Investment sourcing and diligence

One of the key components of building a successful venture capital firm is strong investment sourcing. The venture capital world is becoming increasingly competitive. According to Carta’s 2021 Q1 Private Market Report, 26% of all deals in Q1 were larger than $25 million—the highest-ever percentage for this tier, and a sharp increase from 20% in Q4 of 2020.

To stand out and secure winning investments, it’s critical to develop a set of strong, repeatable processes for deal sourcing. Not only do you need access to a wide variety of companies, you also need to be able to adequately support your founders and return capital to your limited partners. That’s because founders appreciate firms that guide and uplift them, and limited partners value firms that stick to their investment thesis.

Sourcing is the process of finding viable prospective investments for your fund portfolio. A great sourcing strategy comes from a rigorous and thoughtful investment thesis. And finding the right deals means that you consistently find opportunities that align with your investment thesis.

Every investor has a slightly different approach to sourcing. Some firms build systems to automate vetting and contacting companies, while others create platforms for founders and investors to connect. Some firms like to connect with 500 companies a month, while others aim for 50 to 100.

Regardless of the approach you take, your goal should be to build a repeatable process or system that generates quality deal flow. Here are a handful of ways to do that:

1. Set targets for outbound and inbound sourcing

It’s hard to generate sources without a strategy. Start by developing a sourcing hypothesis. Consider the number of companies you want to source per month, where you think your opportunities will come from, and which processes you want to design to generate inbound leads and execute on outbound leads.

As you start sourcing, work on measuring your results. Evaluate which sources provide the highest-quality deal flow and the highest volume of deal flow. Set targets for the number of touchpoints you have with each source, establish expectations for the number of opportunities each source will bring, and brainstorm the different ways you can create value for your deal sources along the way.

2. Build an investor network

Your current co-investors rank among your most important sources of deal flow. Investors who share your investment thesis aren’t far behind. To find them, it’s important to establish open lines of communication with a wide network of investors. As you connect with different investor groups and communities, make a note of the top referrers in your network, then stay in touch with them regularly.

3. Be active in your ecosystem

Trustworthy relationships are crucial to the movement of capital. The more connected you are to your ecosystem, the more likely people are to see you as their investor of choice. Your ecosystem includes the accelerators, universities, late-stage companies, established corporations, nonprofits, and community groups that surround the industries and geographies you invest in.

To stay connected, be an active participant in your ecosystem. Engaging with the communities and organizations you’re part of might mean going to virtual conferences, volunteering to speak on or mediate panels, supporting other people’s events, or sharing advice in discussion forums.

4. Stay in touch with founders

Founders are eager to refer great investors to their peers, which means they’re a reliable source for potential deals. Stay close with the founders you’ve already invested in, and work on building connections within online or in-person founder communities.

You may want to volunteer as a mentor to founder organizations, champion the growth of certain companies, or spread the word about promising founders via social media or your personal networks. If your firm can become a go-to resource for founders, you’ll have a better chance of regular referrals.

5. Build a social media presence

Staying active on social media is a good way to brand your firm, share your investment thesis, and connect with exciting prospects. Regularly posting and commenting on VC news on Twitter and LinkedIn is a good way to start. Consider creating original content to share on your firm’s social media platforms, as well.

To create the most valuable content, consider what prospective investors and founders need help with. For example, knowing that early-stage founders have a tough time figuring out how much money to raise, you might want to write a post sharing strategies for determining your ideal fundraising target. Blog posts, research write-ups, infographics, and podcasts are all effective ways to meet founders, generate brand awareness, and demonstrate your investing insight and knowledge. We’ll share more guidance on creating content in chapter 8.

6. Evolve your process over time

There will always be new and better ways to find deals. Before the coronavirus pandemic, meeting impressive founders often meant getting on a plane to visit. Now, Zoom meetings are just as essential.

Pay attention to how the landscape of deal sourcing changes, and keep experimenting with new strategies and concepts to see what works and what doesn’t.

Due diligence is the process of investigating a startup to see how it’s operating and whether or not it fits into the market. Once you’ve sourced a number of different investing opportunities, you need to do your due diligence to make sure your investments are viable.

Some due diligence processes take a couple of weeks, while others take months. How long you spend in the due diligence phase depends on what stage you’re investing at and whether you have constraints to consider (like jumping on an investment before a round of funding closes).

As part of your due diligence, you’ll likely review the following:

People: Look at a company’s team members and consider their individual track records, credentials, and experience to assess whether company is equipped to solve the problem at hand.

Market: Evaluate the company’s market size and demand, looking closely at the customer base and competition to see whether there’s a significant opportunity and potential for return.

Product: Looking at the product features and value proposition, consider how different the product is from other similar offerings on the market—and how much room there is to grow.

Finances: Review metrics like annual recurring revenue, revenue growth rate, burn rate, cash flow, customer acquisition cost, lifetime value, and profit margin. These all provide insight into whether the company has powerful profit potential.

Legal: In addition to conducting a broad legal review of the company, you also want to figure out what your rights as a VC firm would be and how much control you’d get by investing.