The VC Value Chain (Part 1)

How to approach growing a VC firm from a strategy point of view

11 min readMay 24, 2016

Earlier this year I started advising a startup VC firm. I studied venture capital at the Haas Business School at Berkeley, but I haven’t yet worked full-time at a VC firm. Hence, my views on the subject are formed based on what I’ve read, listened, and watched. This is version 1, and as it’s customary in the Silicon Valley, it is best to launch, get feedback, and iterate on the next version. Therefore, please provide your feedback.

As a starting point, a great strategic framework to analyze an industry is to look at its Value Chain. The Value Chain concept is popular in analyzing industry verticals such as IT, Media, and Telecom. However, I couldn’t find prior work on the VC Value Chain. So here’s my attempt.

I divided the VC Value Chain into 5 Activities: Funding, Sourcing, Investing, Supporting, and Exiting. I will treat each activity in more details next.

Funding

The goal of the Funding Activity is to raise a VC Fund from Limited Partners. Each activity can be decomposed hierarchically into its own value chain with its own activities at a more detailed level. For instance, I decomposed the Funding Activity into:

Credibility: This is a prerequisite step before starting to raise a fund. The VCs are now the entrepreneurs who will be pitching and requesting funding from LPs. Before raising money, the starting point is the VC team, the General Partners. What kind of achievements have they done, what kind of prior investments have they done, what is their investment thesis, and why them.
Access: The LPs are usually Banks, Endowments, Government or Sovereign Wealth Funds, Pension Funds, Foundations, HNWI and family offices, and Fund of Funds. You need the network, the credibility, and the access to such entities. You might enlist help from people/firms who have done that before, whether for other VC firms, Hedge Funds, Mutual Funds, and other investment firms. VC is a risky asset class, therefore, for LPs looking for investment and balancing their portfolios, VCs are an option. Usually, LPs who know of the GPs or their work are easier to raise from due to the appreciation of their credibility.
LPs Sourcing: This is about researching, reaching out, scheduling meetings, and talking with LPs or firms who can help in the LPs sourcing.
Raising: Once identified, the agreement needs to be executed with the LPs. I created a value chain for this activity due to its own specificity. The VC firm has to create an LPs relation function (at the formation of the Fund and along its lifecycle), needs to have the legal support to negotiate, draft and execute the agreement, and the process to summon the dry powder cash when needed.

Sourcing

This is one of the most important activities in the VC Value Chain: Getting high quality startup deals. Similar to the approach in Marketing to generate leads, there are two ways: Outbound Sourcing and Inbound Sourcing (as in Inbound and Outbound Marketing).

Outbound Sourcing:

I structured Outbound Sourcing into 3 main activities.

Outbound Deal Sourcing: This is the most classical approach. The VC firm will use the network of its staff, advisors, mentors, portfolio companies/founders to go after promising startups and founders that they hear or know about. The VC or its network will approach the startups. Sometimes, the VC will be proactive in getting to the early stage startups, setting up students-led mini-funds with presence on main university campuses (i.e., Dorm Room Fund by First Round Capital and others) or deal scouts team at universities and at startups hotspots (i.e., WSJ: Sequoia Capital scouts). Other channels can be: (1) partnering with angels, syndicates, accelerators, and incubators for deal sourcing, (2) networking and being close to the front lines, (3) and mining sites like AngelList and Reddit for early tech ideas trends.
Events: Having a presence and/or sponsorship at main academia or industry events on startups and entrepreneurship, spotting, and following up.
Network Building: There are two parts of this network: The people sourcing the deals, and the deals themselves. For the people sourcing the deals: the questions are how to strategize, focus, coordinate, enable, and support. For the deals side, it is important to have a tool like Salesforce (or Asana) to manage the pipeline of opportunities, manage notes and meetings, data, the scoring and quality of leads (I will touch on Lead Scoring next in the Investing Activity), keep track of high-interest leads for early and subsequent rounds of funding.

Outbound Sourcing is usually high-touch with high startup acquisition cost.

