Dealflow For Kids
I recently had a meeting with an investor at a top VC. During our conversation, the investor asked me how I might approach sourcing dealflow. I am an exceedingly outgoing person who “sources dealflow” every time I leave the house. And yet, I found myself stuttering to answer the question… I had never explicitly qualified how I build my network of builders, specifically those who are launching companies, and was unprepared for the question as a result.
Dealflow, in venture or growth equity, is the exposure investors have to startup investment opportunities. Dealflow is the first part of the investment process. It’s about learning what is out there to invest in. Opportunities can come across an investor’s desk in two ways: Either investors source the opportunity themselves (which I will call active dealflow), or the opportunity reaches out to the investor (which I will call passive dealflow).
Active dealflow requires the investor to put up resources (time, focus) in order to achieve the outcome of generating dealflow. Passive dealflow is fueled by the opportunity. Consider:
Two investors (A, B) saw 500 identical opportunities in one year.
Investor A generated all their dealflow actively
Investor B generated all their dealflow passively
Would you rather be an LP in A’s fund or B’s fund?
Investors have limited resources which must be allocated across all aspects of the investment process. An investor that spends less resources sourcing dealflow can spend more resources on making the best investments. I would rather be an LP in B’s fund because B can spend much more time, focus, and resources doing great diligence and making brilliant investment decisions. A is spending many of their resources sourcing dealflow. Assuming the same opportunities crossed both of their desks, I would bet B makes better investments based on the allocation of their resources in the direction of the investment rather than in the direction of sourcing.
This situation, to some degree, might exist in real life. An investment from a prolific fund will catalyze a startup’s entire round, so smart entrepreneurs are incentivized to reach out to those investors themselves (passive dealflow). As a result, the most famous funds probably achieve a great ratio of passive dealflow. Smaller funds with less name recognition might have to source dealflow more actively and more constantly in order to know about many of the same opportunities. In this way, the top VC’s have a huge advantage. This dynamic may perpetuate a cycle of top VC’s staying on top, generating most of their dealflow passively and spending most of their resources on the investment. On the other hand, optimizing active dealflow might be a new VC’s golden ticket.
I think it’s interesting that there is no rule book for sourcing dealflow, since it is a problem every investor must at some point approach. According to Business Insider, there are >50,000 venture backed startups in the United States in 2023. Globally, there were ~55,000 private equity deals announced in 2022. At this scale, investor B cannot exist in real life. Even if you are a top fund with the best advantage, you have to source dealflow. But, since resources spent sourcing dealflow detract from resources spent analyzing investments, investors should strive for an active dealflow strategy that is highly efficient and effective. The absence of conversation around how to source dealflow leaves a ton of room for innovation and advantage in this node of the investment cycle.
When you Google “How to source dealflow as a venture capitalist”, the results are mostly vague. Naturally, anyone with the secret sauce won’t want to give it away. Here are some of the ways I’ve observed investors actively source dealflow, and my thoughts on how efficient and effective they seem:
Data-driven dealflow
I am hearing a lot of people get excited about using data to drive deal flow. As a data analyst, it’s something I’m comfortable with. Investors are using data in two main ways: 1) to evaluate how companies are expanding internally, and 2) to track revenues and other KPIs. Some use cases include:
- Tracking companies by headcount growth
- Tracking companies by website activity
- Using credit card data to track revenues, unique KPIs, etc.
The main fallback with this strategy is that it necessitates a company has been around for a decent amount of time — enough time to see a notable increase in headcount, or to have a product on the market. If you are exclusively investing in the early stages, data-driven dealflow might not be that useful for you because the information you need won’t be available in data yet.
I think this strategy might be even better for incubators. Tracking market emergence and expansion is a great tool to figure out what the next problem that needs to be solved will be. Hubristically, I think it’s fun to place my own bets on an emerging market. Why would I let the TikTok drop shippers have all the fun?
