Venture Capital | Part 1/7: Deal Flow

Where do great founders like to work, play, and rest?

Hello entrepreneurs, VC aspirants, business students, and general information gluttons. Welcome to my series on Venture capital, where I try (as a VC associate in London) to go through what goes on behind the golden curtain of working in VC, peppered with observations/rules of thumb I have picked up.

Before I start, I want to say — I believe that 80% of VC is an art, not a science. The sciencey part comes in at the wee end of it all when terms, ownership and cheque sizes are determined, but the meat of it is as arty-farty as they come. It’s about people and how passionate they are (Psychology), it’s about economies and what people are likely to pay for (Economics), it’s about cultures and what might work (Sociology), and it’s about ideas and concepts (Fine art, creatives).

Okay so, Why am I writing this?

Well, venture capital is a huge black box. VC associates hold an air of exclusivity (read: god complex) and the industry is extremely, extremely, extremely inequitable. You can read more on diversity in VC in this great report here, but the headlines are -

• 1% of VC money was raised by female-only VC fund teams
• 84% went to male-only teams
• 91% of the total VC capital is managed by men

This affects people at all levels of the value chain.

• Entrepreneurs who want to raise receive rejection after rejection with no explanation, they don’t get feedback and often get extremely demoralised by the opaque process
• Prospective employees struggle to join the ranks as the roles become more and more exclusive, mostly a chicken-and-egg situation around
• Diversity being shockingly low makes it super hard for disadvantaged groups (women, people of colour, and disabilities) to have a hand in shaping the future of the world

Quick overview — here’s how processes typically work in VC

VC process flow

1. Deal sourcing | First, we try to tap into as many sources as possible to increase the number of deals we have to choose on
2. Pitch Deck Screening | Then, we go through the decks that we have and determine which opportunities are exciting enough to look deeper into
3. Initial Meetings | After that, we do ~3 meetings with the leadership team, ask questions and see if we there is a good working relationship between the two parties
4. Due Diligence | If we are sufficiently excited, we go into a detailed due diligence which involves financial, technological, legal and market diligence
5. Investment Committee Meeting | After that, the board members meet and vote on the opportunity — the team is usually the lead general partners (the ones who manage the money) plus a few external experts / members
6. Capital Deployment | If it passes this stage, we make a term sheet, i.e. set the terms for capital deployment including ownership, ticket size and dissolution rights.

And now, without wasting too much time, let’s talk sourcing.

What is Sourcing (i.e. Deal flow)

VC firms need to deploy capital.

We don’t make money if they don’t invest. Because LPs (limited partners, i.e. the rich people and institutions that give them money to manage) give their money to VC funds to make a greater return than the banks and the public markets. If they don’t invest, the money doesn’t grow.

Also, for ourselves, if we don’t invest, we don’t get a cut of the profits once the company grows (this is called ‘carry’, and is also the greatest % of the compensation of someone who works in a VC firm). We also don’t get to raise more funds unless we have used the funds previously allotted (this is called a ‘drawdown’ which essentially means we have drawn money from the pool of money they were given). And the base operating money a VC firm gets is a % (typically 2–2.5%) of the money they manage.

Leonardo DiCaprio throwing money into the sea

So, to earn more, we need to manage more money. And to manage more money, we need to spend the money we have. This means that we are strongly incentivised to invest in companies.

This is the first thing that is important to understand — VC firms want you to succeed. We want you to get the money, and grow. All we want is a strong enough reason to give you the money. Remember this, this mindset shift does wonders.

Increasing TOFU is the strongest way to increase BOFU

In a sales process, TOFU refers to the top of the funnel, which is the complete list of initial stage opportunities. A % of this goes into MOFU, the middle of the funnel, which means things that are in the process and finally, BOFU, the bottom of the funnel where things are almost closed.

TOFU, MOFU, BOFU

Typically, to get more opportunities at the bottom of the funnel, the most reliable way is to increase the opportunities present at the top of the funnel. Because changing the % that moves in each stage has implications on quality and therefore more risk.

And as we discussed, it's in the firm’s interest to have more opportunities in BOFU, so increasing TOFU becomes a priority as well.

What’s important when it comes to sourcing?

