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VC Orphans – Why Investors Abandon Companies and How to Acquire Them

VC Orphans – Why Investors Abandon Companies and How to Acquire Them

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Check out our YouTube video, where we reveal 8 top strategies for successfully acquiring VC orphans, offering insights into how savvy investors turn overlooked opportunities into profitable ventures.

In today’s competitive business climate, research shows that up to 90% of startups fail [1]

While most might associate this with a lack of funding, surprisingly, research also shows that over 75% of VC-backed startups fail to provide a financial return to their investors [2], which typically leads to investor abandonment. 

However, not all VC orphans are unprofitable. 

In fact, there are multiple reasons why investors abandon startups, and in this article, we’ll explore what exactly VC orphans are and provide some common reasons why they exist. We’ll also look into eight essential tips on how to successfully acquire them. 

What Is a VC Orphan?

Data by SaaS Capital shows that over half of SaaS businesses in the Series A and Series B stages grow by less than 35% annually. However, investors typically seek annual growth rates of at least 100%. This expectation aligns with the well-known concept of T2D3, introduced in 2015 by Neeraj Agrawal, a partner at Battery Ventures in Boston [3].

T2D3 suggests that for a company to achieve unicorn status, with a valuation of $1 billion or annual recurring revenue (ARR) of $100 million (assuming a 10x revenue multiple), it should triple its revenue within the first two years. Following this initial surge, the company must then double its revenue every subsequent year for the following three years.

Despite these high expectations, many companies fall short of achieving the anticipated growth. Nonetheless, some manage to secure venture capital (VC) funding at remarkably high valuations. This can be attributed to favorable market conditions or leveraging significant industry trends. 

However, when companies fail to meet growth expectations and market sentiment wanes, typical VC investors become hesitant to provide further funding. This leaves founders in a challenging position, often stuck under a big preference stack and lacking clear pathways to profitability.

In essence, these companies become what’s known as ‘VC orphans’ – startups that, despite promising beginnings, fail to realize the hypergrowth or substantial returns envisioned by their VC backers.

4 Common Reasons VC Orphans Exist

An illustration of a giant hand throwing a man sitting on a building in a trash can, indicating VCs abandoning previously funded startups.

Now that you know what a VC orphan is, let’s consider some of the reasons that cause startups to become VC orphans.

1. Underperformance

One of the primary reasons why VC orphans emerge is underperformance. 

Underperformance in this context doesn’t necessarily mean a lack of revenue or a wrong product-market fit (PMF) but rather failing to meet the expectations of the VC by not living up to the valuation at which the business secured funding.

When a startup fails to meet these progress expectations, it often leads to a reduction or complete halt in funding, leaving the company to operate without the essential capital required to drive its envisioned growth or, in some cases, to sustain its operations altogether.

Instances of underperformance leading to VC orphanhood are frequently seen in industries that experience sudden influxes of competitors, such as in the restaurant booking sector or certain horizontal or vertical software market spaces. 

2. Shift in VC Focus

In the world of VCs, it’s all about securing blockbuster investments for your portfolio. To meet the 20-30% returns promised to investors, VCs prioritize backing companies with the potential for exponential growth.  

This strategy aligns with the power law principle in VC, where the focus lies on amplifying investments in startups capable of delivering extraordinary returns, often exceeding 100x, to ensure the overall success and return of the fund.

Hence, as also mentioned above, in their quest for these exceptional returns, VCs often reallocate their resources towards startups that demonstrate rapid and robust growth trajectories. This preference sidelines companies that, while maintaining a steady performance, fail to exhibit the hypergrowth necessary to capture investor attention. 

Consequently, these overlooked startups find themselves in a challenging position, often overshadowed and underfunded, despite maintaining a solid business foundation.

3. Market Conditions

The availability of venture capital is intrinsically tied to the broader economic climate and ever-changing market conditions. During periods of economic prosperity, venture funding flows generously. However, this dynamic swiftly reverses during economic downturns or market instabilities.

