Oct 26, 2023
 in 
Venture Capital

Revolutionizing Deal Sourcing: How Digital Technology Is Changing the Game in Venture Capital

Author
Michael Sable
V

enture capital is about selling. VCs sell themselves, their firms and the value they can add in helping entrepreneurs realize their goals. Competition is fierce, especially because the venture capital business model—lose money on 8 deals, break even on 1, and hit a grand slam on 1 to cover the other losses—requires a focus on the small universe of high potential startups who meet that criteria. This is why deal sourcing is of such great importance to venture capitalists. They are constantly looking for the next big thing because the next big thing is essential to overcoming the extreme risks inherent in this asset class. At a fundamental level, deal sourcing is business development as a venture capital firm cannot grow without a consistent pipeline of quality deals.

Deal sourcing or deal origination refers to the process that venture capitalists and other finance professionals utilize to find investment opportunities in the market. The process typically involves a combination of networking, marketing, lead generation, pitching to entrepreneurs and those that have access to them, and the ongoing cultivation and maintenance of relationships with both the entrepreneurs and intermediaries. Here is an example of how the process can work:

No one strategy is typically used as each venture capital firm and the professionals within it, often have their own methods for sourcing deals based upon their experience and what has proven to be effective for them. Deal sourcing, particularly in its initial phases, is the least scientific and most people-centric of the business processes intrinsic to venture capital as it is very much about relationships, the capacity to build trust with entrepreneurs, and how the venture capital firm and its professionals are perceived by the broader entrepreneurial community. Venture capital firms and venture capital professionals with a poor brand or a reputation for underhanded dealings will never have any access to the dreams, aspirations, and business plans of the very best entrepreneurs because those with options will assiduously avoid doing business with the untrustworthy.

TRADITIONAL APPROACH

The traditional approach to deal sourcing is highly labor-intensive and at times emotionally draining as it involves a lot of networking, soliciting referrals, and salesmanship. This is the most interpersonal part of venture capital. It is also the last thing that one is likely to be taught in business school and even if it was taught, it is a skill that can only be honed with experience. The emotional drain comes from the constant cold calling and hustling.

Networking is learned by doing. As such it requires a lot of grinding work. Advantages can be obtained by having contacts at a particular school, industry or geographical area but even that is insufficient as getting someone to take a phone call and closing a deal are radically different propositions. The capacity to earn the trust of highly talented entrepreneurs is the scarcest skill in venture capital. This is why reputation and a strong track record of treating entrepreneurs fairly while adding value to their endeavors is so essential.

Entrepreneurs talk and network as well and their transfers of tacit information about a bad deal can blacklist a venture capitalist or venture capital firm without their even knowing it. No trust means no referrals. As is often the case in service industries such as finance and consulting, senior personnel play a key role in networking as their industry experience and contacts developed over years with prominent academic-entrepreneurs and senior professors at key universities can give them a profound advantage in sourcing leads as to which entrepreneurs at which universities have a promising idea that is ready for the kind of financial and technical assistance that venture capitalists are uniquely capable of providing.

In many respects, the imperative to network is why the age bias of venture capital is so dysfunctional as networking and referrals become much easier to facilitate as one develops a reputation in an industry with deep contacts over time.

Networking can be done inhouse with internal deal sourcing teams who reach out to leads, make contact with investment intermediaries and read about scientific innovations to identify scientist-entrepreneurs who may be in need of funding. Oftentimes, the decision to hire a professional to an investment team may be influenced by an assessment of their rolodex and the contacts that they are likely bringing with them.

This is why professionals who have worked in the technology, media and telecommunications divisions of investment banks, particularly those in Silicon Valley, are so highly prized. Deal sourcing can also be outsourced to external teams who have a mandate to purchase mailing lists and funnel contacts to the venture capital firm. Usually, firms do both. In either case, being visible is important. 

Venture capitalists can often be encountered at key technology conferences, industry events and university entrepreneurship competitions where they can develop their knowledge of the important trends and technologies shaping an industry while trying to make contact with the scientists and entrepreneurs influencing those trends. As more and more universities are endeavoring to become startup friendly “entrepreneurial universities,” they are increasingly developing programs and formal mechanisms to introduce their students and faculty to venture capitalists, particularly those with an alumni connection to their school, who can provide the seed capital and advice to get their businesses launched.

