This post originally appeared on Quora: to answer this question:What are the best-kept secrets about venture capital?
Having pitched quite a few VCs as a CEO/founder and taken investment from several, and been through 4-5 liquidity events, over 15 years, let me share a few non-obvious learnings that may help you:
- VCs, as individuals, aren't that diversified and don't do very many deals.
VC firms, as entities, get pretty diversified. But the average VC partner only does 1-2 deals a year. Just one or two. Yes, that's more diversified than you as a founder, of course. But not as diversified as you'd think. Their deals really need to work. So, they don't really want to take much risk. It's one reason why it's harder to get VCs to take a risk on you than you might think, and why you need to have 100% of your ducks in a row when you pitch.
- VCs, even as individuals, may end up owning more than you in the aggregate.
VCs often try to own 20% of each portfolio company as a firm. But as individuals, they own a lot too. If the firm owns 20% of each company, and the VC takes 20% of the gains ... that's 4% effective ownership in your company. Multiply that by say 8 investments per VC per fund, that's 32% effective ownership of one composite company. That's more than you. Plus those management fees.
- VCs have their own investors and usually have to suck up to them, too.
VCs have investors, too, just like you--their Limited Partners, or LPs. The very top VCs don't have to wine-and-dine their LPs. They just pick up checks. But most VCs have to sell up just like you do. In fact, they have to do more of it in some ways, because they probably have to do it to 15-20 core LPs, vs. a founder who just has 1-4 VCs.
- Mark-to-market and valuation upticks really matter to VCs, so they want you to go raise a big round.
VCs of course only make the big money on a big exit. But they make lots of money on management fees too, and to get them, they need to raise multiple funds. To raise another fund, some and probably even most of the track record of the last funds is still going to be illiquid. They'll value that with the most recent valuations, the latest rounds, of their portfolio companies. Do a round at 2x-3x the price of last one, they can tell their LPs for the next fund how strong the IRR is on this investment as well, even if it's just paper gains. They can sell this when they raise the next fund, and tap into the management fees, and also, simply continue and grow the firm to the next level. If there isn't another fund, the firm just becomes a zombie.
- Small VCs align with you, but can lowball you. Big VCs don't align as well, but can pay more.
A smaller VC vs. a larger VC is one of the most important decisions you'll make. The smaller the fund, the more aligned with you they are. They make less in fees, and more on the carry. And more practically, they can't keep up with the dilution, like you. But because they can't write the large checks, they need someone else to. And small VCs also need to buy a lot for a small amount. If they can only invest $2-$3m and want to own 15-20% ... that pretty much puts a cap on Small VC valuation potential. By contrast, Big VC can write a big check. In fact, they want to. But the return has to be huge to impact the fund. Fire the CEO, fire the founders, dilute you to nothing ... they care less. But they'll give you more money to go big. Both have pros and cons. Pick the one that best matches how you want to grow.
In my experience there are several things which I learned over time that surprised me and were very valuable--they group into two:
The "Market Size" Discussion
As a founder the most frustrating and important discussions are always around market size. This is with good reason since it is clearly a massive component of success (see on almost any VC blog posts as the #1 indicator). However, as a entrepreneur, the narrative is almost always:
- "Isn't it obvious that this market is huge?" (blank stares)
- (a while later--market explodes)--"yes--huge market, oh you guys are still around?"
In particular the "is it a $1B market?" is an annoying question to hear over and over again. It seems illogical since company most of your life is spent (rightly) fighting in the trenches, going from $1000/month revenue to $10,000, then $100,000 etc.
Understanding and explaining your market though is the single most important thing you need to do, closely followed by how you can reach it. However there are two "secrets":
- Bottom up market analysis is way better than top down. Top down always gets you the number (we address 5% of this huge market here)--but nobody believes it. Bottom up means, taking sales you have or can reasonably show you could have and showing how exactly those demographics scale up (how many people are there with exactly that need). Feel free to add some top down sugar--but it's almost useless.
- (this is the real killer): when a (top at least) VC asks the question "is this a $1B market,"they do not mean (as I always assumed) "will it be a $1B market in 5 years?" they mean is the total addressable market today a $1B opportunity. This is a crucial difference--it is a different question to ask.
Why is #2 so important? It is because the startup advantage is speed--if the amazing market you are in will be large (check) but will take 5 years to be large, the investors know that even if you take big market share early, it will be while the market is nascent. Then, as the market grows, there is a huge danger you run out of cash or, worse, large players now have the opportunity on their radar and come in heavy.