1. Volume — The number of deals received per week. This is a factor of how present we are as a firm and our reputation among founders
2. Relevance — Do the opportunities keep in mind our thesis? For example, the firm where I work focuses on diversity, and so the more “white male” opportunities we get, it is a bad sign.
3. Stage — Are the opportunities that we are getting more pre or post-revenue? Where does that lie in our preference?
4. Variety — How many sectors do our opportunities span? Are we getting too many buzzword opportunities with little representation of different sectors?
5. Location — Most VC firms have a geographical focus on where they invest, and don’t even look at opportunities outside it. So it’s something to consider if the opportunities are within that parameter or not.

So how do we source?

A representation of all the ways to get deals, and their typical size

There are various ways to get more deals, each with pros and cons.

I. Inbound

Dodgeballs being thrown

Inbound deals are the deals that come in directly to the company. We don’t seek them out, they’re just sent to us by founders looking for funding.

This number is usually the highest. Why? Because of the flow of monetary incentives. Essentially, this means that because Founders stand to gain money from the process, they are more proactive in reaching out, since money is a strong motivator (and an exception to the law of diminishing marginal utility)

These deals usually come through the VC’s website or DMs on Linkedin & Twitter. Small firms get around 30 a week, and larger ones can get 200+. This is a good healthy number to have because it is a proxy for our standing in the market.

If this number goes down, it’s worth investigating. There are a few questions we can ask:

1. Is our reputation struggling? VC is a very tight-knit small community, so word travels fast. Gossip, like a fire, spreads ruthlessly. It’s helpful to meet people, find the pulse, and nip it in the bud if we get a sense of something like this.
2. Is the economy in general struggling, and are people not building as much as they used to? Macroeconomic trends have a huge impact on inbound TOFU because fear can make founders scared to reach out. Matching numbers with other firms help to isolate this cause.
3. Was there a technology issue? Website downtime, being blocked on social media, etc. can make it impossible to receive inbound leads. A couple of days’ downtime in the week can be a huge problem and should be enacted immediately. Checking tech logs of the website is key here.

Now that we know that most of the deals that we see come inbound, what are the concerns with this? Quality.

Most of the time, these opportunities are a dime a dozen. We often see badly constructed pitch decks, companies that are copies of each other, and founders that aren’t as exciting/accomplished.

Why is this? Because fundraising is a game. And people who know how to play the fundraising game are the ones who raise the most capital. And the game rules include this — to be taken seriously, a warm intro is essential. Its a game of perceptions, and once noticed, it changes everything. The attention we give and the beliefs we have about an opportunity change drastically based on how it enters our pile (it is framing, context, biases).

And so, the takeaway here is — inbound is great, it gives us those numbers (which we do want) and can be a good barometer, but if you’re an entrepreneur — always, always try to get a warm introduction.

II. Co-Investors

The office handshake

The second strongest way to get a deal is through co-investors. This is when other VC firms share their deal flow with you, and refer you to companies that they have come across / met. This is where VC being a small community comes in, and relationships become very important. There are several things to consider when it comes to this, and it has arguments both for and against.

Benefits of this pipeline —

• Potential for Co-investing — Typically, many institutions and individuals collaborate to complete a round that is raised. The one that gives the largest cheque is said to “lead” the round, and they usually get the board seat on the startup. When one company (especially one with a good thesis and reputation) is ready to invest in a company, it’s a good chance to get into the deal with a smaller cheque. Often this means that the round is shaping up, things will move fast, and the burden for due diligence will be lower on our firm.
• Vetted deals — Another firm’s initial interest is a trust signal, and these opportunities are of a far higher quality than inbound deals. This means that level 1 is solved for, and often if the opportunity is interesting we can go straight to level 2 — initial meeting — as long as the opportunity meets our thesis.
• More deal flow — This avenue increases our TOFU by a lot, which is our macro goal. There is often a lot of cross-sharing in the community and so is a great avenue to expand.
• Relationships —Nurturing this option has far-reaching benefits, as relationships compound and our reputation builds. Quid pro quo benefits us as well because we can fill our own rounds by adding others as co-investors in the future.

