The “5 Tools” of Venture Capital
What Mike Trout can teach about how to be a complete investor
We love our Philadelphia sports heroes at Touchdown Ventures, but one of our favorite players — Mike Trout — doesn’t suit up for any of our hometown teams. Trout, arguably the best player in baseball, is a Philly sports fan himself, however, and he is frequently seen stumping for emerging stars like Carson Wentz of the Eagles and Ben Simmons of the 76ers. As a result, no one engenders more water cooler talk at our company than Trout. This is much to the delight of Los Angeles native, Wharton graduate, and Touchdown co-founder Rich Grant, who roots for the Angels and for Philadelphia teams, too.
Trout is skilled at every aspect of baseball, and his dominance calls to mind the talent evaluation framework relied upon for years by professional scouts: the “five-tool” player. Even if you aren’t a baseball fan, you may have heard of this rubric, because it was debunked by general manager Billy Beane of the Oakland A’s, as reported in the captivating business book Moneyball by Michael Lewis. For the record, the five tools of baseball are 1) hitting for average, 2) hitting for power, 3) running, 4) fielding, and 5) throwing.
Like baseball, venture capital investing also has five main skills: 1) sourcing, 2) evaluating, 3) transacting, 4) managing, and 5) exiting. Each is essential to being a successful investor. If you are thinking about a career in venture capital, or are an entrepreneur who wants to grasp how the industry works, understanding these roles can provide a useful perspective on the business.
What is it? Surfacing investment leads for the fund.
Why is it an important skill in venture capital? Quite simply, you can’t make investments in deals you don’t see. That’s why sourcing is one of the foundational skills of the business. In a typical venture firm, over 1,000 leads are generated per year. High volumes of deal flow are useful, because this allows the firm to be selective. Look at it this way: if your plan requires making five investments per year, and you generate ten leads, you are going to fund 50% of everything you see. If you generate 1,000 leads, you can be choosy, and pick the best 0.5% of what you see.
How is it done? Everything is a lead. Deal flow can be generated from an investor’s network (including other venture capitalists, entrepreneurs, accelerators, incubators, service providers like lawyers and accountants, etc.), attending conferences; speaking on panels; reading industry publications; spending time at universities where scientists and entrepreneurs may be developing new business ideas, and so on. A critical portion of the sourcing activity includes tracking leads in a database that can be shared across the firm.
Who does it? Usually, professionals at all levels of the firm are responsible for sourcing deals. Younger professionals, including analysts and associates, often source using proactive efforts and research, while senior professionals find deals using networks developed over many years in the industry. Relationships typically deliver higher quality, on-target opportunities.
What is it? Determining whether leads are good investment opportunities.
Why is it an important skill in venture capital? If a firm generates many leads but is unable to distinguish which are the best investments, returns will suffer. While investors frequently debate whether “stock picking” is the most important skill in venture capital, there is no question that the analytical ability to evaluate startups correlates strongly with success.
How is it done? Evaluating a prospective investment requires getting to know a company over time. There are four main stages of evaluation: a) the “first read” (which can be an instant reaction to determine whether the deal matches the firm’s strategy), b) the first meeting (in which the team can be evaluated in person or over the phone, and questions can be asked about the company’s resources and business plan), c) preliminary due diligence (which includes assessing whether there is a market for the company’s solution, competition, basic financial analysis, and initial customer and management references), and d) full due diligence (a deeper dive into all aspects of the company’s operations and plan, culminating in an “investment memo” or “investment decision” presentation for approval by the partnership). It’s normal to identify possible deal terms, including valuation, to complete an investment memorandum.
Who does it? Usually, younger professionals in the firm bear primary responsibility for evaluating deals. Analysts and associates often place initial calls to entrepreneurs, take first meetings, and perform diligence, with support and direction from more experienced senior professionals who can help interpret the signals that emerge while getting to know a company and its team. This division of labor allows senior investment professionals to focus on executing and managing deals and requires that analysts and associates become the “eyes and ears” of the firm.
What is it? Negotiating and closing investment transactions.
