The Importance of Proprietary Deal Flow in Early-Stage VC

Posted on May 4, 2013 | 68 comments


When I was new at Venture Capital I was trying to figure out the business. It was a fun period for me because everything was new and I was curious.

  • What kind of deals should I be doing?
  • What stage? What price? With which other investors?
  • Should I focus on geographies or industries?
  • Should I trust my instincts for founders and products or should I be more focused on the market size or business plan?

Screen Shot 2013-05-04 at 7.52.23 AMOne of the major calibration pieces for me was where to find deal flow. As a VC you want to feel like you have “proprietary sources” of deal flow. Otherwise you’re a stock picker, which in this business isn’t a good thing.

I sorted out pretty early that lawyers were a great source of deal flow. Why? Because entrepreneurs often went to lawyers at their earliest stages to get their company registration done. Entrepreneurial lawyers like Don Lee, Dave Young or Ted Wang are  good at sussing out which entrepreneurs are high potential. They are likely taking losses on their first project with the entrepreneur so they select carefully. I’m not saying that lawyers were my screening process – simply that they knew about deals early on and they had voted with their time and pocketbooks so I knew I had a degree of filtering.

Of course I went through normal other channels of deal flow. I spent time on college campuses. I tapped my friends at big tech companies (Salesforce, Google, Oracle). I asked for intro’s from entrepreneur friends. I attended events. I did speaking gigs. I hustled.

I eventually stumbled on to the best source of high-quality deal flow imaginable – blogging. The sheer number of relationships I’ve built through being public, transparent and being willing to engage in comments and through social media has enabled me to get to know entrepreneurs even before they launch their next company.

There is one source that was always problematic for me – intros from investment bankers. This is no criticism of the investment banking industry (although I’m sure some will read it this way) for which there are very useful purposes. But as a source of deal flow it is last on my list. [no, I'm not talking about SVB, Comerica, Square1 and the like. They are venture bankers not investment bankers. Big difference.]

Before I tell you the reasons I’m concerned about investment banking intros, I should start by saying I think bankers are enormously helpful for entrepreneurs in raising money

  • When you are trying to raise “strategic money” since these people are often hard to reach and they are often more used to being approached by bankers
  • When you are raising a large, later-stage round given by this time you’ve likely got a fairly large business to run
  • International money. Same as strategic – hard to reach, hard to get to know easily

I think the issue I have always had with investment bank pitches was best summed up in this article about Y Combinator in which Paul Graham apparently made the following quotes

“There are two things that people grumble about Y Combinator that are actually compliments,” he told me.

“One is that Y.C. start-ups are overvalued. The only way for a company to be overvalued is if there’s someone willing to pay that price. So what they’re saying is: Going through Y.C. causes companies to raise money on better terms than they would have otherwise. We wouldn’t have the barefacedness to make that claim ourselves!”

Therefore one goal of Y Combinator appears to be “get the highest price and best terms.”

Fair play.

They have an investment in each company so I can understand that goal. And they have access to some of the most talented technology entrepreneurs so this is a worthy goal for them.

As an early-stage investor that is not always aligned with my goal, which I would express as, “pay the right price for the stage & risk in a way that is fair to the founders yet preserves our ability to grow into our valuation at the next financing event.” As far as “terms” go I’m 100% aligned to have the most vanilla, founder-friendly terms I can.

But I think there is a down side that I see in startups that raise artificially at prices above what a normal market might value. It makes it extraordinarily hard to raise the next round of capital.

And I’m seeing this even at some really well run startups.

I have always advised startup companies against letting valuations get massively ahead of market norms. I normally advise “Raising at the Top End of Normal.”

The other Paul Graham quote from the article is this:

“The other thing they say is that they can’t tell on Demo Day which are the good start-ups. Well, it’s not because the good start-ups look bad; it’s because the bad start-ups look good! Which means we’re doing our job.” 

