The old adage of the fundraising process is that it is like getting married, not dating: once the docs are signed and money is in the bank, the relationship is for the long haul. While this truth exists on both sides of the table, the due diligence process during fundraising often feels more like an interview than a dialogue.
However, understanding fit may be even more important to an entrepreneur than to an investor. The best lead investors make game changing introductions, can foresee organizational challenges, and guide from their own experience, while the worst can pull an entrepreneur in a thousand directions, try to manage the company from the Board, or slow progress with protective provisions, redemption clauses, or other punitive terms. What’s worse, is that founders typically have only 2-3 major investors in their company while investors have a portfolio of many companies, so the impact of a negative relationship is concentrated for founders and diversified for investors. Put simply, selecting the right investor is a critical decision for an entrepreneur, but is often overlooked because entrepreneurs don’t feel like they’re in the driver’s seat. To get the right partner, founders need to ask the following questions while raising money:
1. Are you working with the person you want at the firm? I believe that the most important criteria for selecting investor is whether you are working with the PERSON you want, not the FIRM. While you raise money from a firm, the Partner leading the investment will be the one working with you and will guide the firm’s sentiment on your company. The style of an individual partner can vary significantly within a single firm. Important questions to ask are as follows: Is their working style high touch or low touch? Do they have expertise with your market or business model? Does the individual’s ability and relationships match what I need? Many VC firms are now productizing the value that they bring to portfolio companies through in house design leads, portfolio advisors / board partners, full-time recruiters, and other means. While many others follow a more “artisanal approach” – a term coined by Bill Gurley at Benchmark – of having a smaller team. One great way to test for helpfulness, is to ask for help before the deal is done. If they won’t help while trying to close the deal, what is the likelihood that they will help later on? Ultimately it is up to you to decide which type of relationship you’d like with the Partner, but it is essential that you have clarity on expectations going into the relationship.
2. Is the firm’s investment thesis aligned with your future plans? Different venture capital firms have varying tolerances for risks, holding periods, and return targets, which will bias them as Board members and shareholders when it comes time to make a critical decision. Often times, these issues are masked during the fundraising process for two reasons: 1) Entrepreneurs feel pressure to change their pitch to raise money and 2) Investors change their philosophy to win deals. On the former, it is important to tailor a pitch for each firm, but wholesale changes to the business model, capital requirements, or exit strategy at this stage are unnatural, and should only be made if they are the right choice for the business, not solely to raise money. Regarding flip-flopping Investors, firms have been known to chase returns in different sectors or say what they need to close deals, particularly during bubbles. Testing a firm to ensure that you fit squarely within their investment thesis will be important when times get tough and the firm snaps back to its core values. Ultimately, if you felt as though you were being pulled into a different direction while fundraising, then the firm is probably not the best fit.
3. Does the firm’s fund size match your future capital needs and does the firm have a track record of supporting its portfolio? If you expect a significant number of follow-on rounds, one strategy is to seek investors who have large funds that will be able to provide follow on capital. Critical questions to ask during the VC courting process are 1) how often they participate in follow on financings and 2) how much do they have reserved for future financing rounds for your investment. Big funds will have the ability to invest pro-rata in future financings or even pre-empt future rounds, thereby allowing entrepreneurs to focus on their business not raising money. However, bigger isn’t always better. With smaller funds, your company can mean more to their entire portfolio e.g. will the $1M seed investment keep the Partner from the $1.5B up at night? Maybe not, but the $10M seed fund that made a $1m investment may be fighting with you until the lights go out. Further if they choose not to invest, you can likely remove the signaling risk in future rounds. Put simply, if the firm who led your Series A, doesn’t participate in your Series B it sends a strong, negative signal to the market if they have the capacity and strategy to participate in follow-on financings. Thinking through the firm size and your capital needs is critical when selecting a partner and the right answer is highly dependent on the unique needs of an individual company.
4. When will you want to sell? Investment firms have fundamentally different incentives than founders through diversified portfolios, fixed fee-based compensation, and outsized return expectations from limited partners (LPs). Said differently, VCs are playing home run derby, while you may want to play baseball. These incentives can cause tension when the option to sell the business arises. First, I recommend figuring out your number, often referred to as “F&CK YOU Money.” Or when discussed at the dinner table: “How much money would it take for you to retire?” Then what return does this imply for the firm. If they are making less than 3x their money (“ROI”) or 10% of their aggregate fund-size in absolute profit (“Tonnage”) then you may run into issues. I am not advocating for founders to sell as soon as you receive an offer above the “number,” but I think it’s worth thinking hard about the future opportunity in the company at this point. Beyond looking inward at your own number, gaining understand (tactfully) on the following issues can help color your opinion on how this firm will react when it comes time to exit: 1) Has the firm blocked an exit when an entrepreneur wanted to sell or sold a company when the Founder did not want to sell the business and what was their rationale for doing so? 2) Do they allow founders to take some chips off the table, and if so at what stage have they allowed founders to do so? 3) When will their fund end, and how have they handled or will they treat portfolio companies that operate after their fund?
5. Trust but verify: Obtain references on how have they worked with their existing portfolio. Finally it is up to you to trust but verify everything you believe about the firm. To gather references, I think it’s important to ask the firm for their list, but also permission to go outside the contacts that they provide with an eye to speak to a mix of successes and failures.
The above questions are extremely important to ask yourself when raising money. While there are certainly one-size-fits-most firms there are no one-size-fits-all. Each startup has distinct needs and the selection of the right capital partner is extremely dependent on them. It is easy to get caught up in the capital raising process and equally as easy to want to just get the round done, but selecting the right partner is worth the effort when you find yourself in a defining moment.