How to Due Diligence VCs
"It is not the strongest species that survive, nor the most intelligent, but the ones most responsive to change" — Charles Darwin
There are now almost 430 European VCs which can make it tricky and time consuming to differentiate the best from the rest. Inspired by recent articles which address innovation to the venture capital business model, such as Glilot Capital Partners’ VC 3.0 (including Venture Capital 2.0) and Reid Hoffman’s Sweat Equity Ventures, I wanted to share some tips with first-time entrepreneurs and emerging investors on how to evaluate a venture capital firm.
I am fortunate to have experienced both sides of the table.
My first role at J.P. Morgan in 2009 was to advise US pension plans on how to manage their retiree money — this included evaluating venture capital and private equity managers across US and Europe. The newly formed team¹ included professionals (varying in gender, ethnicity, education, and age) with backgrounds in asset management, sales and trading, treasury and cash management, and actuarial science who each had over a decade of experience working closely with pension plans and other institutional Limited Partners (“LPs”) across both continents. In the recent 5 years, I was also involved in the fundraise of European venture and early growth firms, Bessemer-backed Columbia Lake Partners fund I and Dawn fund III.
While it may seem easy and effortless given there are new and bigger funds announced daily, believe me when I say that raising a venture fund is an extremely humbling exercise. Many investors come away with a heightened level of empathy for entrepreneurs raising capital.
In many ways, creating and managing a venture fund is quite similar to how you would think about building a startup or managing a corporate.
Below is an open framework which takes into account 4 key areas:
Fund Size
Fund Strategy
Experience
Competition
Let’s examine each of these considerations in more detail.
1. Fund Size
General rule of thumb: the bigger the fund, the higher the appetite for bigger exits.
As mentioned in a prior post, the best funds tend to have bigger, big winners (not more big winners). This is due to the power law distribution in venture where a very small number of companies generate a disproportionate amount of a fund’s return. (See a16z posts found here and here for more details.)
The ‘scarcity’ factor means that venture investors will typically invest a lot of time and resources into identifying unicorns and owning as much of these businesses as possible once the investment thesis has been proven.
A change in fund size will often result in a shift in fund strategy, given the number of investments per fund and check size for each company are the biggest determinants of where in the private capital world a firm plays — venture, growth, mid-market, or buyout.
The business model of venture is not scalable beyond a certain size (i.e. fund size of ca. €200–300MM in Europe and ca. $400–500MM in US). Therefore as the fund increases in size, the manager will either:
Move upmarket (i.e. invest in growth and/or private equity) where risk relative to value creation is perceived to be better, and/or
Make riskier investments — sometimes called ‘moon shot’ or ‘swing from the fences’ bets.
2. Fund Strategy
General rule of thumb: consistently focusing on a niche strategy results in quality investments and higher returns over multiple economic cycles.
Just as a company needs to define its unique selling proposition (“USP”) in order to have a clear go-to market strategy and defensible moat, venture firms operate in a similar fashion. This increases the likelihood of gaining access to prospective unicorns, including greater baseline expertise over time.
There are 2 key elements to consider here:
A. Business model
B. Underlying assumptions of the business model
A: The traditional venture fund model stands in stark contrast to software companies (described in #3 of this post). It has low operating leverage and positive working capital — these dynamics (plus the power law distribution of venture) make it very tricky to scale and will result in a shift in strategy over time when fund size changes.
This is because the 2 biggest ‘cost of sales’ for a venture fund is talent and travel (paid out of management fees), and their real return on investment (a.k.a. cash distributions or what is known as Distributions to Paid-In Capital or “DPI” for short in the industry) is not evident until at least half a decade later.² As a result, private funds — private equity, growth & venture, hedge funds, other alternatives — are generally valued based on assets under management (“AUM”), rather than a function of revenue and profit — management fees scale faster than cash distributions.
Hence it is super important for a startup and its potential investors to be aligned on near, medium, and long term expectations of what is considered ‘great’, ‘good’, and ‘bad’ performance following a funding event.
