November 3, 2005
Choosing a VC- You need to squeeze the avocado!
I wrote a post the other day on whether the need for capital is changing among emerging growth companies. As I read the comments and looked at some of the other postings on the topic (MikePK has a write-up and some good links to others, so I won’t repeat them here), I realized that another issue is that some (many?) companies might be more happy not having a VC (for them, it wasn’t that they were happy not to need the money, but rather they were happy not to need the VC that came along with the money).
My view is that with all of the different types of VC firms and individuals that make up the industry and with all the different companies, products, and situations that companies find themselves in, the range of possible outcomes is extremely large. When there is a solid fit between the management team, the VC, and the situation, the outcome is generally good (that is, the market opportunity is maximized and everyone feels good that they worked well together to optimize the outcome). When the fit isn’t right, many things can (and do) go wrong and/or the process and results do not meet the ingoing expectations.
Determine the fit before the deal closes!
I am a strong believer in making sure the fit is right for both sides in any VC/management team relationship. As an expansion-stage VC (that is, I invest in companies once they have a product and some customers), I learn as much as possible about the market, the company, the products, the distribution approach, the customer relationships, and the team. I also spend enough personal time with the senior team so that we can build a working relationship and to make sure that we share similar views on how to build a great company.
From the company’s view, I am a huge believer in having the management teams “turn the table” by doing due diligence on both my firm and me to make sure that they understand how we work and how we compare to others. (It actually worries me when they don’t do their work, as I start to wonder if all they want is the money, which is not the basis for great relationships!)
No two VCs are alike…
VCs are diverse, as are the firms that they work for. There are several major differences that are relatively straightforward to determine prior to closing an investment that can help you determine if you have the right fit.
The best due diligence that the senior management of a company can do is to call several of the CEOs that have current or former investments from the VC (the VC will give you a list or you can look them up online and cold call them) and ask them a number of questions (note: most, if not all, of them will say they are happy with the VC and that the VC is great. In order to truly get something out of the interview, you need to ask them much more specific and fact-based questions…see some suggestions below). Also, take the time to understand the individual VC and the firm. Ask to speak with other partners and members of the “value-add” team. Ask them all the same questions. It is a great exercise and you will have additional relationships to call upon once your investment closes!
The Differences- What to look for…
- Market Focus– What is the market focus for the VC? The more closely the VC’s market focus matches your company, the better the fit. Also, the more focused the VC on particular markets (or business/economic models), the better the VC will understand the market. You can easily determine market focus by looking through the VC’s portfolio and asking the VC what interests them (note: You should not depend solely on the portfolio here, as it is a “rear view” mirror of the VC’s interest in particular markets. Talking through the issue with the VC should help you understand current interests…some VCs study a new market for a long time and gain some level of expertise prior to making an investment in that market and many markets are new, so no VC will have the direct experience.)
- “Stage” Focus– What situations are the VCs most familiar with? The skills and network necessary to help very early companies are different than the skills necessary to help companies at the expansion or later stages. Also, while most VCs are growth investors, some investors are extremely good with turnaround situations or other special situations. Again, examining the VC’s portfolio and asking the questions to the VC will help here.
- Past and Current Investments– Understanding the VC’s portfolio is another great way to understand the VC. Most VCs portfolio investments are online, but you might want to ask the VC for the entire list or visit the wayback machine to make sure that you have captured all of the VC’s past portfolio companies (this is also a great vehicle to find out how consistent the VC has positioned itself over time). Call (or, better yet, visit) several of the CEOs of these companies and ask as many questions as you need to get the detailed information.
- Culture and Reputation of the VC Firm– Is the VC firm/individual engineering oriented, distribution oriented, financially oriented or some mixture of skills? Is the firm focused on adding value or more passive in nature (almost everyone says they are “value add,” so you need to dig deeper to truly understand what they mean by it)? Do the partners help out on each other’s deals in a true team manner, or are there silos? Do people in the industry want to work with the VC’s portfolio companies or do they shy away from them? Lots of good questions to ask here!