Recap: Our goal is to find investors who pay the highest price and to help make sure that investors can’t tell whether they’re getting a good deal or a bad deal.

Hmmm. Lucky me.

So I stand by my well-read Quora post of why I don’t attend demo days. I reiterate as I did back then – it’s not a Y Combinator thing. It’s a Demo Day thing. I don’t think they serve investors well. I feel like I’m attending theater rather than looking for deals.

They are terrible predictors of success for investors. We are judging how well you are coached on stage. Do you have good quips? Good vocal variety? Or as the article on Y Combinator suggests, “is your accent too heavy?”

Meh.

I prefer to get to know companies over time.

I know this will read like a criticism of Y Combinator and I’ll get in usual trouble for that, which I reget. Because my nuanced views will be read wrongly. I wish Paul & team could see my views in why Demo Days are not right for me as more of my style than anything I think is wrong with them. And for the record, GRP has funded YC alum.

I view Y Combinator as a sort of Harvard Business School or Stanford in that I know the best young people of our generation want to go there. So I know that the people graduating will have a higher proportion of great talent than other places. I know they will continue to produce great successes and that they have a team of great thinkings and leaders running their program.

I also know that there are people close with the program like Sequoia that get access to the companies early and therefore have a proprietary advantage over somebody like me.

It is not my proprietary deal flow.

I haven’t built Y Combinator. So if I’m the guy in the audience feeling the power of that great baritone projection with that beautifully designed product and if I am able to fund that company without a prior relationship with them, I’m guessing it falls into Paul’s category of “a bad startup looking good.”

Otherwise, “why I am so lucky?” to get access to it when so many other investors who know the companies on a more proprietary basis have picked over it, spent more time with them and chosen not to proceed?

Or maybe I’m paying the highest price? Hardly a reason to get excited about winning a deal.

As the saying goes, “If you don’t know who the sucker at the table is, it’s you.”

Bad companies that “look good.”

And so it goes with bankers.

They are designed to help good companies to get access to investors but also help to make bad companies look good. They do this because they have amazing skills at writing business plans. They know how to build pitch decks. They have blackbelts in Powerpoint. They tell you how to tell your story. They know the VCs so they know what interests them.

Real life entrepreneurs are messier. And that’s how I like it.

I like to see how they got introduced to me. How good they were at follow up. If they made a mistake how they recovered. I like to see their responses to hard questions – even if I don’t care if they have the “right” answer.

I like to watch how they respond to set-backs and adversity. I like to see how they improve their products when there are obvious holes. I like to debate with them how they will land customers and how they deal with the press.

I judge based on their ability to attract their fellow teammates and what choices they make. And I listen to the reasons their co-founders quit their well-payed job to join them.

I like to hear their passion for the idea. I love complexity. And non-conventional ideas. I love when other investors “don’t get it.” I love businesses that don’t lend themselves well to VC Panels at conferences or Demo Days.

If I’m willing to commit early and be out on a limb then I want to know if I can get a better price. If I wait for traction I know I have to pay up. That’s OK, too. I want to know that if I commit it’s not going to be a party round. I hate party rounds. I generally don’t like to work with founding teams to over-value “collecting logos

I know that the simple view of this is that I want “cheap” prices, which isn’t true. I have enough investments that people can diligence to tell you that I’ve been fair on price.

But when your banker is pushing me, telling me

“We’re expecting 3 other offers, so move fast”

or

“You’ll have to top “x” price to win this deal”

You’ll understand why I have no enthusiasm. My value add in this deal? Ability to move fast and pay the highest price?

And my reward for doing this? I get to watch 2-5% of my investment immediately squandered on a banking fee for the introduction.

Lovely.

To all my banking friends … I’m not a hater. Your skills are much appreciated later in our business. I would gladly work with you on a $50 million late-stage, complex financing. I would welcome you in an M&A process. I value your insights into industries and your unrivaled networks.

But for A-round deals please understand why I don’t want to take the meeting.