Inbound Sourcing:

In contrast, Inbound sourcing is when startups reach out to the VC. This tends to have lower startup acquisition cost. However, reaping such a dividend requires a consistent inbound marketing strategy to build the brand and reputation of the VC firm. Particularly, I like this quote for this sourcing strategy:

“The best marketing is education” — Regis McKenna

The core of this strategy is educational content. I will treat A16Z and USV as the main case studies of this strategy in Part 2 of this essay. The Value Chain of Inbound Sourcing has 3 core activities:

Content Creation: It is more about substance than form. It is usually experience driven — founders will be drawn to a particular VC due to their knowledge in a particular space, their experience, and the perspective that they provide. The VCs will invite guest speakers/authors from their network of influence to enrich the content. The content can range from educational, to inspirational (& lessons learned), to open discussions on future trends. One key differentiation in my opinion is the ability to connect with the audience (the entrepreneurs) by being genuinely empathic in intentions and humble in delivery.
Publishing/Distribution: This ranges from using social media (Twitter, FB, Snapchat), weekly or monthly email newsletters, own Medium channel, own publication site (i.e., The Macro by YC), podcasts, classes (Stanford’s Blitzscaling by Greylock, etc.).
Brand Building: Brand is the sum of: what you’re known for, what you stand for (values), what is your value prop, and how you deliver it. It transcends the Sourcing Activity phase and has to be nurtured through all the VC Value Chain. In the Sourcing context, the brand is a major component of what draws the entrepreneurs to you due to all the symbolism it represents.

In my opinion, it is best to have a filtering problem than a pipeline problem. You can always find a way to filter. But a way to influence the top of the funnel in the pipeline is to have a great brand strategy and messaging that will attract certain types of startups to you.

Investing

Investing has art and science in picking winners. The spectrum shifts from art to science with the maturity of the startup.

I believe an infliction point in this mix is the stage of a startup pre and post product-market fit. Pre P-M fit, the VCs (Angels, Seed investors) are relying more on the founders, patterns, and qualitative indicators. After P-M fit, there is data to quantify a measure of CAC, CLV, Growth, Churn, etc., and estimate what the company might be like in 3-5 years from now. Another factor is the Product-Market-Strategy fit, which is about the ability of the startup to capture, maintain, and protect from competitors the value it creates.

Screening: Screening is a top of the funnel filtering. The powerful filter at this stage is the investment thesis, the guiding light of a VC firm. The investment thesis can be per market (i.e., FinTech, Healthcare, Media, etc), or business model driven (SaaS), or business and product strategy (businesses with network effects, marketplaces, B2C, B2B), startup-stage (seed, angel, Series A,..), regional (China, China-US, Europe, or global), market types (new, existing, clone), or technology driven (Blockchain, Drones, VR, etc.), or a combination of the above. The investment thesis reflects a belief in a type of would-be-winners startups AND a comfort of the VCs in picking the winners, and potentially adding value beyond financial investment. Other filtering tools can be: size of the market, P-M fit, P-M-S fit, traction history, founders, vision of the company, quality of the idea, pattern matching, referral channel type (from someone the VC knows). Depending on the deals volume and velocity, this Screening Activity is quick, maybe 1–5 minutes to make a decision. In the future, data science will be used to calculate Lead Scores to pick potential winners based on analyzing the startups operational data from future startups data management portals, reducing friction and making the process more efficient.
Due Diligence: Assume the startup passed the first screening filter, the time and resources investment from the VC grows as the startup proceeds further in the funnel. A pro-forma process is below:

Term Sheet Design: The term sheet will capture the assessment from the Due Diligence activity. It is a combination of risk management, negotiations, and navigating supply and demand with reservation boundaries on the terms. I would mention that the Term Sheet has to be entrepreneur friendly, and/or the VC need to educate and help the entrepreneurs in this process. It will be a partnership between both parties, and it is best if it starts on a solid and trusted foundation.
Decision Governance: Depending on the firm mode of operations, some firms need a single GP sponsorship, some have a voting approach, some are consensus driven (low preference in my opinion). It pays to be provocative in supporting a contrarian idea, which promises high returns if it turns out to be a contrarian truth. By definition, contrarian ideas are not consensus-friendly. Compensation incentives will influence decision making, so critically analyze to ensure an alignment between the two.
Legal: Legal is an unsung hero in VC. It is also an evolving practice, keeping up with the lessons learned and the changes in the industry. In the Silicon Valley, there is a great symbiotic relations between the VC firms, new ventures, and corporate law firms. For a startup VC, it is crucial to establish and strengthen such partnerships early on.

