Some valuable things founders should know about venture capital
I run a Startup Studio (incubator) and invest out of a venture fund. So, I am both a "co-founder" in the Studio companies, where we need to raise money from external investors, and a venture investor, raising funds and deploying capital into external companies.
For founders to increase their likelihood of securing venture investment and aligning their startup work with the goals of their investors, here are a few things that you, as a founder, should know.
VC Funds are typically considered on a 10-year timeframe. For the first three years, a venture firm will make "initial investments" in new"initial investments" companies. As a fund progresses into years 3 and 4, it begins to make "follow-on investments" in the companies it initially invested in. Years 4, 5, and 6 are mostly follow-on investments. Years 6 through 10, hopefully, have exits (sales or IPOs).
As a founder, you should understand where any given fund is in the lifecycle. If you’re in year 4 or 5, there’s going to be much more scrutiny on making an investment or a much shorter-term focus on outcomes. Therefore, you will likely need to exercise more diligence and possibly face more pressure to achieve an outcome sooner.
For example, a $100M fund like PSL would likely spend about $50M (50%) on initial checks and reserve about 50% for follow-on investments.
It’s really important to understand a venture firm’s thesis; what vertical they care about, what founder type they’re focused on, what stage of investment they make, what their average check size is, etc. This may be true for a firm, but it is certainly true for a partner at a firm. In general, they raise their venture fund with a thesis. They may also have a specific exit profile or a target ownership.
For example, at PSL, with our 100M fund, we are focused on early-stage software companies based in the Pacific Northwest. We like to be the first money in to companies. We mostly lead rounds (set the prices and take a board seat) and prefer B2B SaaS companies with strong technical founding teams.
These are all important for founders as well. If you’re looking for the best partner for a given company, considering their own background or focus, you’re essentially trying to understand their lead or follow-on investments based on the size of the round, and then be able to ask what their value-add is. These are all things you can consider when you’re thinking about what the best venture firm to work with is.
Going back to the timeline, firms that are performing well will spend their first 1-3 years making initial investments. If they have any successful exits along the way, they’re likely to start raising their new fund between the years 3 and 4 so that they can start making new investments out of their new fund when they’re making only follow-on investments from their previous fund, and this repeats, layering multiple funds over many different years. If a fund is currently raising a "new" fund, they may also be distracted or delayed from making new investments until they close on the new fund. Knowing where a firm is in its own fundraising/deploying lifecycle is essential for a founder.
Goals for each engagement between VCs and Founders
The primary goal for each engagement is to secure the next one, working toward a decision to invest (yeah) or pass (boo).
For example, with an outbound email, your goal is to get a meeting. From the first meeting, it's about understanding whether you like the partner and whether they like you, all about "fit". To get a second meeting, where you’re generally focusing on critical objections or starting to prepare a way for you to work together. As you progress into diligence, moving toward the "partner meeting", consider having the partner start writing an "investment memo" and thinking about the reasons to invest and the reasons not to invest (read more on this as WWI/KKO). You're getting close, but there are still a few hurdles to overcome.
If you perform well in the partner meeting, it will progress to a term sheet, which can be negotiated, and ultimately, to a signed term sheet. From there, the final diligence process kicks off, lawyers get involved, and you move toward a close!
It’s important for a founder to understand what the overall flow of an investment is and ask a partner in an early meeting, “What is the normal flow? What is the fastest they’ve ever done a deal? What’s the median time they’ve done a deal?” etc., as you want to understand that.
Once an investment is closed, a founder can return to understanding the VC's own timeline, successes, and needs, including the need to return capital and raise new funds. For a founder, understanding their VC's business will help them be more successful and aligned.