And given how easy it is to meet VCs through introductions I also wonder what’s wrong with your startup teams that given the unprecedented amount of transparency and access now in our industry – why they chose to hire a banker. Might there even be some selection bias in the companies in which you’re pitching me?

To the investment bankers in the comments who argue, “Entrepreneurs have more valuable things to do then raise money. They have a business to run!”

I think that misses the point.

The process of raising capital IS part of running a business.

It’s where you get to test your ideas in the marketplace of people who see many similar ideas.

It’s where you meet people who have broad networks and even if they don’t invest in you may prove very helpful in your future.

It’s part of a process where you learn which investors YOU like so you can decide with whom to entrust as a married member of your business.

After all, if the banking process sanitizes your company and makes it more efficient to raise capital without all the “hard work,” so to does it sanitize the investors. Yet once they’re in your deal there is no turning back.

I’ll take messy and hard work any day.

****************

Let’s call this the “Hunter Walk” footnote. He pointed out that while I changed the title from “Why Early-Stage VCs Should Be Careful About Intros from Bankers” to the current title I hadn’t explained the change.

I thought a lot about the original title (by the way, I often change titles after re-reading, editing and reflecting on the post) and I felt it was too hostile towards investment bankers, for whom I have no animus and I have many friends who are in the biz.

The real point of my article seemed to be broader. It was … VCs need proprietary deal flow. Getting excited about a company at a conference and investing is a sucker’s bet. Entrepreneurs raising at prices not normally supported by progress face risks downstream when they have to raise more capital. And that fund raising is part of the job of being an entrepreneur – not something that gets in the way of your doing your job.

So I changed the title to reflect the tone I wanted to get across.

  • Maureen Sharib

    Another good way to do proprietary deal flow is to have someone out in the world CALLING CALLING CALLING talking to private company owners about their interest in selling/talking on investors.
    That’s what we do.
    Maureen Sharib
    513 899 9628
    maureen at techtrak.com

  • Guest

    Thank you Mark. I’m glad I found your article and blog. I am slo

  • James Sisneros

    Mark. I’m glad I discovered your blog. I am the founder of Zaahah (about to launch). Zaahah is based in Philadelphia, which has some great startups and few early stage investors. Would you consider deals in Philly?

  • http://www.pointsandfigures.com/ pointsnfigures

    The last ten meetings I have had with startups started like this, “We need to close our funding quickly.” Who doesn’t?

  • Noobs_R_Us

    Conversely, if you turn out to be the next big hit, you’ll kick yourself as the founder/s for letting so much of your equity go at such low valuation.

  • Jason Smith

    Mark, you cover a lot of bases with this post. I’m a 20 yr tech entrep based in Vancouver, Canada. I’ve had VC funding, bootstrapped, hired and fired bankers, worked in accelerators and have benefited from countless selfless/free hours of advice from mentors. I was trying to come with a word that encompassed how I felt when I finished reading your article…I landed on inspired. Leaving the banker debate aside, my inspiration came from understanding that you (and by proxy assumption, others) actually like the messiness of entrepeneurialism, the grit, the unpolished, and that not everyone needs the Harvard equivalent tech incubator to succeed. I know that to be a given but in all the insider hype that surrounds YC and related demo days, its easy to forget. Especially when you’re outside the valley blast radius. It takes a lot more work to see thru an unpolished pitch to find the business – your entrep background helps there – but I imagine you can unlock undiscovered value that way. Akin to what I’ve heard some US investors say when they come north of the border looking for deals – plenty of talent and ideas, more raw and less connected. I can also see how your blog is your best source of flow. It’s a personal reveal that allows entrep’s to get to know you and like you before meeting. I assume it attracts those who can relate to your way of thinking and enables you to skip a few chapters of the get to know you conversation. Lastly on the banker front, I agree with your early stage/later stage assessment. Huge value at the growth equity and exit level, not so much series A. Part of the game is the hustle required to get the money and the biz plan shaping that unfolds when you talk to folks (VC’s typically) who have seen 10 other companies similar to yours. Only thing I’d like to see more of is VC’s sharing those insights in an actionable way for the entrep. They’re going to keep slogging away at it even if others are in the space so instead of passing without commentary, give them insight into how they could tweak to differentiate. Easier said than done but a few comments with why can go a long way for helping an entrep and generating that goodwill that reverberates around the social web.