Why is it an important skill in venture capital? It’s one thing to find a prospective deal, and another to determine whether the deal is good, but VCs also need to be able to get into those deals. If an investor can’t convince an entrepreneur to take her money, and also structure a transaction that is fair enough for both sides that a deal can be consummated, there’s no opportunity to generate a return.
How is it done? The first step in closing a deal is securing internal approval, which is a natural extension of the diligence process. At that point, the firm will draft a non-binding term sheet, if leading the deal. If the firm is participating in a syndicated transaction instead of leading, evaluating the lead investor’s term sheet will have been part of the diligence process. Now the firm must work together with lawyers on both sides of the transaction to turn the term sheet into definitive documentation that facilitates a legally binding transaction. Ultimately, investors are also responsible for coordinating with back office professionals to close the transaction and provide funding to the new portfolio company.
Who does it? Senior professionals in the firm bear primary responsibility for completing investment transactions, usually with support from associates and senior associates. More experienced junior professionals, including those who have worked closely with a partner for several years, are sometimes given responsibility to draft term sheets. Negotiating the deal, however, is usually the job of one of the more experienced team members.
What is it? Maximizing the value of portfolio holdings.
Why is it an important skill in venture capital? It’s relatively easy to find and execute transactions, but managing investments might be the hardest part of venture capital. Most startups face multiple “life or death” moments, and the support of investors who actively manage their portfolio companies can make the difference between success and failure.
How is it done? Managing investments begins with relatively boring administrative work and good organization habits. This includes assembling key data on new portfolio companies, like CEO & CFO contact information, the plan of record, and tracking financial statements against plan. Managing also includes monitoring company performance by attending board meetings and setting informal interactions with company management. More importantly, managing the portfolio includes assisting entrepreneurs and developing a consensus view with the company’s other investors and board members. This takes a lot of communication and expectation setting. Good venture investors will summarize all this information internally for the partnership, facilitating internal valuation decisions and whether follow-on investments will be made available to the portfolio company.
Who does it? Senior professionals in the firm bear primary responsibility for managing the portfolio. As is the case with transacting, this is usually accomplished with support from associates and senior associates. More experienced junior professionals, including those who have worked closely with a partner for several years, sometimes tag along as unofficial observers at board of directors meetings, gaining the opportunity to learn how to serve as a director and manage investments.
What is it? Reaching liquidity via IPO, M&A, or write-off.
Why is it an important skill in venture capital? VC firms must provide a financial return to their investors, and that happens when portfolio companies go public or get sold (it also happens when investors sell their stock in what’s called a “secondary” transaction, which can happen before the entire company is sold). It’s extremely rare for investors to make a profit via dividends, because high growth startups tend to reinvest profits instead of distributing any extra cash. So if you hold your stock forever, you can’t recognize a return on investment.
How is it done? It would be normal to think that IPOs and M&A are the job of investment bankers, not venture capitalists, but the exit process begins long before the company is ready to exit. Good venture capitalists develop relationships not just with investment bankers, but also with buyers of technology companies. Rather than trying to sell a company, savvy investors recognize when a portfolio company matches an area of need for a buyer, or when the public market may be receptive to a particular story. The process also includes developing a consensus approach with the company’s other shareholders, so that interests remain aligned and the exit process is smooth. Mechanically, exiting includes negotiating transactions; verifying “waterfalls” that determine who gets what; reviewing legal documents; distributing proceeds; determining treatment of public stock; monitoring public stock prices and company news during lock-up periods; and more. And of course, since not all exits are positive, the process could also include leading a company through bankruptcy or shut-down, and providing documentation for write-offs.
Who does it? Senior professionals in the firm bear primary responsibility for generating liquidity. As is the case with transacting and managing, this is usually accomplished with support from associates and senior associates. More experienced junior professionals are often responsible for analysis of scenarios that may occur in potential liquidity events.
Think of the venture capital investors you know — most excel at several of the skills mentioned above. Some are amazing networkers who can generate many high quality investment opportunities, while some are analytically oriented and evaluate deals with ease. If you want to become a complete investor, these are five skills you should seek to develop during your career.
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