By helping young startups, venture capitalists are often networking to help themselves. The sponsorship and participation in hackathons; answering questions on social media; serving as a speaker or judge at an entrepreneurship competition and accelerator event; attending tech happy hours and acting as a mentor or advisor to a young startup—these are all forms of networking that establish relationships with entrepreneurs and universities which can be very beneficial to both parties over the long run.

DIGITAL TECHNOLOGY

In recent years, as it has done in so many areas, digital technology has transformed deal sourcing. The process is increasingly going online which has served to break down geographical boundaries and enhance the competitiveness of younger firms that may not initially have the well-established networks of older ones. Equity crowdfunding platforms such as Wefunder and StartEngine have been at the heart of this nascent revolution as they have allowed entrepreneurs access to a broader universe of financiers and vice versa.

These platforms have thousands of entrepreneurs, hundreds of thousands of investors, and over a billion dollars in investment capital available through digital infrastructure. By concentrating these resources in one location, an entrepreneurs’ ideas may be better marketed to a larger audience and the time that venture capitalists spend looking for good deals is significantly reduced. Another benefit of these deal sourcing platforms is that they increasingly include the provision of augmented data that integrates information from various sources into a cohesive whole.

As artificial intelligence becomes more prominent in the venture capital industry, the data analytics aspects of these platforms and whatever customized tweaks individual firms can make with their own internally developed technology solutions will become an increasingly salient part of competitive advantage in the venture capital industry. 

The universe of deal sourcing tools available is quite broad and includes:

  • Database platforms (Crunchbase, Dealroom, Pitchbook, CB Insights): These websites provide access to in-depth information on startups using customized filters. Filtering criteria can be maturity, size, country, industry, start-up date. Those database platforms are also used to search competitors as part of market analysis.
  • New startup or new product census sites (Pepitech, Product hunt): Recommended for analyzing new startups and new disrupted products launched. An excellent way to track innovations and investment opportunities.
  • Scraping tools (Phantombuster, Snov.io, Hunter): These applications are ideal for recovering hidden e-mail addresses, and are handy to get in contact with the founders.
  • Sales Navigator: This is a powerful tool developed by LinkedIn that allows users to set up alerts via filters by country, by sector, with a purpose to identify people who change their profile title and become for example Founder, Co-Founder, CEO, CTO. These signals are highly relevant for detecting potential contacts. Sales Navigator can capture signals from startups operating in stealth mode. This is a fledgling startup working to bring a new product or service to market under a temporary state of secrecy.

Aside from the aforementioned equity crowdfunding platforms, other online deal sourcing platforms include:

  • Coresignal: The platform provides 98 million startup data and firmographic data records. The latter are data points such as company founding date, location, headcount, industry, etc. This makes it easier for venture capitalists to search for investment opportunities by industry, sector, and technology.
  • Dealsuite: Dealsuite allows VCs to share documents and propositions through plug-and-play SAAS. With an intelligent matching algorithm, this platform is able to provide relevant leads in about 73% of the cases.
  • Navatar: Navatar is global with more than 600 clients in over 35 countries. It provides investor relations as well as comprehensive fundraising. Entrepreneurs may target LPs and nurture a structured process to earn the trust of investors.
  • DealCircle: A Denmark-based platform, this company helps startups as well as angels to find good deals. It is a good option for small companies that prefer the option of outsourcing.
  • BankerBay: This private equity and M&A deal sourcing platform is one of the most popular platforms in the world. Clients are connected to the right party through common interests by adding their sell-side deals or investment mandates as a way for the algorithm to find the right counterparties.

The use of technology to facilitate deal sourcing is growing rapidly particularly as social networking continues to evolve and incorporate new technologies. As is to be expected, a key danger is fraud. The best platforms engage in strict due diligence to make sure that the entrepreneurs and venture capitalists that do business on their platform have integrity.

DEAL FLOW MANAGEMENT

Deal flow management is also a critical part of effective deal sourcing. Deal flow is the flow or rate of incoming deals that are indicative of promising investment opportunities for a firm. As such it is both a determinant and an indicator of whether or not a venture capital firm is successful as it demonstrates how entrepreneurs and investors value the activities of the VC.

The volume and the quality of deals are especially important as metrics of the health of the firm’s deal pipeline. Less than 1% of all sourced deals typically are funded so effective deal flow management is essential to the operational health and efficiency of the venture capital firm:

A venture capital firm is just like any other enterprise in that how it uses scarce time and resources—both of which have costs associated with them—will determine its profitability. Too much time and resources spent on bad deals or not enough time and resources spent nurturing good ones can either undermine or facilitate the growth and development of a venture capital firm.