The market being huge now could be "people are already buying"--this is unlikely since this means large players are already there: in these cases you must have the means to aggressively disrupt additional players (Uber did this for example), or the "huge" market needs to be latent. I.e. it is something which is a clear and present need, but to-date there has been little awareness or there has been no solution. In this case, the product needs to be something people can use immediately. In this latent need scenario, the investors know that with money, you can go on a tear and wrap up a large customer base fast--before anybody else can react. That gives you a great shot at winning.
So, the $1B market question is very frustrating, but it is very real--the key is to figure out the size of the market opportunity right now (not in 5 years). You want your limiters to be money, product, staffing--not the size of the market to grow into.
It seems a subtle distinction, but it was lost on me for a long while, and I only ever heard it stated once by a VC in an offhand comment. (I won't name them but I owe them a debt of gratitude!).
As an entrepreneur when out pitching, it is very easy to get a false sense of progress when you have meetings and people are engaged, friendly, and even follow up. There is steady progress in a relationship. This seems like it may ultimately get you to a term sheet. Unfortunately, many of these engagements, even if they go well, can end up dragging on and after 3-4 meetings fade out--there's never a real "No," but there is no "Yes." What this means is:
- You are doing something reasonable enough, your team is somewhat interesting and there is "something" the investor feels they ought to track: they don't want to say "No." They'd hate to say they missed it if it got hot.
- But, you're not close to being an investment--there are too many indicators missing and they know they are not going to get you through a partner meeting. They also know it's unlikely you'll get funded by anybody else.
Some investors are excellent at feigning enthusiasm--they will also often want to stay engaged and see how you do 6 months later. (Often they will tell you they are unsure of the market).
As an entrepreneur, you rationalize these situations by saying that you only need one investor, so you just need to keep trying until you hit the right one. In the back of your mind, you also hear that the investors all talk to each other--so that as time passes, some kind of "group think" sets in against or for you.
To some extent, both of these are true, but here comes the secret. If you are want to close an investment quickly with a good firm:
- Having a pretty good meeting first time, a slightly better the next week etc. is almost certainly going to fail. You will have to chase for meetings, they will span out over weeks and often end up going dead.
- What you need is that the first meeting is so good that the folks in the room leave knowing they absolutely must invest--it has to be a slam dunk. After that, they will regroup and run more meetings in order to see if there are reasons to disprove their thesis that they should invest. They will be fast, they will be engaged, they will put you high on their list.
The reason is very simple--VCs actually don't need to talk: in any many cases when a company has an excellent first meeting, they recognize a number of absolutely key factors/indicators which make you a no-brainer investment for somebody.
I.e. there are factors which make it obvious to the people in the room that you will raise money very soon from another firm if they do not do the deal first. The effect is immediate and there is no need for communication with other investors, since the indicators (in large) part are similar across firms. As soon as one fund sees "this team will raise money very soon from someone," and if it is a fit for their area, they are by nature on red alert.
If you are on the slow meeting road of death, it means you have not obviously shown enough of the indicators--they know they can safely pass and wait to see what happens. If you ever get a term sheet, you'll probably call them anyway (it's amazing the effect another term sheet has--same reasons). Also even if you don't, it's probably not one of the top 10 deals of the year.
What are the factors?--a VC can answer better than me but:
- Clearly leading team in the space.
- Traction is very clear.
- Very clearly articulated market.
- Excellent shot of being the winner in the market.
This is not to say you cannot raise funds by having multiple meetings with the same firms over time--in fact this can be excellent to build up a relationship. However, usually this happens over years. If you have a specific time window to raise money and you are not knocking it out of the park in first meetings, you are likely dead in the water.
It's better not to iterate slowly on a deck/story that is "doing ok," but throw it out completely and try a totally different angle.
Of course, there are many cases where an outlier VC does a deal no one else is hot about. We all dream about that, and it's fantastic when it works. However, the reality is that if you can knock it out the park in meeting one, you give yourself the chance of a totally different dynamic.
So, I have no doubt that VCs do talk amongst themselves--but they effectively don't need to--in many cases everybody sees the signs of a company that will raise a round as clear as day from the company's own pitch. When they do talk--they'll likely spend more time talking about those which they thing are going to be on more people's radar.
Note to VCs: telling companies early and honestly that you're not that into them (and why) is incredibly valuable--and props to the investors that do--it helped us a great deal.