What every entrepreneur should ask their prospective lead VC, Part I

Diverging paths: The investor you choose for your business could be the difference between success or failure

Fundraising is possibly one of the hardest things that an entrepreneur has to do. It’s also one of the most important.

The investors that an entrepreneur chooses to work with in each fundraising round will have a long-lasting impact on the future of their business.

As a seed stage investor, a big part of my job is to help our companies graduate to Series A. That means working with them to navigate the fundraising process and acting as a sounding board as they select the lead investor for their next round.

For an entrepreneur, working with a VC means a long-term partnership. It could be ten years or more before there’s an exit. There will almost certainly be difficult decisions for the entrepreneur and VC to navigate over that timeframe, so any lack of alignment in that relationship with regards to timing, personalities, or otherwise, can negatively impact the company’s success. That’s why it’s critical for entrepreneurs to accurately understand how their prospective lead VC investor thinks about the investment and their ongoing partnership with the company.

As an entrepreneur, picking your lead investor should be just as much of a test and evaluation process as it is for the investor picking the entrepreneur.

Having just watched a few of our recent Seed investments complete successful Series A and B rounds, it is clear to me that there are a lot of nuances about venture capital funds that entrepreneurs should understand before they decide to enter into a long-term partnership with their lead investor.

That’s why I want to open source the questions that I shared with a few of our portfolio company CEOs before their Series A and B raises with the hope that it helps entrepreneurs navigate a Series A (or B) fundraising process and to ask the right questions to prospective investors.

This post will be the first of a three-part series that will cover questions that entrepreneurs can ask their prospective VCs about their funds, how they think about board dynamics, and how they add value post-investment.

“How big is your fund?”

Fund size will often drive how the VC thinks about ownership percentage at Series A and the type of exit they will be looking for when they invest in you (more on VC fund math below). A $100M exit for a $25M fund can be a great outcome for a fund of that size (depending on ownership at exit), but potentially not such a great outcome for a $1B fund. It’s important to understand the VC’s fund size and what the VC’s expectations are because this may drive (i) how much of the company they need to own at Series A and beyond and (ii) when and how they want you to achieve a liquidity event. It’s critical that you are aligned with the VC on potential exit outcomes as what could be a life-changing and successful exit event for you and your team might not be an optimal outcome for your VC.

A related question to ask VCs is the check size they usually write at a certain stage. If the VC has a $100M fund, there is a high likelihood that they can lead a $3–5M Series A, but won’t be in position to lead a $10–15M Series A due to the amount they can invest into each company because of the diversification they will likely require for their fund.

“What is your target ownership size? For this round? At exit?”

Knowing a fund’s target ownership size at initial investment will help you understand how much the fund needs to invest into the round to meet their ownership threshold and the minimum round size they require. If the Series A VC needs to meet a 20% initial ownership target and they are offering a $30M pre-money valuation, then they have to invest at least $8M of a $10M round in order to achieve that ownership target ($8M/$40M = 20%). That means the round size needs to be at least $10M for the VC to meet that ownership target (and that’s without taking into account conversion of notes or SAFEs and an option pool, which will also impact ownership). It is important to understand this point in the context of dilution as a founder.

It’s also important to understand ownership expectations at exit. Their answer to this question will give you some insight into the number of financing rounds the VC expects you will require and help you better understand their expected outcome and exit timeline. It will also provide you a sense of how much dilution there could be for you, your team, and other early investors down the road.

“What do VC fund economics look like?”

Let’s review some simple math about VC fund economics … for illustrative purposes, say we have a $100M VC fund that is targeting to return 3x of its fund size to its Limited Partners (investors in VC funds, who can include high net worth individuals, family offices, pension funds, endowments, etc.). At the end of the 10-year life of the fund, the VC fund will need to return $300M in cash to its investors. What does this mean in terms of aggregate exit value across the entire set of portfolio companies in the fund?

Say this VC targets 10% ownership stakes in the companies that it invests into with its initial investment. On average, the fund writes ~$2-3M initial checks into 20–25 companies (for illustrative purposes, we will assume roughly a 1:1 follow-on ratio relative to initial investment). We’ll assume that across the entire portfolio, this VC owns 10% of each of its portfolio companies when it initially invests, but gets diluted over time to ~5% ownership as additional rounds of financing are completed. Fast forward 7–10 years … the portfolio matures and the successful companies in the portfolio have an exit, whether it’s via an IPO or acquisition. What does the total aggregate value at exit of the portfolio of 20–25 companies need to be in order to meet $300M of returns for the fund? If this VC owns in aggregate 5% of all of its companies at exit, then the aggregate exit value of the portfolio will need to be $6B, since 5% of that value would return $300M to the fund’s investors.