  • http://bothsidesofthetable.com msuster

    gotcha. I guess I didn’t see blog comments as a “pitch opportunity” but more as a “conversation” – get to know each other platform. But I’ve read your summary. Send a deck to my email address and follow up. I’ll read and try to give some thoughts.

  • http://bothsidesofthetable.com msuster

    James, thanks for thoughtful response.
    1. I would always take an intro from a thoughtful, connected banker such as yourself if it were a referral with no strings attached. In a New York minute.
    2. On big deals there are fewer investors who can write big checks and therefore one has to be more creative about sources of capital (asia, strategic money, hedge fund, etc.) and thus a banker more appropriate. Not a question of finding “dumb” money, which nobody prefers.

  • http://bothsidesofthetable.com msuster

    Yes. Especially for Eagles fans ;-) But probably likely a slightly later stage deal than I’d otherwise look at.

  • http://bothsidesofthetable.com msuster

    amen

  • http://bothsidesofthetable.com msuster

    thanks for the thoughtful comments. On the topic of feedback I wrote this: http://www.bothsidesofthetable.com/2011/12/07/why-id-rather-err-on-the-side-of-direct-feedback-than-pleasantries/

  • lksugarman

    I’m a bit late to this party, but wanted to submit my $.02.

    First of all, great piece. I really appreciate the insight you’ve offered into what goes into your relationships and investments, Mark.

    Second, the same two points you cited from the Sunday NYT Magazine piece also caught my eye. Well, those and the fact that the article led out with a profile of the exception to the rule of YC with a 37-year-old woman were very interesting.

    Third, the way I write, I always try to come up with a title for a piece to kind of anchor since I can be a bit “bright, shiny things.” But, frequently find that when the piece is finished the focus and emphasis have shifted making the original title a misfit.

    And, in between all the comments about investment bankers, no mention was made of those people, not affiliated with any investment bank, who clothe themselves in banker’s clothing and make a lot of promises while taking “fees.”
    of x% of monies raised.

    Hmm, perhaps the recurring theme for all parties concerned is – beware.

  • http://www.xtrant.com/ Xtrant

    Great article, Mark. I’m so glad I’ve found you (very refreshing not to be talked down to in a VC blog.)

    We’re in Memphis, and it can be hard to find local deal flow to be a part of. Or it becomes a longer more delicate dance as many local investors are less start-up oriented. There is less noise to cut through here, though.

    I will be hanging around, learning, and connecting. Cheers

    Jim

  • LaVonne Reimer

    Just saw this. Great post. “I’ll take messy and hard work any day.” You are still on our side of the table! :<)

  • Camilo Acosta

    You mentioned that you “love when other investors ‘don’t get it.'” Doesn’t that imply that other investors have already checked out the deal and passed? In other words, it’s not a proprietary deal flow kind of deal. How do you reconcile that sort of situation?

    Camilo

    CEO
    PayByGroup
    http://www.PayByGroup.com/Merchants

  • http://about.me/baekholt Geir Bækholt

    Thanks!

  • James Sisneros

    Thanks, I just saw this and I will be in touch. High hopes for Kelly this season.

  • Liz Dean

    I’m an entrepreneur with a company I am launching next month. Most of this article is above my head. Thankfully, it makes me realize that we have a lot to learn before we start pitching to VCs! Thanks for the motivation and insights from the mind of a VC. I like to try to tap into these types of resources to learn and grow. Love it!