- Pros: Quantitative and exact, low resource expense, visibility into unique opportunities, great visibility into competition
- Cons: Limited use cases in early stage investing
Building software
I recently spoke to an investor in charge of dealflow at a PE firm. His team specializes in uncovering investment opportunities using generative AI. There are infinite use cases for generative AI models, and companies like OpenAI make it easy to harness the power of these tools. Investors are creating their own training sets of relevant information and using GPTs to develop generative AI tailored to their investment thesis. While this strategy takes a lot of upfront work, if done well, these models can yield impressive results with little upkeep.
Later, I met a venture capitalist who built his fund on a scraping software that allows his team to quickly identify and evaluate dealflow opportunities. This software has been so effective at generating dealflow in the first years of the fund that he joked during our meeting that he no longer has to use it. By “cracking the code” on dealflow, as I mentioned above, this investor has been able to focus more heavily on the investment and grow his fund’s reputation.
Building software to generate dealflow is not the status quo, but it is the direction I believe the industry is heading in.
- Pros: Visibility into unique opportunities, no groupthink risk
- Cons: Extremely expensive (expertise required)
Attending conferences
My friends who are venture capitalists are often away for a week at a time attending conferences. On the one hand, conferences are amazing. They are immersive, network-expanding incubators where attendees are bound to learn something new and meet amazing potential collaborators. On the other hand, they breed groupthink. Because many investors attend conferences, individual investors who attend are not gaining a competitive advantage, rather, they are simply leveling the playing field. Plus, attending the conference does not highlight you or build your rapport as an investor in a unique way.
- Pros: Network expanding, learn a lot, lots of opportunity
- Cons: Groupthink risk, not a major rapport builder, highly competitive setting, high resource expense, not much visibility into unique opportunities
Networking with organizations on college campuses
I don’t think VC’s do this nearly enough. College campuses are hotbeds of innovation. College students are hopeful, bright eyed founders who are eager to be mentored and see the future differently than post-college adults do. Plugging into a campus entrepreneurial center is a great way to learn about generational ideas, increase your mentorship network, and invest in companies early.
- Pros: Network expanding, learn a lot, visibility into unique opportunities, mentorship opportunity
- Cons: Medium resource expense, inexperienced founders might not be your ideal partner (depends on the investor!)
Globalize your fund with scouts
Large funds often have scouts or principles (who may have other full time roles) on the lookout for potential investments. VC scouts are like executive recruiters, first funneling and then connecting the most relevant prospective supply with their firm. Scouts broaden the net of startups VCs are exposed to as a result of their robust personal network, their geographical dominion, and their primary job.
- Pros: Network expanding, lots of opportunity, major rapport builder
- Cons: Expensive, requires some name brand recognition to be worth it for the scout
Hosting dinners, cocktail hours, or networking events
Originally, I put this option first because to me, it is the most fun. In college, I joined several communities where the main purpose was to get together and share ideas. Food was basically always involved, provided by the organization, so it was free for students to attend. The food and wine made students feel comfortable, but the context led the conversations in an organically intellectual direction. I left every dinner feeling energized, having learned something new, and with an expanded breadth of friends.
Being able to build communities like these is one of the most important skills I learned in college. Sharing ideas in a noncompetitive environment is the easiest way for two people to realize they are perfect partners for a project or venture. In the VC context, however, the goal is higher stakes: to source high quality dealflow, or at the very least, meet brilliant people who can contribute to passive dealflow or join your team down the line. The strategy for inviting individuals to such events is actually a marketing challenge, because an optimal event means that a high % of attendees are new dealflow. Qualitative goals include, 1) what is the quality of the new dealflow? 2) how much has the event expanded my network? 3) how much has this event helped build my rapport in the ecosystem and increase future passive dealflow?
After spending some time exploring the private investment space, I realized this method should be moved to last because it is the most common method. Plus, because of innovation in VC, there are leaner ways to source dealflow. Events are fun and energizing, and we should continue to embrace this core part of our industry’s culture. But, the expense to payoff ratio is not super alpha generating for a lean fund.
Other barriers to hosting successful events include the monetary cost, the time cost, and finding a location to host the event at. It helps to not be starting from square 1 and to have a bit of a network under your belt so that you can encourage your existing network to bring in new people.
- Pros: Rapport builder, network expanding, visibility into unique opportunities, learn a lot, fun
- Cons: High resource expense, bad expense to payoff ratio
