Due Diligence the VCs: Part Two, The Founder Perspective
I started off my previous post with an acknowledgement of a few trends, including the institutionalization of pre-seed and the increase of early stage capital generally. Despite, or perhaps because of the proliferation of funds and increase in deal size, raising early funding might seem more difficult than ever. The number of deals is actually down (especially in consumer internet) and evidence suggests only a minority of firms actively lead rounds. So this post, part two in Due Diligence the VCs, will highlight what founders should look for when evaluating potential investors.
The idea that founders should due diligence prospective VCs may seem counterintuitive at first (shouldn’t you just take any investment you can get), but I’d argue that spending a bit more time to vet potential investors makes sense in an increasingly crowded field. It can be tempting to just look for the VCs who’ve had the most successful funds, backed the highest profile companies, or whose firms have massive name recognition. Taking the extra time to do some due diligence can help refine which VCs would be the best match for your company, and provide some insight into how to tailor your approach when pitching them. As with the last post, the evaluation can be divided into three filters, investments, people, and in this case, additional value.
The first and most important place to start is with the VCs investment approach. If you are pitching a consumer internet idea, it wouldn’t make sense to approach a VC from that invests only in proptech or SaaS. So right away a great question to ask is, it a thesis driven or vertical specific fund, and if so what is the investment thesis or vertical? If the product or service your company is built around fits with others in the firms portfolio, that would be a strong signal. There are also plenty of VCs that state publicly what they are looking to invest in, either on their website, their blog, or on social. It is even better if they have published writing that describes an alignment with or interest in the idea you’re going to pitch. When it comes to how the VC will receive your idea, seeing them genuinely wrestling with the concept in their head is a great place to be.
Beyond vertical and thesis, you’ll want to know what stage the VC invests at and how much they generally invest. Unless it is a stage agnostic firm, determining when they invest should be as easy as looking at the website. Asking about the average check size will help you understand whether they typically lead rounds and how much additional investment you would need to close your round. This is something you can ask directly, although it could also be deduced by researching the firm on a service like Crunchbase.
Another thing to understand is that the VCs themselves have to fundraise. In most cases, the VCs will raise a new fund (the vehicle they will invest out of) every 2–4 years. This means that except in the rare case of an evergreen fund structure, it can be helpful to know where the VCs are in the lifecycle of their fund. That information could be important in providing color to your conversations with potential investors as well as discerning who is back-channeling, who is actively writing checks, and who might be looking to build a relationship for possible investment in the future. I’m sure it’s rare, but there are stories of VCs taking meetings just to maintain interesting deal flow while not actively deploying capital.
You’ll also want to know about the firm’s follow-on strategy and if the firm does follow-on investments, how much capital is kept in reserves. Chances are you will have to raise another round in the future and you’ll want to know what role an investor will play in future financings. Will they re-allocate reserves to the best performing companies in their portfolio, or are they committed to working with companies through troughs. If a company is achieving success, nearly all top tier VC firms will exercise pro rata rights to participation in follow on financings. Some micro VCs, certain seed funds, and angels will not share this strategy however and may not participate at all after an initial investment. Understanding follow-on strategies can give you a better sense of value beyond your current round.
I can’t emphasize enough the importance of evaluating potential investors through the filter of the people involved. Signing a term sheet means entering into a relationship that will be several years in length at least! In many cases it will be longer, and there will be ups and downs along the way. You should not only be comfortable having a multi-year relationship with any potential investors, but you’ll also want to confident those investors will remain helpful even in tough times.
Other than asking whether or not you can see yourself in a working relationship with a VC, you should also use references to diligence the people aspect. Ask potential investors if you can speak with a few current portfolio company founders or execs. Most VCs will have a list of references for you, and won’t be surprised by the question. Great VCs aren’t content to be commodity capital and will want to emphasize how they’ve helped their portfolio co’s succeed. More on that later.
Even more important though is to use backchannel references. You can be sure that the VCs you’re pitching are doing this on you, so why not borrow from their playbook? A solid place to start would be to speak with the founders of portfolio companies that didn’t succeed. Start ups fail, and VCs expect a percentage of their investments will never take off. If a founder’s company has failed, and yet they speak highly of the investors, that is a strong signal. In cases where the relationship might not have gone as expected, this is where you’ll hear about it.
In the cases where a VC firm prominently displays a portfolio on their website, it may be worth digging a little deeper in to that. Not every firm will do so, but you could ask if they’ve removed any companies from the portfolio section of the website, and if so what was the last company removed? If they have, it could be an opportunity to learn a bit more about how your potential investors approach complications with or failures of portfolio companies. Seeking out the cases where things didn’t go as planned is usually where you can discover the most revealing information.
Lastly, who are their limited partners? This is a question that has become more relevant recently, and it’s one you may want to know the answer to for your own ethical and informational purposes. In nearly all cases the GPs who have invested in your company will have to provide a rationale for that investment and explain your business to their investors, the LPs. Depending on the track record of the VC firm and their LP structure in the fund, that could happen monthly or quarterly, and the level of scrutiny can vary as well. A founder doesn’t need to know every detail behind the capital GPs invest, but they should know whether a fund is backed by public money, international money, or private money. They should know too whether the LP base is primarily institutional capital (Pensions, endowments, large foundations) or if the LPs are mostly HNW individuals and other non institutional sources.
Nearly all VCs will emphasize what differentiates them from commodity capital and how they can add value to your company beyond investment dollars. In evaluating different VCs, look for some expertise and demonstrated value beyond just a track record in capital. Some of this will be revealed during any references you conduct, but there are also questions you can ask directly. Can the VCs point to specific examples of where they’ve helped Founders in the past? Do they engage with the founder outside of board meetings or financing discussions? How many customer introductions can they make? How many quality candidates can they refer during the hiring process? How will they leverage their network to help you?
Firms that have stellar track records when it comes to adding additional value may provide that value in different ways. Some have built out entire teams to assist their portfolio companies with the hiring process or with biz dev. Some rely on a more intimate connection, emphasizing close availability and advice. Others may be heavily network driven, with the ability to make valuable connections at the right times. Knowing what a VC is best at and how their strengths relate to the needs of your company and your needs as a founder will help determine the best fit.
Starting a company is almost always a massively difficult undertaking, a journey guaranteed to have its ups and downs. Taking the time necessary to bring on the investors that are best suited to help you on that journey can remove some unneeded complications. By knowing what stage investors can be most helpful, what was their board is involvement like, and how they might approach complications or problems, you’ll be better equipped to find the best ones for you.