I’m an investor at Foundation Capital, and in the last 14 months, I have met with hundreds of companies. Of those companies, we’ve invested in exactly one. The takeaway from this is that even if your company gets a foot in the door of a traditional VC firm, the chance that you will be funded is extraordinarily slim. So how do we decide which few lucky companies we will invest in? Diligence.
Diligence is the process by which venture capital firms evaluate startups for investment. It’s both tedious and exciting, which, if you stop to think about it, is kind of like dating. You have to meet and build relationships with a lot of people in order to find the one you want to stay with.
I’ve found that many first-time entrepreneurs don’t know what to expect from the process, which can leave them intimidated, unprepared, or worse, both. So consider this your diligence primer; it just may help you find the one you’re looking for.
Step 1: The Pre-Screen
If VC funding worked like Tinder, the pre-screen would be where I swipe left or right. In most cases, companies reach out to me. Sometimes I go in search of investment opportunities. The pre-screen is really just an initial review of the company—target market, geography, existing investors, team backgrounds, and what kind of traction they’ve built. I swipe right about 70% of the time. Don’t judge. I just like to get to know people better.
Step 2: The Screen
About 20% of the companies make it past the pre-screen review process to the screening, which is basically our first date. We’ll spend an hour together and both assess if it’s worth spending more time with each other. You’ll be deciding if we can be helpful in getting your company to the next level, and we’re trying to figure out the same. If our initial meeting goes well, I’ll do some market research and ask you to come hang out with a couple of my friends—the Foundation Capital partners.
Step 3: Formal Diligence
Only one company out of a hundred makes it to the formal diligence stage. So if you make it this far, while we haven’t reached the point of co-habitation, we’re going to be spending a lot of time together. And like any relationship, if you do the same things over and over again it starts to get dull, so formal diligence gives us a chance to get to know you in lots of different ways.
The “us” in this case is the deal team, a group comprised of myself, a Foundation Capital partner, and others who might have experience in your field. Over the course of the process, we’ll become both your biggest advocates and your closest researchers. There are a number of areas we look into during formal diligence, and by the end we’ll know if you’re marriage material or not.
One of our criteria is that any investment we make should have the potential to grow by double digits and eventually become a multi-billion dollar company. The main goal of the market exercise is to figure out whether your company is equipped to take on its specific market, or if it’s positioned well enough to create a market of its own. We do this by conducting primary and secondary research on any given market. We’ll talk to relevant executives at different companies, apply the unique insights we’ve gained in our experience with other companies, and compile all this data to help us better understand the context of what it will take for your company to succeed. This aspect of diligence is also a huge business development opportunity for your company, because the people we talk to may one day become your customers. These early stage introductions lay the foundation for long-term growth and the questions these potential customers ask can help us better understand how to strategically position your company.
Product & Technology
Typically, a lot of time is spent on this aspect of formal diligence. On the technology side, we aim to discover what sort of technical differentiation exists in your offering and if your infrastructure can sustain massive growth. On the product side, we try to assess customer use cases and better understand the product roadmap. Of course, we also evaluate the overall strengths and weaknesses of your team as a whole. To accomplish all this, we often rely on the expertise of trusted friends, who may include CTOs and VPs of our portfolio companies, other startups, or large corporations. With the permission of the prospective company, these friends help us with our deep dive and share their perspectives. In some cases, these introductions lead to long lasting relationships, with the people we bring in ultimately adding technical expertise to your company and advising you on strategy.
As I mentioned, our goal for every investment is to see huge growth and build companies that can be in it for the long haul, so as part of formal diligence, we look for a demonstration of solid growth in the past or a convincing argument as to why growth has not yet begun. Metrics vary depending on the company, but we might look at MRR, MAU, or even a custom metric—in the end, we want to see the potential. In some cases, we might also need to look beyond the numbers. As my colleague Ashu Garg recently noted, metrics aren’t everything.
Financials & Valuation
After looking at growth, we dig deeper into your company’s financials. If it’s an earlier stage company, we’ll only spend as much time as the information requires, but later stage companies get a thorough review. Our thorough review process could include stress-testing assumptions for projections, building our own projection models to account for variables in performance, looking at metrics on revenue and cost sides to understand company trends, as well as looking at historical trends in cash requirements. To create a valuation, we take all of the financial information into account and then look at comparable companies that have been funded, acquired, or have gone public.
The last area of focus in formal diligence is your company’s leadership team—and in many cases, the team is really what’s most important. I spend a lot of time with each team member to better understand how they see their role in the company, and the impact they hope to have both on the company and on their industry. In the process, I ultimately learn the vision, capabilities, and aspirations of the leadership team, while also understanding them as people—their families, their favorite foods, and more. Great people build great companies, and by learning all about your team, we can better steer you toward ultimate success. We don’t make hundreds of investments a year, so knowing that your team is made up of people we can work with, and vice versa, is of the utmost importance.
By this point, I know pretty much all there is to know about you and your company, and my grandmother is asking every day when we’re going to get married. “I don’t know, Gram.” I say, “Soon. We just have to execute a term sheet.” That’s the last step. Once we’re agreed on terms, our union becomes official.
Diligence is a process. While it would be nice if companies could just work through a checklist and receive funding, the real world is not so black and white. Like deciding to get married, the ultimate decision about whether to fund a company is based on a gut feeling. We have funded companies that only scored well in one area and have not funded companies that have outperformed in all areas. People often say that when you find the right one, you’ll just know. But as any VC will tell you, a lot of information helps too.