Best way to determine what could happen is to speak with entrepreneurs (and also LPs) that the venture firm has worked with — understanding from prior and existing customers the historical behavior in ‘great’, ‘good’, and ‘bad’ situations is vital. Conducting professional references and social validation is a two-way street.
B: Understanding what feeds into a fund strategy is similar to evaluating the execution plan behind the go-to market strategy for a software business.
What is the competitive positioning and differentiation?
Aside from overall fund size (described in #1), there are many variables to consider (listed below):
Geography
Industry sector(s)
Stage of business maturity (e.g. seed, Series A, B, C, etc.)
Number of investments per fund (e.g. 15 to 35?)
Check size per business (i.e. initial investment, reserve capital for follow on)
Investment holding period
Fund vintage (i.e. when was the fund raised? how much money is left?)*
Recycling mechanism (i.e. what portion of fund commitments can be invested more than once?)
Sourcing strategy
Follow on strategy
Syndication strategy (i.e. which other funds do they partner with?)
Portfolio support³ (e.g. hiring, fundraising, exit, etc.)
LP base (i.e. institutional, government, family offices, high net worth individuals)**
In other words, what does the capital allocation pie look like? Who are the people in the fund, and how does the team collectively work together to deliver on the expectations of founders and LPs?
There are countless ways to source, evaluate, and invest in a company. Using a defined and proven methodology in arriving at decisions (e.g. consensus, majority, veto)⁴ allows a team to move quickly — having first-mover advantage and more importantly a strong brand are the key determinants to successfully gaining access and investing in a ‘hot’ startup.
The composition of the team and how each person’s respective expertise & network contributes to the sourcing / follow on / syndication of investments and post-investing portfolio support are also critical factors when evaluating success in venture, particularly in the eyes of experienced LPs. Great entrepreneurs can come from anywhere, therefore it is vital to have a complimentary team that appeals to different founders and can capture the “X” factor (i.e. chemistry, personality fit) involved when it comes to making a decision between multiple venture firms and their term sheets.
Diversity increases fund performance
As this Harvard Business Review article on organization structure shows not only does diversity contribute to differentiated opportunities, but it also reduces poor decisions resulting from “group think”. A diverse team would include people varying in:
Work experience
Academic institution and discipline
Ethnicity and culture
Gender
Age
Working style
Personality
‘Hunger’***
The best firms tend to stay disciplined to their core strategy with a team that shares investment philosophy, yet are diverse in background.
An example of this would be West Coast venture firm Benchmark, highly regarded for consistently delivering outsized returns and its lean & equal partnership structure (described in more detail here and here).
*Fund vintage: Founders raising capital should understand (i) where a venture firm is in terms of their fundraising cycle and (ii) how much dry powder⁵ is remaining to be allocated towards new investments and existing portfolio companies. The reason this is important is it can impact the startup’s ranking within the fund and how to manage (sometimes varying) shareholder interests around the Board. Often, this only becomes evident after raising capital when the business misses budget or some other performance milestone, thereby impacting perceived value of the company and its founders.
**LP base: In general, the higher governance and longer experience an LP has with a particular type of manager, the more qualified it is to assess the manager, resulting in a positive reflection on the performance and quality of the firm. Institutional LPs (e.g. pension funds, endowments, fund-of-funds)⁶ tend to prefer venture firms with consistent and predictable performance — having a proven track record is really important. Pattern recognition and references play an important role, and are also key reasons why raising a new venture fund is not so easy.
The very best venture firms tend to raise from highly sophisticated LPs that bring significant value aside from capital — deep network and strong governance to guide strategy and performance of managers. In fact, tier 1 multi-generational venture firms typically do not accept new LPs.
***‘Hunger’: Understanding the motivations and ambitions of a venture investor and firm is often a key consideration for sophisticated LPs. Is there sufficient ‘skin in the game’ to balance risk aversion relative to pursuit of opportunity?
Generally, LPs require managers to contribute 1–3% of the overall fund (e.g. £100MM fund translates to £1-3MM of personal investment). That can be a lot for young investors, especially those from certain socio-economic classes, who are also compensated with equity upside in the fund (a.k.a “carry”). A way for LPs to address this common problem is to inquire and expect fund contributions as a % of individual net worth. Hunger is sometimes valued as highly as experience for LPs.