Startups that once received generous funding, particularly during the hyped times of 2020 and 2021, may suddenly encounter a lack of investment as venture capitalists retract their commitments in response to the evolving economic landscape. In essence, when the market tightens its grip, so do the wallets of VCs.

4. Changes in the VC  

Venture capitalists, despite their long-standing reputation within their funds, do transition out over time. 

While the presence of a founding partner leading an investment typically ensures stability, the evolving landscape of venture capital, characterized by larger firms and a significant proportion of deals handled by non-partner professionals, introduces a notable risk. It’s not uncommon for the primary investor overseeing an investment to exit the firm, potentially leaving the funded company in a vulnerable position. 

An example of how challenging it can be for companies relying on VC funding is Popup, an e-commerce platform founded by Matteo Grassi. Despite initially securing substantial funding, Matteo faced difficulties in acquiring more investment when his main contact at Accel, the VC firm, moved to a different venture. This left him without a dedicated advocate within the firm, ultimately leading to the shutdown of the startup. 

To learn more about the risks of VC funding in SaaS, check out our podcast episode with Matteo Grassi

How to Buy a VC Orphan Business – 8 Top Tips

Now that we’ve had a look at what a VC orphan is and identified four common reasons for their existence, let’s explore some strategic tips for acquiring a VC orphan business and leading it toward success.

1. Sourcing Opportunities

An illustration of five white light bulbs in close proximity and one yellow light bulb located far from the rest, indicating finding a good VC orphan acquisition opportunity.

When it comes to uncovering VC orphan acquisition opportunities, a different approach is required compared to your typical VC search methods. This is because there are no demo days or pitch events for VC orphans.

Here are some ways you can source them:

Explore Bootstrapped Companies 

You want to look out for companies that have previously raised funds but haven’t done so for at least two or three years and approach them opportunistically.

Some data suggests that companies that have not raised funds for over 24 months face diminished prospects for growth or subsequent fundraising rounds compared to those that raise funds every six to 18 months. This is just a proxy that can assist you in sorting through massive amounts of data in various databases such as Pitchbook, Merger Market, and CB Insights.

Despite these challenges, there may still be opportunities for acquiring and turning around these businesses, especially if approached strategically and with the right expertise and resources.

Utilize Your Network

Another effective approach to sourcing VC orphans involves reaching out to VC funds within your network. Be direct in your inquiries and ask if there are any portfolio companies where initiating acquisition discussions could be beneficial. 

Emphasize that while it may not be a home run for them, it’s the preferable option compared to writing off the business entirely,  which is ultimately what might happen to that organization if nobody comes along to “save it.” Many VC orphan players are seasoned market participants, but with ample opportunities available, there’s room for newcomers to enter the game.

Clarify Intentions

Finally, while there are many potential VC orphans out there, successfully acquiring and gaining consensus from all parties involved is rare. Hence, it’s beneficial to make your intentions known within your network. By informing others of your interest in VC orphan acquisitions, you increase the likelihood of receiving referrals to relevant opportunities.

Many SaaS aggregators are on the hunt for VC Orphans and healthy bootstrapped businesses. If you are interested in learning more about the players in this field and want a complete list of all the aggregators in the software space, along with examples of the companies they have acquired, check out our article on SaaS aggregators.

2. Deep Dive Into the Business 

Before considering an acquisition, you must gain a thorough understanding of the venture orphan’s business. This involves acquiring in-depth knowledge of its underlying business model, assessing its financial health, and identifying the operational challenges it faces.

As with any business endeavor, be prepared to conduct a thorough examination across various fronts. This includes digital assessment, legal scrutiny, and financial analysis. It also includes technical analysis, which involves a comprehensive review of software quality to prevent any potential setbacks that may arise from code quality issues or an overwhelming technical debt load. 

It’s necessary that you do your due diligence, but it’s equally important to not only analyze the current situation of the business but also focus on the following:

  • Envision its potential for growth,
  • Identify obstacles that may hinder it, and
  • Determine whether you possess the capacity to overcome those obstacles and unlock the business’ potential.

