How to narrow down deal flow to appropriate opportunities
This is a multi-part series on Venture Capital Due Diligence. Throughout this series we cover the basics of deal flow screening, management due diligence, and financial analysis.
The Screening Process
The goal of screening is to whittle down from potentially thousands of investment opportunities those that are eligible for consideration given a VC funds’ philosophy, stage and sector preferences, and other criteria that define the interest of the VC. Between the offer of a term sheet and closing of a deal, preliminary and final due diligence are conducted to ensure the risk and return potential are appropriate. To many experienced VCs, a large percentage of investment opportunities can be eliminated from consideration in minutes due to the screening processes in place.
As we discuss below and in more detail throughout this series, an obvious but often overlooked question for startups is whether or not venture capital funding is necessary. In addition to a more thorough review of the team abilities, product, and market size, there are important and necessary questions to ask as a VC to determine if venture capital is required and whether or not venture capital from the VC’s fund is an appropriate fit.
The initial screening process can be formal or informal, depending on the number of decision makers involved in the fund. For smaller teams, the screening process is likely to include all members in the group whereas for midsized funds (six to eight), it is more common for the decision to be led by one or two partners, with investing done on the basis of these partner’s research and presentations to the full partnership. For large funds, on the other hand, written memos and pitches by partners to senior leadership become a critical component of the investment decision making process. Below we discuss the types of screens applied by VCs.
No matter the fund size, the quality of screening, also known as deal flow, is a critical component to success. “Sourcing” a high quality deal flow is not only challenging but also requires significant amounts of time, so having strong screening practices in place can help VCs become more efficient and focus time on potentially more value-add activities to existing portfolio companies or fund operations. Like most practices across the venture capital world, there is no formal screening process. It can be as informal as a conversation between a VC and a third party or as formal as an in-depth review of a company pitch deck or business plan. Most screening processes start with the compatibility of the investment with the fund and quality of key aspects of the venture, known as strategic fit.
Not all VCs are the same. Like the companies in which they invest, VCs often try to differentiate themselves by developing a unique culture, sector-focus, stage preference, or geography tendency. This makes screening out ideas easier based on some of these categories. The LPs, in the Limited Partnership Agreement (“LPA”), define areas in which the investment will be made, and these preferences/restrictions cover areas such as stage, geographic region, and sector, among others.
While most GPs will want to leave these definitions as broad as possible (to be able to cast as wide a net as possible), most LPs will agree — again, to facilitate the ability to find only the best ideas, unencumbered by restrictions. There are, however, good reasons to narrow the scope. GPs may have specific domain expertise, developed thesis in certain verticals, or have specific networks in which they intend to tap. The following is an overview of the common screens applied at this step.
“Renaissance Venture Capital was formed with the philosophy that venture capital is important for economic growth and that many major regions are under served in the amount of venture capital available to fund exciting new ideas and technologies.” — Renaissance Venture Capital
The fund philosophy may change over time, but often captures the sentiment towards the markets in which it is addressing, the overall health of the IPO market, thoughts on the problems, competition, and overall opportunities that exist, and many more hard-to-define factors. Most of this ambiguity comes from the fact that VCs at the end of the day are investing in people and ideas, not just products and companies. Given the rapid rate of technological development and velocity in which trends change, VCs can only consume and understand so much; and it is often the case that there may be great opportunities that simply do not align with the areas of expertise, sentiment, or ability of the firm.
A great example of fund philosophy is Renaissance Venture Capital, whose website clearly explains their belief that certain major regions of the United States are overlooked — lending to the possibility of discovering opportunities where others may have not sought. These philosophies can be developed further, like Renaissance, into smaller segments or more broadly, such as Andreessen Horowitz’s famous “Software is Eating the World” motto.
Another example of philosophy is impact investing, where companies are delivering solutions to under-served areas or populations. Examples include micro-finance loans in third world countries, educational and food-based resources and services, and many others.
Funds are often considered specialists or generalists. Generalists will be receptive to ventures across almost any industry or sector, while specialists are just the opposite: they consider themselves experts in a select few domains and look for leading opportunities given known problems in the vertical.
Moderne Ventures and MetaProp are two Real Estate focused venture funds on the East Coast. Moderne’s website reads, “We’re looking for companies with strong teams that can execute on bold mandates to advance the multi-trillion dollar real estate, insurance, finance, hospitality and home services industries, and provide value to our strategic investors and partners within them.”
By focusing on specific industries and sectors, VCs believe they can form opinions on the probability of success of an opportunity more quickly and better understand the forces of nature that will dictate success of failure. Pitch decks and business plans that do not focus on these areas can be easily discarded.
Another easily applied screen is based on the stage in which the fund generally prefers to invest. Some funds focus exclusively on seed and early stage rounds, while others believe their expertise (and interest) lie further down the growth curve (growth equity or later). This, again, is due to the VCs experience and where they see themselves as best able to provide value. Given the size of some firms, the inability, economically, to write smaller checks may actually preclude them from investing in earlier stages (and vice versa).
Below is an overview and examples of stages and typical round sizes, courtesy of FundersClub.com
|Seed|| Have generally demonstrated early traction; need capital |
to continue product development and acquire initial customer-base.
|Series A|| Usually have achieved strong product-market fit; seeking |
additional capital to scale their customer/user base and increase revenue.
|Series B|| Startups should be able to demonstrate highly measurable |
results (strong revenue, large market share, repeatable growth engine);
focused on scaling their internal team and achieving market domination.
|Series C +|| Can generally demonstrate large scale expansion; |
focused on developing new products or expanding into new geographies.
