The Venture Capital Process
This is Chapter 2 of The Venture Capital Bible by Kieran Ryan.
2:1 How do venture capitalists source deals?
VCs source new investment opportunities through several channels, including:
- Direct outreach: Like any industry, VCs use LinkedIn, media lists (i.e., Forbes 30 under 30), demo days, and other sources to find exciting founders or companies that meet their investment thesis and directly message them via email. Many VC firms use a data-driven approach to spot and find diamonds in the rough. For example, CircleUp, a consumer-packaged goods VC firm, built an internal sourcing machine called Helio, which scrapes and aggregates public, partnership, and proprietary data to identify and recommend companies to reach out to.
- Warm introductions: VC firms rely on their existing networks to source deals. VCs try to provide as much value to other people in the startup ecosystem (i.e., founders, investors, law firms, etc.), who then recommend founders for them to meet. After a VC and startup founder agrees to meet, the shared connection will send a warm introduction email that suggests a next step of meeting up in person or jumping on a call.
- Feeder programs: VCs spin up communities, accelerators, incubators, and other programs to build relationships with people who may meet their bar to invest in the future. For example, the Kleiner Perkin Fellows program allows its VC firm Kleiner Perkins to build early relationships with high-potential students in product, engineering, and design so that if they start a company down the road, they'll have an upper leg on other VC firms. Another example of a feeder program is Sequoia Arc, a top accelerator program. Sequoia Arc allows its VC firm Sequoia Capital to make small and early bets in outlier founders, work with them for eight weeks, and collect more data to decide then if they want to invest more money into the company to secure a more significant stake.
- Content: It's a running joke that all VCs are content creators. VCs write content to help startup founders, position themselves as thought leaders in specific industries and verticals, and build brand awareness and recognition for themselves as investors and their VC firm. As a result, founders have already heard of them and put them at the top of their lists when they plan to fundraise. Almost all VCs share their thoughts openly on social media, blogs, newsletters, podcasts, personal websites, etc. My favorite VC content to consume is Digital Native by Rex Woodbury from Index Ventures and 3 Things by Elaine Zelby.
2:2 How long does it take to raise money from venture capitalists?
In 2020-2021, the average time to raise a seed round was 18.5 weeks (~4.3 months) from the first VC meeting to money in the bank. Knowing many founders who have raised VC funding, there is a massive amount of variance based on one thing, how promising the startup is.
The best startups and VCs most fast. For example, Rippling, an all-in-one HR and IT platform, raised $500 million in 12 hours at an $11.25 billion valuation. Front, the customer communication platform, raised $10 million in 10 days for its Series A financing round.
It's important to note that while Rippling and Front were able to raise from VCs in record time, they both spent time building stronger relationships with new and existing VCs who could potentially play a part in their rounds in the months leading up to the raise.
2:3 What is a venture capital term sheet
A VC term sheet is a simple contract between the VC firm and the startup which outlines the investment details. It is not a legal promise to invest.
Here is a Series A Term Sheet Template provided by Y Combinator that you can download.
After a term sheet is signed, the actual obligations of the investment are worked into the following documents:
- Stock-Purchase Agreement
- Investor-Rights Agreement
- Incorporation Certification
- Right of First Refusal (ROFR) & Co-Sale Agreement
- Voting Agreement
While it's frowned upon for a VC firm to back out of a signed term sheet because of repercussions to its reputation in the industry, it does happen. So, startups should not assume the deal is closed until the money hits their bank account.
2:4 How do venture capitalists send you money
After finalizing the investment details, VCs (sender) will start the process of wiring your startup (recipient) money from its bank account. A wire is a way of moving funds electronically between bank accounts. Wires are a fast, reliable way to transfer funds domestically and internationally.
For domestic wires, the VC must provide the following information to their bank:
- Sender's bank account number and ABA routing number
- Recipient's name
- Recipient's bank name
- Recipient's address
- Recipient's bank account number and ABA routing number
- Amount of money
For international wires, the VC must provide the following information to their bank:
- Sender's bank account number and ABA routing number
- Recipient's name
- Recipient's bank name
- Recipient's address
- Recipient's SWIFT/BIC code
- International Payments System Routing Code
- Amount of money
Good VCs know to avoid dragging their feet when wiring money because money in the bank signals the end of the funding process, allowing the startup founder to return to building their company.
2:5 What do venture capitalists look for in companies?
Whether VCs explicitly state it or not, every firm has an investment thesis – or things they index on to build conviction to invest in a startup. In addition, it's important to note that each Partner you meet with at a VC firm will also have their interpretation of the firm's investment thesis or their nuanced individual version, which they will use to guide them during the due diligence process.
