VC's Are Not A Commodity
How to choose the right VC for your startup
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When fundraising, most founders look to optimise for money in the bank, ideally from brand name VCs without giving up too much equity.
Money allows a founder to start or continue growing their company and it's even better if that money comes from someone with a lot of clout. Raising from a top-tier VC creates the perception that a startup has made it.
That couldn't be further from the truth.
As weird as it sounds, in some cases having no money is better than having money.
As I covered in Compromised Cap Tables Create Consequences, founders should protect their equity like it's their life. Unfortunately, this doesn't happen enough.
In the current funding climate, term sheets are rare. Founders are often willing to accept the first term sheet that comes their way.
However, equity drives decision-making.
90% of founders don't think hard enough about why they're bringing someone onto their cap table, yet it literally dictates the direction in which the startup goes.
In this article, we'll explore how to think about constructing a round, what to do when you only have one option and a framework for figuring out whether you should take an investor's capital.
Optimising For The Next Round
Let's imagine you've managed to get a few term sheets and you're trying to decide which one to take. You can look at the numbers or the people behind the numbers.
We've spoken before about how high valuations don't help anyone. It's easy to get excited by big numbers but all they do is distract you from building an enduring business.
It's a pretty simple equation - at pre-seed and seed, the bigger the number, the more pressure to perform. If you don't perform in 2 years, you may as well shut up shop.
There are some caveats around the type of business you're trying to build and the relative capital requirements, however, for most, that advice will ring true.
Now the trickier part is evaluating the people behind the offer.
The best way to think about this is to evaluate investors based on short-term (18-24 months) and long-term (3-5 years) leverage.
In the short term, your main concern should be to build the right foundations and grow enough to be able to raise another round of capital.
Again, building the right foundations is different for every company. For some, it could mean hiring a CTO or specialised engineers, and for others, it could mean opening doors to large customers.
To evaluate this, follow this process:
Ask the investor to highlight what they think your biggest challenges will be and to introduce you to some of their portfolio companies who had similar challenges when they were at your stage. If the investor is credible, there should be no delays with this.
If you're looking to evaluate whether the investor is actually helpful with problem-solving support and advice, ask them the following questions:
When faced with [insert problem here], did you consult [insert investor name here] and what was their advice? Who did you consult first, or what steps did you take before consulting [insert investor name here]?
Did you follow through on that advice, and what was the result? How did [insert investor name here] help you navigate [insert problem here]?
If you're looking to evaluate the investor's network, then ask the following:
What has been the most valuable introduction [insert investor name here] has made? What have the unlocked for you?
Did you feel comfortable tapping into [insert investor name here]’s network? How easy was it to get an intro, and how quickly did it come?
Beyond being able to help you work through challenges and speed up your rate of growth, in the short term, the best investors provide their portfolio companies with fundraising leverage.
Now I don't mean they physically go in and pitch your business (you still have to do that), but rather through their own brand and investor networks, they allow startups to have a higher-than-average chance of raising their next round.
I like to call this a fund's graduation rate.
Using Crunchbase, find out the number of portfolio companies that have raised a subsequent round of capital that was led by another fund. Divide this by the total number of companies in their portfolio to find their graduation rate.
VC investors are incentivised by markups and exits. VCs should be actively doing anything they can to get their companies funded by other investors. You can measure how good they are at doing that through their graduation rate. There will be data imperfections, as not every round is captured by Crunchbase, but it should be good enough for a quick and dirty calculation.
Once you’ve got this, rank the VCs that you’re considering and highlight the top few. There is a level of randomness to this number, as it is reliant on the success of individual companies, but it should serve as a decent indicator.
Thinking For The Long Term
If you've got term sheets from similar firms, with similar short-term benefits, you need to consider the longer-term implications of taking their capital. This is largely reliant on the actual partner at the firm that you'll be working with.
At the early stages, the partner is likely to be on your board for a few rounds of fundraising at the very least. The incentives that guide them and their advice will impact your company's trajectory far more than you can imagine.
Moreover, if you decide one day that you don't vibe with them, or that they aren't that helpful, it's incredibly hard to borderline impossible to remove them from your board and cap table. Unfortunately, this is where a lot of founders get caught out.