Supporting

The goal of this activity is to support the growth of the startup after an investment is made. The spectrum of the Supporting Activity varies across VC firms. It is usually inversely proportional to the deals volume per firm due to the limited capacity of the VC firm resources. The exception to this is Y Combinator as it found a way to scale this activity by mobilizing and leveraging the YC network of portfolio companies.

The Supporting Activity own value chain starts with:

Key Partners: This is the strong core around which the other layers of this value chain are built. The support can range from serving on the board to rolling up sleeves and being in the trenches when needed. A nice anecdote I like here is when Marc Andreessen visited Brian Chesky at midnight when AirBnB was facing a PR crisis when a guest vandalized a host’s place. For a company designing Trust as a product, it is an existential threat, and Marc’s input played a pivotal role. In moments of crisis (common for a startup), knowing that you can get such quality support, even at midnight, is invaluable!
In-House Experts: Depending on the size of the fund, the firm might afford growing its support services by bringing in-house experts.
Network of Experts/Partners: The firm can grow its support services by tapping into a loosely coupled network of experts and partners. Those can be on a per-need basis, likely paid. Or unpaid but with a strong sense of purpose and common shared values and experiences. YC is such example where is tremendous esprit de corps among its alumni to support each other. For VC firms outside the Silicon Valley, building bridges with SV represents another strategic move in this value chain.
Process Formation & Streamlining: I have seen accelerators build a mentor network just for show but with little value extracted from it. This whole Supporting Activity needs to be measured and continuously improved. Again, it is about substance not form. Therefore it is important to have the right governance structure in place on how to grow, measure, and improve this Supporting Activity.

Exiting

Venture Capital is a business with a day of reckoning when the VCs need to close their fund, mostly after 10 years, cash out, and return the money to LPs with hopefully high IRR. IRR is the #1 KPI.

So, sooner or later, they need to cash out. Ready or Not (with few 1–2 years extensions). As the day of reckoning approaches, it puts pressure on their startups CEOs, through the Board, to get to a liquidity event.

The Exiting Activity has its own value chain with the following activities:

Identifying Options: The main options are: Acquisitions and IPOs, with few instances of exiting through secondary markets or existing shareholders. If the startup is under financial distress and the prospects for Acquisitions or IPO are just not there, then it might have to raise mezzanine or private equity financing. This can subject it to debt holders takeover where ownership and board decision making will change and shift away from the founders and the VCs.
Finding Buyer or Underwriter: For Acquisitions, it is best for the startup to be bought than sold. Being bought commands a premium, rather being in a situation when the startup needs to get sold and thus loses leverage in negotiation. Unless the startup has already received acquisitions bids, there are M&A boutique firms that specializes in finding buyers. For IPOs, if and when the startup is ready, the VC can help in finding an investment bank as an underwriter, and support the startup and its Board in the IPO process.
Executing: This is mostly the work of the ecosystem of this value chain, investment bankers, lawyers, regulatory authorities, etc.

Exiting is the last activity of the VC Value Chain. It is a major milestone for the VC and for the startups. It has different scenario paths ranging from positive to negative. How can the VCs help in this Activity, are they active or passive, do they have the relations, can they help with honorable exits when the outcomes are not promising, do have a staff for exists, etc. How strong is this Activity in their value chain?.

This is a Version 1.0 attempt to analyze Venture Capital from a value chain perspective. Next, one can use this framework to analyze and compare different VC firms, identify strengths and weaknesses, and formulate strategies and execute on plans to fill gaps and create core differentiations.

Everything being equal, the entrepreneurs care about the Supporting Activity in picking the VC. The LPs care about the outcome of the Exiting Activity. The VCs care about the whole end-to-end value chain, with the Investing Activity as their most crucial and idiosyncratic component.

PS: Part 2 will be a short case study on couple of VC firms touching on some aspects of this Value Chain.

— Mohamad Charafeddine (@mohamadtweets)