At a foundational level, VCs evaluate startups along three pillars:
- Market: The idea that demand from a rapidly growing market will make great companies. a16z indexes heavily on a startup's market, stating they would rather invest, all things being equal, in an average team in a great market than an exceptional team in a middle market.
- Product: The idea that a good product sells itself and the best product wins. OpenAI is an excellent example of this. With no advertising or marketing spend, OpenAI reached 100 million users within two months of launching ChatGPT, making it the fastest-growing consumer internet product ever.
- Team: The idea that an exceptional team can create a new market or expand its market if needed. The team is the easiest pillar for VCs to evaluate. Even if an outstanding team fails, the VCs who funded them can always support their next startup or at bat, which might hit. This frequently happens in the industry.
Of course, VCs want to find great teams in great markets with great products, but it's a spectrum, and hard to find companies that stand out along each pillar. When they do, the startup becomes a generational company like Uber, Stripe, or Airbnb.
At a more granular level, VCs may index heavily one or many of the following details:
Market
1. Total addressable market (TAM): The opportunity if the startup captures the entire market.
2. Serviceable addressable market (SAM): The opportunity within reach that your startup can capture – limited by factors such as geography.
3. Serviceable obtainable market (SOM): The actual amount of the market that you can capture with your startup's products and services.
Product
An example set of questions a VC may use to evaluate a startup's product:
1. Does it work?
2. Is it easy to use?
3. Who needs your product?
4. How do you know they need it?
5. What problem does your product solve?
6. Does the product solve the intended problem?
7. How do users use the product today?
8. What makes a user stop using the product?
9. What makes a user recommend the product to a friend?
10. What's something unexpected you learned from talking or observing your users?
11. What are the next steps on the product roadmap?
12. How fast can you ship the next product feature?
13. What metrics are you tracking to gauge product success?
Team
1. Ability to build
Y Combinator, the best accelerator in the world, notably screens out teams who can't build the product internally. This is because startups need to move fast and iterate. If they can't make the product themselves, then they will be slowed down by web agencies and contractors.
To assess a team's ability to build, a VC may ask:
- Can they make the product internally?
- What product did they create?
- Why did they decide to make that product?
- How long did it take them to make it?
- What have they built in the past?
2. Speed of progress
VCs fund startup teams that move fast but not to the point where they are cutting corners. Speed is critical to a startup's success and one of its only competitive advantages over incumbent companies with more resources. It also gives them more at-bats to find product-market-fit before they run out of money.
To evaluate a team's speed of progress, a VC may ask:
- What has the team accomplished to date?
- What do they hope to achieve in the next month?
3. Experience
VCs pattern match for experience and track record as a leading indicator of success for a startup. A strong credential from the Thiel Fellowship or Stanford University can help a startup attract top-tier investors.
To better understand if a team's experience with help them with this startup, a VC may ask:
- Where did they go to school?
- What did they study?
- Where did they work in the past?
- What role did they have?
- How quickly did they progress in previous roles?
- What is the slope or trajectory of this team?
- What other experiences could lend themselves to this startup?
4. References
VCs shape their opinions by the opinion of other VCs. VCs often follow other VCs they respect to investments in a phenomenon called herd dynamics.
To assess a team's references, a VC may ask:
- Who is their reference? Here are the best references to provide to a VC.
- How impressive is their reference?
- What is the strength of their relationship? How well do they know each other?
5. Startup exposure & fundamentals
Startup exposure and fundamentals are a spectrum. For example, repeat founders have lots of startup exposure and learn the fundamentals by making mistakes. On the other hand, first-time founders may have startup exposure by working at a startup, reading startup-related content (i.e., Zero to One, Paul Graham essays, etc.), talking to friends who have started companies, networking with founders, or something else.
If the founders have limited startup exposure, how fast can they learn to become world-class founders?
During a conversation, a VC can see where someone falls on the spectrum concerning startup exposure and fundamentals by asking them how they think about their startup along the following lines:
- Talking to customers: When do they do it? How often do they do it? Why do they do it?
- Building the product: Shipping cadence? How do they pick what to make next?
- Fundraising: When do they want to fundraise? Why do they want to fundraise? What will they use the capital on?
- Cofounders: How do they think about who they want to work with?
6. Judgement & problem-solving
Startups are hard, and teams encounter lots of roadblocks. As a result, VCs often evaluate a team's judgment and problem-solving ability.
For example, here are some ways to check for sound judgment and strong problem-solving skills:
- Where is this team focused? For example, it is a negative signal to a VC if a first-time founder with no product or traction tells a VC they want to spend the next month raising $5 million even though they still need to validate their idea.
