Behind the scenes of fundraising – the initial chat between Founder and VC

Four key questions start ups should ask VCs

Behind the scenes of fundraising – the initial chat between Founder and VC

My work as a VC predominantly consists of scrolling through pitch decks and hearing your pitches. To sum up three years of pitch meetings, I have set up this blog.

In the next “few” paragraphs, I hope to cover one side of the table: what questions do you need to ask a VC and why. In a subsequent blog, I will cover the other side: what questions will a VC ask you and why.

To help you remember the content of this blog, I have set up a framework with the 4S-questions a start-up (also starts with an “s”; cheesiness intended) should ask.

The 4S framework

Start-ups should ask:What you mean:1) StatusCheck for run-around, follow-on and pulling-out2) Sweet Spot Check for the ‘too-early’ excuse, ‘hairy-deal’ experience and the “laggard” experience3) SectorCheck for competition or experience4) SpecialisationCheck for Venture Developer, Professional Investor or Industry Expert

Let’s get started. Imagine you are having a call with your favourite VC (I suggest that’s Notion…). After three failed attempts at downloading Zoom, you step onto the conference call and we start chatting about the weather in London. Next, I ask you how you would like to structure the call today.

In my view, you should let the VC introduce its fund first as it allows you to ask a few important questions like:

1. “What is the status of the fund?”

  • Run-around - Institutional VCs, like Notion, typically raise a 10-year fund of which the first four years are used to invest in about 20 companies. The next six years will be used to scale these companies. At the end of year ten, the VC will pull out. Now, imagine a VC fund is in its fourth year (at the end of its investment period) and can make one more investment. Naturally, the VC will be very selective. To not portray to the market that the fund is almost closed for business (as people will stop sending deal flow), the VC could give you the run-around. During the first call the VC appears interested and asks many questions. After the call, the VC asks for access to the data room and you start celebrating. Then, after a few weeks of silence, the VC writes back to you that they won’t invest (something the VC knew from the beginning).
  • Follow-on - Moreover, in the fourth year of a fund’s life, the reserved money for follow on funding is steeply decreasing. The companies that received an investment in year one of the fund, will raise multiple rounds of follow on funding (likely in years three and five – every two years). This might leave no reserved funds for you in year six (two years after the initial investment in year four). The VC might do its pro-rata investment in your next financing round but you shouldn’t count on more funding.
  • Pulling-out – Many institutional funds have a lifetime of ten years before money is returned to the Limited Partners. Simplistically said, any investment made in year four of the fund will have only six years to grow. At this point, a VC can sell its share to a PE fund or push you towards an exit. Compare this to a company that received an investment in year one, meaning it has ten years to grow before an exit event is contemplated. This fund dynamic also partly explains why VCs focus on later stage investments toward the end of the investment period. Note, however, that it is becoming more common for VC funds to stay invested post the ten-year mark for fast-growing companies. It is worth asking the fund directly.

Now, another question you like to ask to gauge whether you get an investment is:

2. “What is your sweet spot investment?”

  • “Too early” excuse - Many blogs have been written about the most common excuse used by VCs to pass on your company: “you are too early”. This can either mean that (1) you are too early or (2) the VC doesn’t believe in your business model. As usual, the VC wants to leave the door open in case he/she made a bad judgement, your company suddenly starts growing like a rocket and other VCs start hyping up your company. Basically, to reduce the FOMO. By asking a VC at the start of the conversation what their sweet spot investment is (e.g. in Notion’s case $1m+ annual revenue and 2-3x+ growth YoY), you know at the end of the conversation whether you are really “too early”.
  • Hairy deal experience – The ‘hairy deal’ experience is a deal that falls outside the straight sweet spot investment. This can be due to lower growth, you fall outside the VC’s usual sector focus or you are too early in revenue, etc. A hairy deal will see a lot of work on both sides of the table (read: time wasted). The VC will ask for customised materials and multiple calls while they try to get their head around your business model/sector/stage. In truth, VCs are less flexible than they think they are. Your time is better devoted looking for VCs that write cheques to similar companies to yours on a daily basis. The likelihood of receiving an investment is much higher, the VC is more specialised in helping you and the road to investment is less cumbersome.
  • Laggard experience – Once invested, it is equally important that you fall into the sweet spot investment of the fund. Follow-on funding is determined based on the comparative performance of your company versus the rest of the portfolio. If you don’t fall into the top 25% on the metrics, your chances of receiving more than a pro-rata investment are small. The bottom 25% (or more) might not receive any future investment. This will make raising your next round a nightmare. Naturally, it is very exciting to choose a strong-branded VC but when you are a laggard from the start, it can easily backfire when this VC will not do at least a pro-rata investment in the next round. It is an indicator to other VCs that your performance lacks.

Yet another question to gauge the likelihood of investment:

3. “Do you have any experience with the sector I am operating in?”

  • Competition or Experience – I like this question because you will either get one of two answers: (1) the VC starts talking about all the competitors they have seen that are similar to you, indicating that you are lumped with the dozen other players in the market (not a great primer for an investment). Otherwise, (2) the VC can rise to the occasion and show their enthusiasm and true experience they have in the sector, creating a moment for the VC to sell to you.

The last question you will want to ask in the initial call with a VC entails:

4. “What are examples of your specialisation in working with companies?”

In my view, there are three categories of investors (a modified version of Chris Tottman’s original framework of VCs). Before you ask the question, I would suggest you think about which type(s) of VC you need for your next phase of business growth. By asking for practical examples of added value, you hope to figure out which bucket(s) this VC falls into and how this stacks up against your needs:

  • Venture Developer – has first-hand experience in scaling businesses in their career (e.g. the Partners at Notion are ex-MessageLabs). They will help you build optimised processes against tried practices and prevent common operational mistakes.
  • Professional Investor – has a career pedigree in investing. This investor has the ability to pick winners, navigate this murky investor world and can help you access bigger & better funds or exits in the future.
  • Industry Expert - has worked in your industry for many years and can leverage their network to help you access clients or position your brand.

Note that this division is not mutually exclusive nor collectively exhaustive, but it sketches a framework to prioritise VC conversations.

In sum, we have discussed why it is important to ask:

  1. “What is the status of your fund?”,
  2. “What is your sweet spot investment?”,
  3. “What do you know about our sector?”
  4. and “How are you different from other VCs (specialisation)?”

I feel confident that with those 4 questions you will make a great impression on the VC (and lets him/her sweat a little too). More importantly, you are now able to gauge the likelihood of getting an investment and whether this VC is the right partner for you.

We will now turn to the other side of the table. In the next blog you will learn the questions a VC will ask you and the hidden meaning behind those questions.

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