The stages delineated in the above graphic are indicative of the typical VC deal management process:

Stage 1--Deal Sourcing: Networking and leveraging referrals is foundational to the overall process and has been discussed.

Stage 2--Deal Screening: After being vetted, an initial exploratory meeting is held with entrepreneurs to collect the information that the firm believes is vital to the investment decision. The information requested may vary based upon the industry, investor knowledge and how much is understood about the entrepreneurs. The idea is to fill important information gaps. Organizationally, at this time, a dedicated point of contact is assigned. The information gathered will be compared against other potential deals in that industry to determine which is most competitive or offers the most value for the venture capitalist.

Stage 3—Partner Review: The point of contact presents the most competitive opportunities to the internal decisionmakers/partners. Only a small percentage—10-15%--will survive this stage.

Stage 4—Due Diligence: This is a very labor and intellect intensive stage in which the venture capital firm will vigorously analyze the firm-product fit including interviewing customers and sampling the product or service. The process is onerous as it can take months.

Stage 5—Investment Committee: The investment committee which is comprised not only of firm partners but also industry experts and other seasoned professionals that the firm trust will now review the investment opportunity based upon the totality of the information it has gathered. Each firm is different but the objective is the same—to make the best investment decision for the firm that is consistent with its financial, strategic and moral goals.

Stage 6—Deploy Capital: Sign the entrepreneur to a term sheet and send them the money.

The difficulties in navigating this process demonstrate why venture capital is such a unique asset and risky asset class.

Competent venture capitalists have an impact not just with the financial capital that they provide but with the intellectual capital that they provide. This is why thought leadership is such an important part of effective deal sourcing and deal flow management. Inbound marketing through the writing and curation of educational and insightful content such as blogs, articles and books will impress entrepreneurs by informing them that the VC truly understands their industry and what is essential to success within it. A good venture capitalist seeks to shape the conversation around innovation in the spaces in which they operate. In so doing, they market themselves and their firm and become attractive business partners.

Good deal flow management is also driven by embracing automation. Customer relationship management platforms that organize data, track metrics and evaluate progress while aggregating information into a single unified space where it can be analyzed by artificial intelligence and Big Data tools are helping to enhance efficiency in the venture capital industry. CRM tools like Salesforce can be adapted with customized (Application Programming Interfaces) APIs to meet the specific needs and priorities of a particular venture capital firm. Through the integration of APIs, a venture capital firm can automate data exchanges between various systems and ensure that relevant information is accessible whenever it is needed which in turn can lead to faster decision-making with reduced labor. New Software as a Service (SAAS) platforms with robust features are constantly emerging to serve the needs of the business community so there are many choices.

METRICS

Numbers matter and the venture capital industry is no exception. Metrics that are important in deal sourcing, deal management and deal evaluation include:

  • Startup Industry: Rate of Growth, Stage of Development, Growth Potential and Total Addressable Market
  • Team Quality and Team Experience
  • Intellectual Property and its Defensibility
  • Volume: The number of deals that a VC firm evaluates over a particular period of time.
  • Quality: The potential return on investment and the level of risk associated with each deal. This is usually quantified by the average expected return on investment for deals which incorporates internal rate of return (IRR) or net cash flow.
  • Conversion Rates: The proportion of evaluated deals that progress to the investment stage
  • Diversity: The variety of deals in terms of industry, stage of development, geography and size of investment.

Non-financial factors are also important as the best firms do not invest solely on the basis of monetary considerations. 

At the end of the day, effective deal sourcing starts with recruitment—one of the reasons why those with elite educational credentials and experience at Fortune 500 companies are sought after so highly to work at venture capital firms is that it is believed—probably erroneously—that their preexisting network through their educational and professional affiliations gives them a powerful networking advantage.

This self-reinforcing echo chamber is emblematic of the homogeneity of background and perspective that the venture capital community has long been criticized for. It is also probably not the best thing for the venture capital community as there are many other ways to acquire a network such as through military experience, extensive experience in an industry, or age with all of the attendant contacts that one acquires over time. This bias towards youth, elite academic credentials and traditional Fortune 500 experience must be examined and challenged if the venture capital community’s deal sourcing activities are to be reinvigorated with access to new non-traditional networks where innovation is burgeoning.

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