3. Experience
General rule of thumb: the greater the (i) number of relevant, successful exits and (ii) time spent in venture, the better the quality of investments in line with core strategy and realized returns to LPs.****
Given long investment periods as well as the significant value derived from pattern recognition and deep network & expertise (mentioned here), the best venture firms tend to have been in the industry for a long time and have multiple successful exits (those that generate 5x or higher return over initial capital invested).
In order to be more than ‘just lucky’ and establish a credible brand, it takes time to build expertise on the markets startups operate in and experience working with entrepreneurs from all walks of life.
****Note this trend tends to be less applicable to venture firms and individuals that invest earlier than traditional Series A, where I believe there is a lot of opportunity for new and emerging managers, given the greater emphasis placed on depth of local networks and personal connections.
4. Competition
General rule of thumb: increased market competition results in divergence from core strategy and less investment due diligence, resulting in reduced quality of investments and often lower realized return to LPs.
As previously mentioned, compared to 5 years ago, there is significantly greater supply of financial capital to European software companies. After years of rumors and with ‘fly in VC’ no longer acceptable in today’s market, Sequoia and Lightspeed have hired local partners in London. Insight also has ‘boots on the ground’ in Europe and buys up entire venture portfolios in Israel. For better or worse, terms have converged with the US market with certain sub-scale European companies being valued at 40–50x+ revenue — shocking when compared to public software companies with significant scale, attractive growth and daily liquidity (i.e. can buy/sell public stocks with ease) that trade at 13x on average.
The pressure to invest and deploy capital at a pace promised to LPs can result in what is known as ‘style drift’ in investing (refer to this summary and this paper for details related to venture funds), which can result in poor investment decisions and returns over time.
One of the key benefits for startups who raise capital from a specialist venture firm is to connect and learn from other entrepreneurs who have gone through a similar journey. Therefore being disciplined and staying consistent with the core strategy is not only valuable to LPs, but also equally beneficial to the founders of high growth scale ups — arguably, the most important customer of venture firms in the long run.
Why does this matter?
Having experienced the peak and bottom of the recent decade’s (2) economic bubbles, I can understand why in today’s market, it is easy and can appear attractive for:
Startups and founders to raise lots of capital at high valuations and other ‘off market’ terms
Venture firms to invest aggressively and ‘style drift’ in order to raise a bigger fund, sooner
LPs to invest directly in young companies in ‘collaborative competition’ with specialist venture firms, in order to participate more in the upside
The behaviour above has historically demonstrated adverse selection and lower performance in the medium-long term.
We must remember that success in venture happens over a decade (often, longer) and a vibrant ecosystem requires majority of its participants to act rationally in order to fuel and sustain growth.
Notes:
(1) The Pension Advisory Group was launched within J.P. Morgan in 2005 to address the ‘perfect storm’ in the defined benefit pension world — a severe under-funding of pension assets relative to retiree liabilities due to (i) low interest rates which increased pension liabilities, (ii) over-allocation to alternative investments including private equity, growth equity, and venture which performed poorly and had illiquid underlying assets, and (iii) changes in regulation. In 2011, the group was bought by Pacific Life Insurance and subsequently bought by Goldman Sachs Asset Management in 2015 (more details here and here). Special thanks to Calvin Yu and David Oaten for giving me a job in New York during the worst time of the Global Financial Crisis and for believing in a 21-year old kid who knew very little.
(2) For a more detailed understanding of the venture fund model, read this article. Distributions are also described by Fred Wilson and Wilson Solsini. For the technical analysts and math nerds out there, you may like this post.
(3) For a deeper dive into whether VCs really add value to founders, I would recommend reading this Hackernoon article which includes data from the fundraising decks of VCs.
(4) In a future post, I will discuss the different styles of fund decision-making.
(5) To understand ‘dry powder’ in the context of today’s market, read this and this.
(6) In a future post, I will discuss the different types of LPs in more detail.