting existing investors by 20%, the VC investor will need the valuation of his successful investments to increase 17X from the time of his original investment for his fund to be successful. Although the best seed stage startups currently command valuations north of $5M, a more comprehensive data set shows that the average seed investment takes place at a $2.5M valuation. This means that a startup’s target market needs to be large enough to accommodate at least a $40M business in order for it to attract VC interest. 
This does not mean that a startup can’t be successful otherwise. There are plenty of businesses with valuations south of $40M that are very successful and produce great personal rewards for their founders. They just might not be suitable for VC funding.