In the process of assessing the company, you might encounter some red flags that seem intimidating, but they might also present opportunities for revitalizing the business. As a result, it’s necessary to have a good understanding of all aspects before proceeding with the acquisition. 

If you possess the skills, data, or distribution channels that could infuse the orphaned business with newfound strength, this could serve as a compelling motive for acquisition.

3. Negotiation and Transparency 

An illustration of two men shaking hands and standing at the top of two merging arrows, indicating a successful VC orphan acquisition.

Effective negotiation, coupled with transparency, is key to acquiring a VC orphan. It requires clear communication about the acquisition’s goals, as well as potential benefits for all parties involved, including founders, equity holders, and debt holders (if any). 

In other words, when negotiating, striking the right balance is crucial – this means being transparent about your intentions for the business, such as operational adjustments, restructuring, and streamlining the team, while also being understanding with the founders and having empathetic consideration for their perspectives.

According to Speedinvest CEO Oliver Holle, VC firms can build a lot of reputational capital by going out of their way to help underperforming companies find new VCs or figure out their next steps. Doing this can even improve their overall fund performance. 

However, despite these potential benefits, not many funds choose to do so. This could be because the traditional way of VCs is to focus on top performers and double down on them while ignoring their slow growers. Additionally, it is likely more enjoyable for VCs to help their winners rather than deal with the emotional and complicated work of dealing with underperformers.

Understanding these dynamics of underperforming investments and the potential for divestment can inform your negotiation strategies and valuation discussions during the acquisition process.

If you want to learn how fund returns improve, you can download a financial model to simulate how your returns can improve by eliminating some of the underperformers from your portfolio.

4. Strategic Deal Structuring

When considering the acquisition of a VC orphan business, several strategic tips can help steer it toward success:

Equity Resolution

One of the most important things to consider is equity retention and potential equity reset. It is crucial to review the current equity distribution to ensure that any excessive liquidation clauses, which are usually associated with preference shares granted to investors, do not limit the founder’s ability to profit from a successful exit.

Without a fair distribution of equity, the founder may find little financial incentive to drive the business forward beyond an acqui-hire scenario or simply paying themselves a salary for a few more years before letting the business shut down.

Debt Resolution

Additionally, if the company has incurred debt, addressing debt resolution is necessary. This includes addressing any personally guaranteed debt by the founders and handling any venture debt. Ensuring these obligations are managed or renegotiated not only safeguards the financial stability of the founders but also makes the acquisition more palatable.

Operational Measures

Finally, operational efficiency measures have to be communicated upfront. While implementing operational cuts to achieve a profitable run rate is often necessary, it’s a step most founders are reluctant to take. So, it’s essential to transparently convey that operational adjustments will be required and ensure that all stakeholders are aligned. This upfront clarity fosters a smoother transition and enhances the likelihood of long-term success for the acquired business.

5. Timing and Speed

An illustration of a man in front of a computer screen with a rocket launching out of the screen, suggesting a speedy business deal when acquiring VC orphans.

When acquiring VC orphans, it’s important to act quickly. Speeding through the due diligence process, submitting offers in a timely manner, and engaging in effective negotiations are key to taking advantage of opportunities before the company’s situation worsens or competition intensifies. Taking swift action not only demonstrates your seriousness as a buyer but can also result in better terms and prevent the loss of value in the target company, making speed a strategic advantage in the acquisition process.

6. Ethical Considerations

Acquiring a VC orphan business is not just a financial transaction; it’s a process deeply intertwined with ethical considerations. You need to navigate the delicate balance of pursuing a deal without negatively impacting the personal finances and livelihoods of the founders and their teams. 

Hence, ethical diligence is crucial to ensuring that the acquisition does not disrupt existing agreements or exacerbate the challenges faced by the company’s original creators. 

