Anatomy of a Series A Deal: Part II – Assessment
In part one of this monologue I discussed how VC’s source deals. The second step in the venture capital investment process comprises assessing (I chose this word instead of evaluating, because that frequently gets confused with valuing, which is completely different) a potential investment.
There are two stages to assessing an investment – (1) a preliminary assessment, to determine if some new project (VC speak for deal) is interesting enough to warrant digging in, and (2) a comprehensive assessment, also known as due diligence.
In general, active VC firms see several thousand business proposals each year and have to winnow this number down to a very small number (in our case 8-10) of new investments. Therefore, a preliminary assessment – a SAT test for startup ideas – is crucial. I mentioned in the previous post that I review each and every business proposal I receive. If I didn’t have a reasonably quick method for first level fit assessment, I might not have sufficient time to make a single investment.
What criteria do we use for this preliminary assessment? I first look for relevant experience and point of view for the problem/solution – “fit.” For example, an enterprise software veteran pitching an HDTV tuner semiconductor idea is likely a poor experience fit and unless there were extenuating circumstances, I would pass on the opportunity.
Other attractive aspects include novelty of the idea, early customer feedback and engagement, and of course advanced development work on the product or service. While none of these are pre-requisites for us to make an investment and conversely, having them (all or part) does not ensure we’ll engage, they do help.
Often, VCs make snap judgments about prospects and turn them down immediately – really a “blink” reaction. It may be because we didn’t really care for the entrepreneurs (based on negative visceral reaction, or credible reference checking), the space, the business model, the level of competition, or any/all of the above. While I would like to think that substance prevails over form, the reality is that a good first impression matters a lot.
What doesn’t help? Here are a few of my pet peeves:
- A phalanx of advisory board members. Unless they are REALLY contributing to the company in a meaningful way, which usually only happens with bio/med tech companies, the long long list of advisors seems silly to me. I am sure he’s a great guy, but the identity of your accountant doesn’t make me what to invest in your company.
- Powerpoint animations & reveals when presenting. These waste everyone’s time and slow down getting to the meaningful aspects of one’s business.
- Chewing gum while pitching. Really. In this day and age I have observed on 3 occasions in the last 2 weeks, people pitching to me while chewing on some Wrigleys or Bubblicious. At least it’s better than Skoal I guess.
I view this preliminary assessment as culminating in a declaration of seriousness to entrepreneurs – or not. In the affirmative, we are saying that we are inclined positively to make an investment and need to dig in deeper.
How long does this take? Usually measured in days or a couple of weeks on the outside, but really depends on immediate reaction (+/-), competitiveness of the deal, geography, and workload. As a rule of thumb, if after a first meeting you haven’t heard from a VC for four weeks, forget about them …
Due Diligence (Comprehensive Assessment)
IMO, a comprehensive due diligence program is a requirement for VCs making a new investment and I believe it should be a requirement of the entrepreneurs as well. There is no better predictor of how engaged a VC will be on your board of directors post an investment than how seriously they take learning about your business in the first place.
This doesn’t have to mean a slow and painful odyssey; but unfortunately it often is. We strive to be very straightforward in our approach, sharing the high level plan with entrepreneurs – to get their input and feedback and also to be as transparent as possible on the issues that we are considering. That way a team knows how to calibrate progress in a more quantifiable way. A typical diligence program usually comprises many of the following elements:
- Team:resumes for founders, key execs and employees, references both supplied by company and “back channel,” spend as much time as possible getting to know the team and vice-versa.
- Technology Assessment: architectural evaluation, review of development schedule and status, resource plan, intellectual property review
- Market Opportunity Analysis: current state of landscape (if appropriate), customers, partners, suppliers, competitors, sizing of opportunity, go-to-market strategy, exogenous factors that may impact the business in the future, exit analysis
- Operational Review: develop perspective on overall company financial plan, capital and resource needs
This type of diligence process involves face to face meetings, phone calls, email, etc.
Some usual questions we hear, include the following.
How long does it take?
It really depends – on the state of the startup, prior relationship with the founders/executives, state of the market, etc. In our experience, from time of “declaration of seriousness” to a commitment (term sheet negotiated and diligence done) typically spans about 4-6 weeks; sometimes shorter, sometime longer.
When does a term sheet appear?
Ideally, we like to submit a formal term sheet when we are done with all our diligence and ready to close a deal. We start discussing terms (including valuation, equity, option pool, key issues) as soon as we get into comprehensive diligence. Sometimes, however, term sheets are submitted prior to the completion of diligence, but this is not a preferred scheme – and shouldn’t be by entrepreneurs, as it ties them up while the VC firm finishes their work.
Next up – Part III, Negotiation of a deal / the term sheet