- What is the order of operations to obtain a significant milestone? For example, it is a negative signal to a VC if a technical founder wants to spend the next six months building the product before figuring out who their customer is.
- When reflecting on past experiences, how would they have done something differently?
- How do they want to build their team? For example, it may be a negative signal to a VC if the founder doesn't construct it to show you they know their blindspots and how they might derisk the business from an execution standpoint.
7. Outlier potential
What does the team spike at? VCs want to back the smartest people solving the biggest problems.
2:6 How do venture capitalists conduct due diligence?
The way a VC conducts due diligence may be different based on various factors, including the type of company, the stage of the company, how well they know the founder, etc.
However, it may look like a variation (note: VCs may kill the process during or after any of these steps if they don't want to invest) of this:
- Initial meetings: An informal phone or video chat to share basic information about each other to see if it makes sense to move forward now.
- Data room access: A collection of documents and materials to get a prospective VC up to speed on your startup. Inside, you should include a pitch deck, cap table, historical P&L and burn, usage data, and LTV/CAC and payback period. For examples of data rooms by category (marketplaces, social apps, subscriptions, e-commerce) of business, read this by Justine Moore of a16z.
- Formal meetings: An in-person meeting with specific Partners or Advisors to learn more about your business. This may be a combination of 1:1 interviews and group interviews.
- Reference checks and backchanneling: VCs talk to everyone. Nothing is off-limits. They'll call or email your listed references, speak to other investors, and backchannel to people who may know you (i.e., former colleagues, your econ teacher from undergrad).
- Investment memo: The Partner at the VC firm leading the investment into your startup will write an investment memo to discuss the deal with the rest of the VC partnership. Check out the investment memo Jeremy Levine and Sarah Tavel, Partners at Bessemer Venture Partners, wrote to discuss Pinterest.
- Partnership meeting: The Partner leading the deal will present live to the VC partnership why they should invest in the startup. This allows other Partners to ask follow-up questions based on new details from the Partner's presentation or the initial investment memo.
- Term sheet: If the VC partnership decides to move forward with the investment, they will send the startup a term sheet with the investment details.
- Negotiation: The startup and VC firm then negotiate on specific terms outlined in the term sheet until both parties sign it.
- Send money: After both parties sign the necessary documents, a VC firm will send money to the startup.
2:7 How do venture capital firms make decisions
Similar to the due diligence process, VC firms make investment decisions differently. The four most common ways VC firms make decisions are:
- Consensus: All Partners in the VC firm must vote yes to the deal.
- Investment Committee: The VC firm creates an investment committee, typically with a mix of Partners and Advisors, to review and make final investment decisions.
- Majority: Most of the Partners in the VC firm vote yes to the deal.
- Individual: A Partner at the VC firm has full autonomy to do a deal.
How VC firms decide to make decisions depends on various factors, including their team composition, the VC fund size, what they want their investment process to optimize for, and more. For example, a VC firm deploying a fund of $1 billion as $1-5 million checks into Seed stage startups may opt for individual investment autonomy to optimize for speed and finding outliers. Meanwhile, a VC firm with many junior Partners may elect to invest via an investment committee to pressure-test decisions.
2:8 What percentage do venture capital firms take?
Since startup returns follow the power law, VC firms will invest as much money as needed to secure a more significant stake in the best startups. This means doubling down on the startup, again and again, to retain their ownership as other VCs invest in future rounds and dilute them down.
Here are some VC benchmarks for target ownership in startups by round:
Seed
- VC firms typically set an ownership target of 7-10% when leading a startup's Seed round.
- Startups may have to give up 10-15% to complete their Seed round.
- Startups should avoid giving away over 25% of their equity during their Seed round as it may impact their chances of raising money in the future.
Series A
- VC firms typically set an ownership target of 8-12% when leading a startup's Series A.
- Startups may have to give up 15-25% to complete their Series A round.
- At this point, startups should be below 40% in total dilution from funding, meaning the startup's founders, employees, and advisors still own 60% of the company.
Series B
- VC firms typically set an ownership target of 8-12% when leading a startup's Series B.
- Startups may have to give up 20-30% to complete their Series B round.
- At this point, startups should be below 60% in total dilution from funding.
Series C
- VC firms typically set an ownership target of 7-10% when leading a startup's Series C.
- Startups may have to give up 15-20% to complete their Series C round.
- At this point, startups should be below 80% in total dilution from funding.
Throw out these benchmarks for exceptional startups. I've seen hot startups give up less than 10% in total for a Series A round. Category-defining startups, such as OpenAI, have the leverage over VCs to fundraise on their terms.