Therefore, when opportunities are presented on the opposite end of the spectrum, these can be passed on (or perhaps referred out). An important note on stage is that VCs can define stages differently (especially early on) and as companies grow, they obviously progress from stage-to-stage, and it is common that VCs who invested in earlier rounds may invest in rounds at later stages as well.
A related consideration with stage is the actual investment amount requested (and dictated by the round and investments already made by others). Some VCs, due to the size of their fund, may be willing to only write significantly large checks, whereas others do not.
Like business sectors, location can play an important role in understanding the risks and opportunities of a potential investment. Beyond the well known headquarters of venture capital flows in general that is concentrated on the coasts in the US, different geographies may be more appealing to funds given the actual venture. The Midwest, for example, is a greater area of opportunity for startups building in the industrial space, than those in rural areas. Similarly, real estate startups such as OpenDoor have launched in the Southwestern United States given the homogeneity of homes when compared to cities. VCs may prefer to invest locally not only because they better understand the drivers of their local economies but have a closer physical proximity to the founders.
Beyond these features of geographic preference and proximity is the value of network effects within VC and startup communities. It is not a coincidence that Silicon Valley has continued to dominate as the land of VC — there are real benefits to being able to leverage shared networks, talent pools, resources, and information within a well-developed ecosystem. It may be the case that VCs invest in companies in certain areas due to the VC’s belief that those resources will be more readily available to founders and companies, increasing the probability of success. Conversely, this may be a reason why VCs may look to ‘underserved’ areas of venture capital — to lead the way in developing these networks.
Other considerations for screening include the quality and reputation of other investors either interested in or already invested in the venture. The quality of the lead investor may also dictate a fund’s willingness to review and participate in the round as well. If well known funds such as Sequoia Capital or Benchmark are leading the round, smaller funds can often rest assured the initial screening and due diligence process has been done (and done well), taking risk off the table. The quality of those associated with the business and its investors may matter. For example, existing strategic partnerships, brand quality, and strength of supporting roles (accounting firms, law firms, among others), may add validity to the venture and ensure it passes screening.
Other considerations include the fit of the company within the existing portfolio for the fund. Does this company directly compete with others in which the VC has a vested interest? Beyond market conflicts, legal ones can arise when VCs, for example, acquire board seats with competing companies or have investment terms that conflict with business operations.
Now that we have discussed fit, assuming it exists, the next step of the screening process is to review the quality of the potential opportunity. This spans the quality of the origin and related parties.
Source and Origin
Given the volume of opportunities that come across a VC’s desk in any given period, an easy screen to apply relates to how the opportunity was discovered. Referrals, warm leads, and introductions from trusted sources are almost always preferred to cold outreaches.
Sourcing ideas from experienced and trusted contacts within the industry can help de-risk the opportunity, especially if the referer has already conducted some preliminary research and due diligence into the business or can vouch for the strength of the founding team. When your reputation is on the line, especially when money is involved, information tends to be high quality.
Professional contacts, especially referrals coming from the same industry in which that person is an expert, should be highly considered as well. It is likely the referer has experienced the same problem the venture is trying to solve, and a VC’s wide network across business professions can help in sourcing ideas. It is much more common the VC will have intimate knowledge and trust of their source than of the idea and founding team itself, so this is a natural and easily applied screen for VCs.
Outside of the source of opportunity is the genesis of the idea itself. VCs may prefer to invest in ventures started by successful and well known entrepreneurs of business leaders. This is viewed as a more calculated risk than an unknown. Similarly, how was the problem in which the venture intends to resolve identified? Was it personally experienced by the founders (and possible the VC)? Does the management team have experience solving similar problems in the past through other ventures or their current job? VCs should look to patterns of success with the founding members in order to understand in whom they are investing. We will discuss this in more detail in the following sections, but suffice to say for a preliminary screen, the idea source is a commonly applied screen.
Partners and Business Associates
Similarly, VC capital is often provided to a company but is then redistributed by means of strategic partnerships, spent on accountants and lawyers, and used to acquire customers. All of these areas have both direct and indirect influences on the VCs role within the company and need to be considered as well.
Who and of what quality are the other investors in the round? An impressive lineup of investors are often indicative of a high quality opportunity, and one that has been scrutinized by other quality VCs. The quality and value of the networks brought to the table through other VCs can add a significant amount of value on top of capital. All of this points to the potential to gain an “information” advantage with the venture — an advantage even those with perhaps better products or plans may not be able to topple.
The quality of the company’s legal counsel, accountants, and other professional services should be considered as well. Especially at early stages, companies need good legal counsel. Poorly structured corporate entities, employment contracts, customer agreements, and negotiations can have material impacts down the road and need to be seriously considered when reviewing operating risk of the venture. Similarly, the quality of financial record keeping (especially as it relates to taxes and cash flow management) are critical in review. By outsourcing much of these tasks to reputable professionals, companies can focus on where they should: creating value and building their company. Knowing these tasks are being handled appropriately can remove significant risk.
Last but not least, does the company have any significant and impressive customers? If the company has secured, for example, an exclusive agreement with a market leader, this may often trump other considerable risks. Having a secure sales channel, already developed brand, or cost advantage can be immediately impactful when it comes to the ability to develop a sustainable competitive marketplace. Look for letters of intent or finalized contracts to gauge the quality of customers, but also take into account the potential customer concentration risk. Is the company relying on a single customer? What happens if that customer relationship ends?
We now have a thorough understanding of the screening process, next we’ll tackle arguably the most important metric for Venture Capital investing – the market size.
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