Demystifying the VC Underwriting Process
One of the hardest aspects of being a venture capitalist is constantly telling bright, ambitious people endlessly toiling at their life’s passion that I am not going to fund them. It sucks. Naturally, I am often asked the question, “how do you decide what to invest in?” Usually this is in response to a rejection, but some entrepreneurs seek this guidance proactively to better tailor their interactions. So, this post is centered around the process that we undertake at IDEA Fund Partners which I believe to be very similar to other VCs.
Before we outline the process, it is also important to know that we say “no” for many reasons beyond the merits of your business. You may be looking for too little or too much money for us to make our investment mandate fit. You may have caught us on the back part of our investing cycle and we may be prioritizing companies with greater traction. We may have ZERO understanding of your industry and no one to help us get up to speed quick enough. There are tons of reasons. So, believe us (90% of the time) when we say, “It’s not you, it’s us”.
The investment underwriting process at IDEA Fund is generally four stages and we strive for a 4-to-6-week turnaround between introduction and term sheet. Some people (I’m looking at you Silicon Valley) think that is a long time. However, we feel that if we are going to play the role of lead investor and we are going to be working together for 7 to 10 years then it seems prudent to make sure we both want to do this. Below is a high-level outline of the process:
Step 1: Strategy Fit
The first step in the process is to determine if you fit our investment strategy. IDEA Fund Partners’ strategy is to invest $500,000 to $1 million into Series Seed, Seed Extension or Series A investments and we want to own at least 5% post-money. We prefer to invest in companies in “overlooked” geographies such as Raleigh/Durham, Charlotte, Atlanta, Denver/Boulder and Austin and we love to back overlooked founders. We’d like to see early-revenue traction (between $200k and $1m) and our hope is that you align to our view of the world when it pertains to technology and industries. This step is pass/fail and generally takes less than a week to determine.
Step 2: Opportunity Scoring
The next step is to determine how compelling the opportunity is. We do this by calculating a market size (both top down and bottom up), gaining a perspective on market growth, determining the competitive dynamics of the industry and assessing how differentiated your solution is from incumbents and other startups in the space. We want to make sure that the market is either big enough or growing fast enough to support a very large outcome and we want to see that you have some competitive advantage in technology, business model or distribution. Every company is scored using our proprietary scoring system which, in conjunction with the bandwidth of our teams and size of our pipeline, steers a decision whether or not to dig in. Our goal is to complete this phase by the end of week two.
Step 3: Partner Conviction
Now that we have determined that you are a fit for our fund strategically and you are uniquely tackling a large opportunity, the goal of the next two weeks is for the lead Partner to get conviction. This involves two of the most important analyses: team underwriting and venture return potential. Underwriting the team involves spending time to get to know you, test you on your level of understanding of the problem you are solving, trying to get a sense of your character, resilience, humility and charisma. We seek to go beyond the traditional signals of founder competency (i.e. Ivy League school, top-tier tech experience, etc.) to really get a sense of who the team is and what makes you special. It’s the hardest and most subjective analysis that is done but also the most important. Finally, we analyze venture return potential by looking at how fast the company can grow, the capital intensity of the business, understanding exit multiples and depth of buyer universe and stress testing the financial assumptions necessary to achieve a level of exit that can “return the fund” (i.e. gain a return on our investment equal to or greater than our total assets under management for that fund). Generally, for us, a minimum target exit value for a portfolio company is $500m+ in 7 years. If the lead Partner determines this is a good investment, then he or she recommends a pitch to the full team.
Step 4: Team Conviction
The full team pitch lasts approximately an hour with 30 minutes dedicated to the founders telling their story and 30 minutes of Q&A. After the pitch the IFP team reconvenes to have an open discussion on how we each feel about the opportunity and to gather a list of open questions and concerns. If there is excitement over the deal, the next two weeks becomes an exercise for the lead Partner to generate a deal memo, conduct reference and customer checks and answer outstanding questions. Upon finalizing the deal memo, we bring the opportunity to a vote. For us to invest, we require a unanimous approval (some firms go with consensus, but we are small). If the vote is positive, we issue a term sheet and begin the process of documentation and closing. If negative, the lead Partner will draft an email that outlines the reasons we passed. This last step is important to us and core to our philosophy of transparency and decency to founders.
As I said before, there are a multitude of reasons we say “no” and the majority of those reasons are not tied to whether you will build a good business. Sending out the pass email is one of the worst feelings in venture, but I hope that this view into the process shows that there are a number of stars that must align for an investment to be made. Don’t be discouraged. Keep pressing on and remember two things: just because one firm passes doesn’t mean that others won’t invest in you (it’s a numbers game) and every major success story includes investors who passed on them.