- Background, Skill, Intellect, Personality, Current Interests and Passion of the individual VC– The partner involved with the deal, who will most likely be sitting on your board, is the most important individual to evaluate fit with and get to know. Some firms, including mine, assign a full team to a portfolio company. When this is the case, evaluated each of the team members and make sure that the fit works and that you are going to enjoy working together (at least as important as money in my view). Ask the portfolio companies about the individuals and spend as much time with the team as possible before the investment. Also, ask each team member individually the same questions. It is always good to see the consistency of the answers.
- Engagement Approach– How does the VC work with its portfolio companies? Does (s)he show up daily, weekly, monthly, Quarterly? Are they formal or informal? Is there a team of experts behind the VC that helps on various functionally specific issues? How do they work with the companies? What is the relationship between the VC and the company (do they partner well or does the VC expect to be the “boss”)? Do they engage when asked?
- Philosophy/Values– This is not a throw away touchy-feely point, as mismatched expectations are important to identify up front. Is the VC conservative or aggressive when it comes to deploying capital? What is the “right” level of profitability? What is the “right” growth rate? How does the VC think about the “operating points” for the “dials” of product development, sales/marketing, and customer service? Is the VC looking for “control”, to set up a multiparty governance structure, just a “seat at the table”, or some other approach to the control issues? Does the VC want to replace senior staff, work with current staff, or see how the individuals and company evolve? What is the “exit” philosophy (“reasonable exit” or go for the grand slam, sale or IPO)?
- Available time– Most VCs are extremely busy people. They are trying to digest a huge amount of information every day to stay on top of the “news”, build their networks (that are extremely helpful to the portfolio companies), build relationships with the large technology companies (again to help their portfolio), work directly with their portfolio companies, and find new investment opportunities. Just how much time are they going to spend with you? There are a few approaches that I would recommend to get a basic understanding. First, find out how many companies the VC is personally involved in and/or sits on the board of. Second, take the full staff of the VC and divide it into the number of portfolio companies (to get a staff per company calculation). Third, take the full staff and divide it into the new portfolio companies over the last 12 months (to get a staff per new company…this is important because the VC is generally the most intensive the first 18-24 months of an investment). These three stats can give you a basic idea of what to expect, especially if you are evaluating relative to other VCs. Also, ask the current portfolio company CEOs for the details on how much time they get with the partner and the team in general (again, ask for the details!). Finally, ask the VC directly and get his/her commitment early on of the amount of time (s)he will be spending with you…setting expectations early is good!
- Level and type of Value Add (most important)- All of the points above add up to the value add (or value minus) that you can expect to get from the VC, but there are two more questions to ask both the VC and the VC’s CEOs to get the most detailed understanding possible:
- Can you give me a detailed list of the value add that the (current portfolio) company has received from the VC in the last week, month, quarter, and year?
- Can you give me one or more difficult issues involving the portfolio company and VC and how you worked through those issues?
I believe that you will find that most good VCs will accept, even encourage, your due diligence effort. I encourage the effort for every company I talk to, as I believe the fit is a truly important vehicle for success. I know some truly amazing Venture Capitalists and I believe the process that I outline above will help you determine the right one for you…
Additional thoughts on the process
I can’t help but point out two other relatively obvious points on how emerging growth companies can set up for the most favorable outcome in working with VCs:
- Don’t get your company in the situation that you “need” the money (I know, easier said than done in some circumstances). This will allow you plenty of time to determine if you have the best VC partner.
- Get yourself the best deal lawyer with the best experience that you can find. A good lawyer will be in a position to help you understand the terms (it is just math and logic, but the words are unfamiliar and the lawyer can point out where terms are “off market”). From the VC perspective, it makes the legal documentation process a lot easier as well.
Take the time to do your work!
Choosing a VC is similar to going to the supermarket to get an avocado (I hate overripe avocados and am too impatient to wait for an avocado to ripen). I have only figured out one way to tell if an avocado is ripe (not too soft or too hard)…You need to squeeze the avocado!