7. Founder Involvement

In any acquisition, especially with VC orphans, the question of how to involve the founders post-deal is pivotal. Whether it’s a sole founder or a team, their profound knowledge of the business, its culture, and its customer base is deeply valuable. Deciding on their ongoing involvement requires a nuanced approach; sometimes, it’s beneficial for them to stay and help with the transition, and other times, the company might need to move forward in a new direction.

To this end, it’s essential to have a meticulously crafted contract outlining the transition period, potential earn-outs, and non-compete clauses. This ensures clarity and safeguards the interests of all parties involved.

8. Learning From the Process

Acquiring a VC orphan, whether successful or not, can be a valuable learning experience. By reflecting on the process, you can better understand the complexities involved in such transactions. It’s important to remain flexible, considerate, and strategic, ensuring that deals are structured to align with the interests of all parties. Learning from each experience can refine approaches to future acquisitions, making them more efficient and effective.

Invest in the Services of Full-Stack Growth Agency NUOPTIMA

When it comes to acquiring VC orphans and driving business growth, NUOPTIMA stands out as your trusted partner. We have extensive experience working with numerous private equity funds and individuals seeking to acquire VC orphans and helping them navigate the complexities of the acquisition process.

Our expertise extends beyond traditional growth strategies. We specialize in digital due diligence, meticulously analyzing the performance and potential of businesses you’re looking to acquire. Whether it’s assessing market positioning, evaluating customer acquisition channels, or analyzing financial metrics, we provide comprehensive insights to inform your investment decisions.

We also excel in helping businesses scale. Our tailored solutions and innovative tactics are designed to maximize growth opportunities and optimize market presence. If you own a business and aspire to scale it to new heights, we’re here to help you execute that vision.

Ready to explore how NUOPTIMA can unlock your full growth potential? Book a free discovery call with us today and take the first step toward achieving your business goals.

Conclusion

Even with receiving significant funding from venture capitalists, many VC orphans fail to meet important performance benchmarks. This puts them in a difficult position: they may become attractive acquisition targets but at a much lower valuation than their initial funding, which means the founder will not profit from the sale. 

Alternatively, they could continue to grow, but this is often a tough and lonely uphill battle without the promise of further investment. In this case, the founder may find it more profitable to start a new business altogether. Because VC orphan founders face these challenges, it becomes essential to keep ethical considerations in mind while approaching an acquisition. It’s also crucial to structure equity distribution in a way that ensures the founder benefits from the sale.

Despite these additional considerations, acquiring a VC orphan can offer numerous benefits. By conducting thorough research and due diligence, prospective acquirers can uncover valuable assets and opportunities for growth within these companies. Furthermore, with careful consideration and support from founders, there’s an opportunity to foster a collaborative and mutually beneficial relationship. 

Additionally, various types of investors, such as traditional Private Equity funds, SaaS aggregators, and secondary funds, who are happy with more modest returns than traditional VCs, are increasingly interested in acquiring VC orphaned businesses. Recognizing their potential for value creation in the market has even led to the emergence of dedicated orphan funds.

FAQ

What is a VC orphan?
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A VC orphan is a startup that has received funding from venture capitalists but struggles to secure further investment. These companies often face challenges in sustaining growth and may experience difficulty in attracting new funding or support.

Why do some startups become VC orphans?
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Startups can become VC orphans due to factors like failing to meet growth expectations, shifts in market trends, or changes in investor priorities. This can lead to a loss of confidence from investors and make it challenging to secure additional funding.

What are some strategies for acquiring and reviving VC orphaned businesses?
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Strategies for acquiring and reviving VC orphaned businesses include conducting thorough due diligence, identifying growth opportunities, leveraging existing resources, and developing clear post-acquisition plans. Additionally, focusing on restructuring and aligning the business with market demands can help revive its prospects.

References

  1. https://explodingtopics.com/blog/startup-failure-stats[1]
  2. https://www.fastcompany.com/3003827/why-most-venture-backed-companies-fail[2]
  3. https://techcrunch.com/2015/02/01/the-saas-travel-adventure/[3]

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