That being said, there are a few concerns as well —

• Why aren’t they investing? — It’s important to know why the company has shared their opportunity. Are they investing and looking for a co-investor? Are they passing on it, and if yes is it because it doesn’t meet their thesis in some specific ways (geography, stage) or is it not a good enough / large enough opportunity?
• Tunnel vision — Relying too much on this avenue shouldn’t come at the cost of self-sourced opportunities, because it can make the world of opportunities smaller and less diverse.
• Trust is fragile — As relationships become more important, it is a tightrope to walk. Reputation can constrict our behaviour and it’s almost impossible to please everyone.
• Prohibitive for new entrants — New VC firms have to work very hard to enter the club, so it reduces the equitable opportunity for people to enter the market, which reflects in small-mindedness and power being concentrated in smaller hands.
• Harder to be contrarian — Going with the crowd, or even being overexposed to the crowd makes it harder to invest differently. And wealth is made by going against the grain — so in a way, it reduces your chances of success.

III. Founder Relations

Simpsons therapy circle

Knowing founders and staying in touch with people online as well as offline is a great way to get deals. Often, founders live in packs and support each other through challenges, introductions, recommending team members, lobbying for policy, and more.

Being close to these circles means that whenever a company is ready to raise, you can get the information first — and you get the pick of the litter. It’s a long game to play but has many benefits of choice and timing — especially when a deal is hot and moves fast.

IV. Attending Events

Modern family gold

One thing that VCs have to do a lot of is attend events — Pitches, VC networking, support events, expert network launches, and more. Here you meet a lot of interesting people, take numbers, add people on Linkedin and create a reputation. This pipeline is useful and ongoing, but quality can be on a range.

V. Public Information

Tom Cat reading the newspaper

One more thing we can do is read the news, stay in touch with startup trends and follow industries.

1. Follow geographies — Pick markets that are growing, as well as sub-markets that we see interesting activity. In the UK, that is typically London and Manchester, and in India, Bangalore and Gurgaon (Delhi NCR).
2. Follow industries — Pick industries that are growing in these markets, and keep a watch on when the cycles are lower, and therefore likely to be underpriced
3. Follow companies — Look for newly incorporated companies in these industries and geographies, do some research, and wait patiently for them to be ready to raise a round.

This is very effort-intensive and has a high failure rate. In practice, this method is outsourced to analysts and most investors don’t do much of this.

What companies do, though, is create platforms that crawl platforms that incorporate companies (In the UK, it’s Companies House), and the technology creates a list for them that meets their requirements — which makes it easy to follow.

VI. Follow-on

Creepy bird following gal

In very small cases, companies that we invested in earlier do really well and we participate in the next round as well. This is good because follow-on cheques in VC can often come on better terms.

This increases the absolute return on your investment. Basically, Absolute return refers to the amount of funds that an investment has earned. And this increases if we don’t get diluted and maintain our initial position once the company has grown.

This also helps with governance, because if our stake is not diluted, we can maintain relative control within the company and have a hand in the growth journey.

The reason this is rare is VCs typically prefer a stage to invest in (eg. seed stage investors can’t always participate in Series A rounds because the capital required is much higher). It’s only the really large firms (Sequoia, Accel, whathaveyou) that can do so with ease.

This also requires a lot of skill and is a very strong test of a good VC. It involves facing the sunk-cost fallacy of deciding to pour more money after a bad investment or to continue to back a winner.

To Summarise, here is how I see it work practically when it comes to sourcing deals:

A 2/2 Matrix of Effort and Quality on sourcing pipelines

In all this, firms track these metrics on a weekly if not daily basis to continually monitor the deal flow pipeline, and tweak strategies as needed.

This draft is the first of a 7-piece series focusing on the inside of the VC industry. It is told by a current VC associate, to help entrepreneurs lift the curtain. The goal is to learn to raise better by speaking the language and giving VCs what they look for. It will include —

1. Sourcing | Where good founders like to work, play, rest
2. Pitch Deck | What we look for in Ideas
3. Initial Meeting | What do we look for in People? On Founder Market Fit
4. Due Diligence | How Heavy is the Past? — Data in VC, Financial analysis of VC firms
5. IC | The Art of Making Good Decisions
6. Deploy | Term sheets
7. Exit | Ways to do it