Further, it’s worth noting that not every company in the portfolio of 20–25 companies will be successful, so it’s highly likely that only a subset of those companies will drive the majority of the value and return a good portion of that aggregate exit value. That means this VC will most likely need at least a few of its portfolio companies to achieve $1B or greater (and some companies much bigger than $1B) exits in order to hit their 3x return target for investors.

Think about this example in the context of fund size. If $6B in aggregate exit value is needed for a $100M fund to return $300M in exit value, think of what a $1B fund needs to return in aggregate exit value across its portfolio to do a 3x fund!

“What is the composition of the fund’s LP base?”

Different types of Limited Partners (LPs) — from family offices and HNW individuals to pensions and endowments — will have different return expectations. While family offices and individuals may be less concerned about the fund’s IRR in a given year and focus more on the multiple of invested capital at the end of the fund’s life, institutional investors like pensions and endowments may care more about the fund’s IRR since they have to report to their investment committee every year. The LP base of the fund may influence how the fund thinks about their investments, which may impact your company’s growth and expectations.

Other reasons why it can be helpful to understand the fund’s LP base are:

(1) LPs can act as direct investors in the company in later rounds. Certain LPs seek to co-invest with VC funds at later stages, so it’s possible that the fund’s LPs will want to invest alongside the fund in the next round.

(2) LPs in the fund may have the ability to add value to your business as an advisor or by connecting your company with potential customers. If a fund can add value to a company through their LP relationships and network, that can be another good reason to partner with that fund.

“What fund are you on?”

A VC fund that is on its 11th fund will usually have a much higher likelihood of raising its 12th fund than a first time fund will have in raising its second fund. If you want to have confidence that the VC fund who you partner with to lead your Series A or B will be around for the long term, understanding how many prior funds the VC has raised should give you more comfort that the fund will raise another fund in the next three years.

It’s worth noting that we’ve seen a number of new funds launch in recent years, where GPs at top-tier brand name funds have spun out to start their own firms. These funds may have less established names and only be on their second or third fund, but the quality of the investor is high and many will have the staying power to become the next generation of leading firms, so making a decision based in part on the number of prior funds a VC has raised may be less relevant than in the past.

“Where is the fund in its life cycle? Just starting to invest? Or will this be one of the last investments out of the fund?”

This is a critical detail to understand about the fund that may invest in your company. Where a fund is in their life cycle can have a major impact on (i) how much they are able to invest in your company over multiple rounds and (ii) when they decide to try to find an exit for your company. If the VC is just starting to invest out of their current fund, they may have more capital available to participate in follow on rounds, particularly as certain VCs may not make crossover investments from fund to fund. The VC will also have a longer timeframe to help build the company if they are just beginning to invest out of their fund. Most VC funds have ten year lives, with two one-year extensions at the LP’s discretion. Funds generally have a three-year investment period, which means that they are focused on deploying the fund’s capital over the first three years of the life of the fund and then focused on growing their portfolio companies and “harvesting” (exiting) the investments in years 7–10 of the fund’s life.

“How much does the fund usually invest into companies over the lifecycle of your investment? And how much do you leave in reserve for follow-on investment?”

Say your sales cycles ends up being longer than expected. You want your Series A investor to be there to support you when you need capital to extend your runway with a bridge note. Say you raise your next round, a large Series B round. You want your Series A investor to step up and take their pro rata because, if they don’t, it may be a negative signal to other investors.

A VC’s first check into your company is most likely not their last. It’s important to understand how much the fund plans to invest into your company over the lifecycle of the investment. Generally, VCs reserve at least 1:1 for follow-on investment (relative to their initial investment) so they should continue to support you in future rounds.

“What were your biggest risk factors with the company when evaluating the investment? What makes you comfortable with those risks?”

Fundraising can be a great opportunity to learn more about your business. It provides a chance to hear outside opinions on your business from investors who have a high-level view of the market and evaluate all sorts of business models, go-to-market strategies, and, likely, your competitors. Risk mitigation is critical to startup success. If you think of each stage of a startup as a level in a video game, the goal is to do what is necessary at each level in order to unlock the key to the next round.

Understanding the risks that face your business and systematically taking actions to reduce those risks — whether they be related to go-to-market, team, hiring, competition, etc.— will go a long way towards advancing the business through each level. It is also helpful to understand the investor’s perspectives on what areas of the business they believe need improvement. Not only will it help you focus on those areas of the business once the round closes, but it will also help you understand what success looks like to those investors since they will expect to see those issues addressed in advance of the subsequent round.

Check back next week for Part II, which dives into board dynamics and how entrepreneurs should think about VCs on their board.

Special thanks to my Partner at Broadhaven Ventures, Greg Phillips, Trinity Ventures General Partner Schwark Satyavolu, and ScaleFactor Co-Founder and CEO Kurt Rathmann, for reading drafts and sharing thoughtful comments and feedback based on their experiences as entrepreneurs and investors.