Duet Partners
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Weekly Briefing Note for Founders

26th October 2023

This week on the startup to scaleup journey:
  • The miscreants of venture capital
  • Why are VC's so hard to contact?

The miscreants of venture capital

Serial founders often say that the toughest capital-raising experience of them all was their first institutional round. As a first-timer they found it hard to get the attention of the bigger, well-known funds. Their network within investor circles was limited and they were still building a profile as a 'must-back' founder. Out of necessity, they gravitated to the smaller, lower-profile investors that were more willing to give them time. This is very common in early funding rounds. Here, there is a whole smorgasbord of different types of investor from emerging fund managers, to more experienced pre-Seed and Seed fund managers, and many other niche players that sit outside the classic VC fund construction. But the motives and operating priorities of those that don't manage institutional funds can often be much harder to figure out. This creates a danger zone for inexperienced founders who may find themselves unwittingly engaging with unconventional (and sometimes unscrupulous) players. For example, those that market themselves as VCs but in reality are some other form of private investment vehicle. They may just be managing the money of a wealthy individual or group of connected angels, more in the vein of a family office than a proper institutional fund backed by limited partners. And that drives very different motives.

Then there are investors that specialise in investing in 'distressed' businesses. Many of these also look like VCs at first blush but they are angling for controlling positions and operate with a 'PE' rather than 'VC' mindset. In other words, they are probably looking to re-engineer the business into something more exciting - with or without the original founder - before selling it on. They usually wait until a business is running really low on cash before making a final offer, so they love dragging out negotiations. There are many other types of investor that are adjacent to but quite different from the classic VC fund model. The problem in dealing with such a diversity of capital sources is that it's easy to fall prey to the wrong type investor and unwittingly buy a whole raft of downstream problems due to mismatched expectations. This could even include an emerging manager that is struggling to pull together their first VC fund. In this case they actually fit the VC model but may not (yet) have the means to invest if a deal comes together quickly. But that doesn't stop them pursuing deal flow and taking up precious founder time. And of course there are the legitimate, well-established funds where an unscrupulous partner may be happy to take advantage of a naïve first-time founder when negotiating terms. Every founder will have heard one of these horror stories. Figuring out who the miscreants are in this diverse, early-stage funding ecosystem can be a tricky business.

All of this is a reminder that investor due diligence is a crucial aspect of the funding process. Just as investors dig deep on founders, so too must founders dig deep on investors. The most reliable route is to take references. Talk to other founders that have taken money from this investor. How did it work out? But this is only something you want to spend time on if you are considering a term sheet. Prior to that, when building the investor target list, what are the most useful indicators to check? The obvious ones are fund size and age, Limited Partners, AUM, portfolio size, typical deal size, and typical % stake taken. From their portfolio you should also be able to deduce the real investment thesis (versus the one that is marketed). Is there in fact a clear thesis or do they operate at all points on the map? This basic research will quickly reveal if the investor is a classic managed VC fund or some other less conventional variety. Beyond this it's often very revealing to check out their co-investors on prior rounds. Even more importantly, do high-quality mainstream funds subsequently invest in the later rounds? i.e. Are top-tier funds happy to sit on the cap table (or even on the board) alongside this earlier investor? If these initial investors don't 'collaborate' in some way with other investors this is usually a red flag. Mainstream VCs operate in a syndicated world where their reputation (especially amongst other investors) is essential for survival. If you stumble across a lone wolf, make sure you don't get bitten.

Why are VC's so hard to contact?

Every growth business wants deal flow. Startups want deal flow to build their sales pipelines. Investors want deal flow to find great investment opportunities. Startups, just like other companies, go out of their way to tell the world what they do. This is 'first base' for deal-flow creation. It begins with the website, then extends to social media, content marketing, speaking at conferences, being interviewed on podcasts, and so on. Anything that will get the business noticed. But investors, especially VCs, face a dilemma about telling the world what they do. They are wary about this kind of self-marketing for 2 big reasons: 1. They don't know precisely what they are looking for until they see it (and they don't want to turn away founders before they've had a chance to look at their investment proposition), and 2. They will get besieged by so many pitches they simply won't be able to filter them. The upshot of this 'anti-marketing' mindset is that VCs either don't tell founders what they are looking for - except in the broadest terms - or they make themselves very difficult to contact. And very often it's a combination of both. This is not just a nightmare for founders, it's highly inefficient for VCs, who end up rejecting well over 90% of what they look at. But this is the imperfect system that the industry has settled on, mainly because there's nothing better - at least from a VC's perspective. And this is likely to continue whilst the number of startups seeking funding dwarfs the number of VCs investing.

This system creates a big imbalance of power and causes endless frustration for entrepreneurs, especially founders who are experiencing this for the first time. To be fair, most VCs have some information on their websites that broadly describes where their interests lie, but this is often vague. And when a founder thinks they have found some useful alignment, the next problem is figuring out how to get in touch. Very few VCs publish contact information. Benchmark Capital, one of the top VCs in the world, is even more elusive. They’ve invested in some of the biggest tech companies over the past 20 years. But if a founder looks at Benchmark’s website, all they will find are 2 office addresses and nothing else. Nada. Scan the websites of other big funds and there is often little to guide a founder towards any point of contact for their particular proposition. And if you're looking further afield at say family offices, small cap PE firms, and even corporate venture capital funds, many don't even have a website. VCs and other tech investors make themselves hard to reach out to because few are set up to deal with the avalanche of pitches they would get if they made themselves available to all. Looking at a company is a time-consuming process, so many VCs and other institutional investors take the view that if a founder has a proposition that would be a great fit for that fund's investment thesis, then either the fund will proactively find them or the founder will find a creative way of contacting the fund. As one VC commented recently: "Making yourself hard to find is partly just a defense against having millions of plans show up in your inbox and partly a way of immediately disqualifying people who can’t find a way to end up in it anyway."

One of the reasons founders seek the help of capital-raising advisors is to cut through all this subterfuge and restore the balance of power. A core capability of a good advisor is their investment research. This ensures founders are able to confidently align their propositions with well-matched investors and also identify the most relevant person to contact at each fund. But experienced advisors, just like many serial founders, also know that even if a company fits an investor's thesis, the investor still won’t meet most of them. This requires another key step in the outreach process. Investors apply a further filter and this often relates to feeling some sort 'connection' with the founder. This 'connection' can come in different forms, the 3 most common being: 1. It could be that the fund had already identified the startup as a company of interest. This is why experienced founders are 'PR machines' and make their startups highly visible, especially when they do something noteworthy. In other words, they know how to get on the investment community's radar. 2. The founder is introduced to the fund by a trusted source who knows the stamp of deal that the investor may be looking for, or 3. A cold email approach where the investor can immediately sense that the founder has done their homework and is reaching out to them specifically. They are made to feel special, because the founder is asking them for something more than money. And even though this 'connection' element is vital, it will usually only have value if there is a strong underlying 'thesis match' to carry the deal through to offer. Founders that start with the thesis and then find a strong 'connection' put themselves in the best position to drive their deal forwards.

Happy reading!

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