A lot of the entrepreneurs I meet have a fascination with the way venture capital firms actually work.
One part of this fascination is a healthy, rational interest in how their companies get discovered and analysed, and how investment decisions that affect them get made. Another part of it is just plain nosiness – which is no bad thing as most great entrepreneurs I know are endlessly curious about the ‘model’ of any business or industry.
The good news is that there is no great mystery to the workings of a VC firm, as (most) of the behaviour is entirely rational. So I hope to shine a light on how it all works during some of these monthly articles.
One thing to note is that I’m going to write this stuff based on some mean approximation of every firm I know, rather than mine in particular. That will hopefully be more useful to more people!
For the first month, I think key is to understand the process that venture capital firms follow when they initially make an investment in a particular company.
The relationship after an investment (equally, if not more important) will come in a future post. I break this first part of an investor and company coming together into four distinct stages:
I’ll cover the high-level of each of these stages here and will dig deeper into each in the future. In each of these posts I will include a single, specific, insider tip that I believe will help entrepreneurs achieve a better result when they work with venture capitalists.
First of all, we have to know that your company exists. All venture capitalists obsess over what is commonly known as ‘deal flow’ and, in particular, the elusive ‘proprietary deal flow’. This is just MBA-speak for ‘knowing about amazing companies that no one else knows about’.
By volume, most proposals that any well-known VC firm receives will be blind submissions from their website – in other words, entrepreneurs just emailing the ‘Contact Us’ section of the site.
The next most route of discovery is via either structured and unstructured professional networks. As you can imagine, investors work with people who they and their firm trust to help put them in touch with good companies. In an ideal case, these companies are relevant to the firm’s investment thesis, and are coming up to a point where an investment makes sense. Structured professional networks are the obvious ones – usually comprised of other investors and advisors. Unstructured networks are less obvious (but equally influential) groups like lawyers and PR people, other entrepreneurs and their teams.
Then there’s what I call content-driven submissions. These are similar to a blind submission but a bit smarter. For example, the VC blogs, and the company responds intelligently to a specific topic that she has been writing about. Or the VC speaks at a conference about a particular topic, and the company thinks their mission resonates with her point of view.
Last but not least, there’s just plain data. App Annie, LinkedIn, Github and a countless list of other resources can tell you a lot about a company or a product that is growing rapidly (or in an interesting way).
For reference, we see about 8,000-10,000 companies at this ‘discovery’ stage every year.
After discovery, companies that stand out are analysed. There are a very large number of companies that require analysis, and relatively small teams to analyse them. Sometimes a partner will lead this work, and other times it’ll be an analyst, associate or principal. Often this work will be undertaken by some confused amalgam of the above – again, roles and titles in VC will be the subject of a future post!
At this point, the investor will do a lot of background research, meet with and talk to the company, and also incorporate opinions from others in the ecosystem. These can be from industry experts, ex-colleagues of the entrepreneur, current or potential customers and more. It is worth noting that the vast majority of companies are dropped during this part of the process, for a variety of different reasons. At part of this evolution from Analysis to Decision funnel, some sort of internal summary document – usually called an investment memo – will have been written
For reference, we look at about 2000 companies in depth every year.
One area that every firm I know constantly monitors and questions is how they make decisions. Decision-making is a tough process and one prone to all manner of unexpected and unintended biases. Broadly speaking, however, the typical process involves one or more partners in the firm (in this example, ‘partner’ simply refers to anyone who has the ability/rank in the firm to actually present a company for investment) digging deep, and ensuring they agree that they really are the right firm (and partner) to help the company in its next stage of development. In our case, about 500 companies make it to this level of analysis.
If so, they will usually build some sort of consensus amongst their team. Usually this being with lots of one-on-one meetings and, eventually a ‘partner meeting’ at which the entrepreneur and his team pitch all of the individuals who can make a decision on the investment. As part of this decision-making process, there will often be more significant due-diligence, often involving customer conversations and, depending on the company, possible legal or regulatory analyses of things like the business model.
Once this stage is complete, an actual investment decision is made. The process for this can vary, but most firms have some sort of vote where all partners have a say (but not necessarily an equal say) For reference, we take about 50 votes on new investment decisions each year.
If the company meets some threshold of relevance to the firm (I strongly believe that good investors don’t just invest in the ‘best companies’, they invest in the best matches between company and investor), then the firm typically issues a term sheet at this point.
This is a one-page document that details the high level offer of investment and the terms it will be bound by. If acceptable to the entrepreneur, both parties execute this document. This is usually followed by a phase of post-term-sheet due diligence that needs to take place before the final documents are actually signed. This involves more detailed legal and financial audits of the company, more references and the drafting of the relevant legal documents.
While the investing members of a venture capital firm are generally better known to the industry, this is where the other members of the team – operating partners, general counsels, CFOs and their legal, financial and technical teams get to work. They may not be as well known, but these guys are every bit as important (and their stage of the process every bit as critical) as the others. So smart entrepreneurs and smart firms should build relationships here too. Assuming this all goes according to plan, documents get signed and money gets wired. For reference, we fund about 10 companies a year.
Tip #1: And so my first tip to entrepreneurs is simply: know this process and map yours to it. Simply knowing what your potential investor is doing at any point of the process means that you know what information to provide to them, and how to support them in getting to the next stage (if that is, indeed, what you want). You should also ensure that your own processes match theirs, so that time isn’t wasted on either side. For example, a good entrepreneur will gain references for their potential investors too – and I advise that all entrepreneurs do so. If you make sure that you do this during Discovery and Analysis process, you can be ready and focused on selling when the decision is made, safe in the knowledge that this is an investor that you want to work with.