So how do you actually think about choosing the right partner for the long term?
Values alignment
By far the most important long-term consideration is values alignment. If you're successful, you're going to be working with the specific investor and fund for anywhere from 5 - 10 years, if not longer. You want to ensure that both of you respect each other and have similar values. If not, there's probably not a strong case for that investor or fund to be on your cap table.
You need to think about their demeanour during the meetings you've had to date. Have they been low-ego, and direct, or have they tried to boast about past deals and achievements? Are they hot-headed and emotional or level-headed and methodical?
Think about the type of person you would want to call if things are going wrong.
Board members and advice
Board composition is an incredibly important factor that many founders ignore. It's pretty trendy to not have a board for an early-stage startup (and even some late-stage ones), but given the recent governance challenges that have plagued the startup sector, it's an absolute necessity.
The incentives that guide board members will affect the advice and direction that they push you to pursue. The simple advice here is that the size of the fund will guide their expectations around the speed and magnitude of growth required.
For example, through 2021, there are numerous stories of mega fund partners pushing their companies to hire excessively or pursue high-burn marketing strategies, to completely pivot their advice away from this in 2022 when things got harder.
You can clearly see the impact of that through mass layoffs across the startup sector, down rounds across the board as startups struggle to get access to emergency capital and completely burnt-out founders who are frustrated with their board and VCs.
The best board members will be 1) qualified in some capacity to give you advice, and 2) will push you, but not demand you to follow their advice.
Thesis alignment
This might seem a bit weird, but it's an interesting dynamic that happens in venture. VCs don't always invest in companies where they have a strong thesis. In many cases, a VC will chase deals that they think are hot or will get marked up heavily in the next round. They don't actually have a thesis in the area, and they'll spend a lot of their time trying to sell you on their ability to be helpful (spoiler alert: they won't ever be helpful).
You want your investor to actually believe and care about what you're doing. You want them to stick by you through all the highs and lows and all the pivots that are a part of the startup journey.
The onus is on you to evaluate, whether they actually believe in the hard fundamentals of your business, and have a thesis for where the market and company could go or if they believe in the hype around a market and are just placing early bets.
You should ask VCs to share their investment thesis or decks with you to understand what they see in your business. It'll help evaluate their level of commitment to you, but might also uncover things that you haven't thought about with your own business.
What Happens If You're Desperate?
At your pre-seed or seed round, receiving only 1 term sheet is a common occurrence. Not all deals will be hotly contested, and when investors are taking a contrarian bet, not everyone will be a firm believer in your vision.
So what do you do if you've only got one option?
Firstly, conduct a reverse DD process. You need to figure out if this investor will have a Positive, Neutral or Negative impact on your company. The best way to do that is by talking to at least 3 existing portfolio founders (as mentioned above) and understanding how the investor has or hasn't helped them. Ideally, you choose 3 founders who run businesses with differing levels of perceived success and maturity. Depending on what you determine here, you can go in three different directions:
Positive: Not much needs to be said here, it's probably worth taking the capital and going back to building your business.
Neutral: If they haven't really added much value to existing portfolio companies, then they probably aren't going to change their ways any time soon. In this case, you should definitely be careful with how much capital and equity you take from them. Think about negotiating the terms of the fundraise, with particular emphasis on dilution, raise size and board rights.
Negative: If their own portfolio founders don't vouch for the investor, you should absolutely walk away. It's not worth taking bad capital out of desperation. It's very very hard to remove an investor from your cap table. Start to explore different funding solutions and consider bootstrapping your business until you are closer to PMF.
A Quick Framework
To conclude the article, I’ll leave you with a quick framework to choose the best VC for your startup, ordered from most to least important:
Vibe - Optimise for vibes above all else. Make sure you get along well, and respect the investor who is backing you.
Incentives - Understand the incentives that dictate the investor’s advice. This could be fund size, brand name, fund/personal performance pressures etc. As Munger said, “Show me the incentive and I’ll show you the outcome”. This absolutely rings true when advice is dished out by VCs.
Support - Qualify whether a VC will actually jump in the deep end and help you. Very few do.
Terms - Assess the terms offered, but don’t get hung up on them. Make sure it’s a fair deal, but don’t hold out for the best deal.
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Abhi