Investors and founders reveal how to know if venture capital is the best way to fund your startup, and what paths to take if it clearly isn't

Flickr/Het Nieuwe Instituut

Take a step back.

• Successful entrepreneurship is about knowing the best way to fund your business.
• Raising venture capital isn't always the answer.
• VCs say the most important factor to consider is market size: How big could your company get?
• Ultimately, VCs want a big return on their initial investment.
• Click here for more BI Prime stories.

If you're thinking about raising venture money for your startup, you should start by asking yourself one question:

Is this business appropriate for a venture capitalist's investment?

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Too many founders answer "yes" (if they bother questioning the wisdom of raising venture capital at all). It's part of how high-profile companies like Amazon and Google achieved success, the thinking goes, so it must be advisable for every startup.

And yet, in blindly pursuing venture capital, these entrepreneurs are setting themselves up for a series of rejections (or a difficult partnership with an investor down the road).

That's because VCs look first and foremost at a company's potential market size. If yours isn't large enough, they won't want to work with you.

The economics have to make sense for a VC to invest in your company

David Rose, who runs Gust, a digital platform for early-stage entrepreneurs and investors, previously told Business Insider that a VC's decision comes down to numbers.

If, say, you're bringing in a maximum of $1 million a year in revenue, "it may be a great, wonderful, much-needed business," Rose said. "You may be doing the world a favor, or you may enjoy it and support your family. You may be able to make a fortune yourself and take vacations."

But, Rose emphasized, the economics of a business that brings in $1 million a year in revenue "are just such that there is no way that you can get an investment from me at any reasonable number for that to make economic sense."

Rose's approach to investing is hardly unique: Investors expect outsize returns on their money. Sometimes it's even a large multiple of what they put in. If your startup is generating revenue in the low millions, or if the likely exit price is in the low millions, a VC has minimal incentive to support you.

That's especially true because VCs are well aware that most of the companies they back will fail. In fact, they generally make money only from the sliver of portfolio companies that are wildly successful.

Market size is the most important factor in a VC's decision to invest

Take it from Scott Kupor, managing partner at Andreessen Horowitz, the venture-capital turned financial-services firm that invested in Facebook, Airbnb, and Lyft. Kupor previously told Business Insider, "For a venture capitalist who knows that they're going to be wrong a lot of the time, they have to figure out what's the likelihood this company could be in that upper-right tail of returns" (the small number of companies with the highest return on investment).

Kupor went on: "When we're doing an early-stage investment, what we're trying to imagine is the 'What if?' question. 'What if this company worked? What could it look like? How big could it be? How much revenue could it generate? Ultimately what could the equity value be?'" Then Kupor considers, "What do I think the likelihood is of that happening," based on what he knows about the company?

Read more: Founders and investors reveal the ultimate guide to scaling a startup - and common pitfalls to avoid

For entrepreneurs, that translates to one all-important consideration. In his 2019 book, "Secrets of Sand Hill Road," Kupor said anyone raising venture capital should be able to convince themselves and their potential investors that their business is able to bring in several hundred million dollars a year in revenue over the next seven to 10 years.

That means you could reasonably take your company public at a market capitalization of several billion dollars, Kupor writes. Which in turn means that "the returns to the VC on this investment should be meaningful enough to move the needle on the fund's overall economics."

A business doesn't have to be a unicorn to be successful

To reiterate what Rose said, if you aren't positioned to become the next Google or Facebook, that doesn't necessarily mean you're not building a successful business. It means your company may be a "lifestyle startup," which doesn't require venture capital and probably won't ever be a "unicorn" worth $1 billion.

Read more: The founder of a billion-dollar startup says you need to nail 'message-market fit' if you want to raise millions from investors

In the book, Kupor mentions smaller VC funds and debt financing from banks as two potential paths to raising capital without traditional VC money. (You can also bootstrap your business, using personal funds and money from friends and family.)

Perhaps the most important takeaway here is to clarify your personal definition of success. You don't have to build a unicorn to get there.

As Angela Lee, founder of the venture-capital firm 37Angels and chief innovation officer at Columbia Business School, previously told Business Insider, a lifestyle startup can easily bring in $10 million a year. And, Lee said, "since when did making $10 million a year become a failure?"