Investor Fundamentals No.001 – Understanding the Venture Investment Process
There is a lot more involved in making an investment in early-stage companies than just a “Gut Feeling”. There is a process for any deal opportunity to go through. The process is designed to ensure that any and all issues, concerns, and challenges that range from sourcing the deals to a successful exit are addressed properly
In our experience, there are ten core steps in a traditional venture process, some investors use all of them or some combination of them, yet they will have to go through the process one way or another. A traditional process, if done with a high level of discipline, will take on average 90-180 days depending on the complexity and size of the deal.
- Sourcing the Deal – Investors can get exposed to opportunities from many channels, some more credible and some not. Getting the deals from the right source is as important as the deal itself, especially for independent investors. One needs to establish reliable channels for building their deal flow and to make sure the sources are credible and consistent.
- Screening a Deal – Developing a repeatable and robust screening process is essential to the quality of the deal flow. The screening process looks at, for the most part, the strength of the founder/management team, the problem being addressed, an industry of interest, market need/size and solution, and stage of the startup, and sometimes the size of the deal. As an investor, you need to create a set of parameters that will allow you, fairly quickly determine if the deal fits your investment strategy.
- Qualifying the Deal – After the deal passes through the initial screening, there will be a need to qualify the deal, by taking a deeper look at the opportunity in terms of best market fit, go to market strategy, and in current market conditions, the barrier of entry and future fundraising requirements.
- Initial Decision – After the determination that the deal is the one you would like to pursue, the investor will need to establish their level of interest, primarily based on their risk profile, and to understand their equity position within all future raises and what the potential upside might be.
- Evaluation Benchmarking – Before committing time and resources, we have learned that creating the evaluation benchmark is key. The opportunity may seem attractive, yet if the valuation is not aligned or the startup is not open to negotiating it, it might not be worth it to move forward to a more expensive stage, the due diligence phase. If the company has already post-money and has a ready to use the term sheet, its covenants, and especially valuation, you need to decide if it fits your investment strategy approach.
- Due Diligence – This is the most critical and most expensive stage of the deal. It typically takes 90-180 days and the level of complexity is depending on the type of industry, stage of the startup, and the size of the investment. In this stage you, the investors, take a “Deep Dive” into the company and its strategic business, marketing, and operational plan, projected financials, milestones, and benchmarks to assess the probability of success. It requires a range of professional disciplines and will demand the involvement of experienced people in their field. There is no one person that can possess all of the required knowledge to make a solid decision. That is the stage that an investor will need to use its network of advisors, such as attorneys, CPAs, and others, which come with a cost
- Due Diligence Summary Report – After completing the due diligence, the investor or its advisors will prepare a summary of findings that outline the Pro and Cons of the deals, red flags and establish the negotiable and non-negotiable items, what the investors can live with and what they can’t all which will need to be addressed when entering the negotiation stage.
- Final Decision – When determining that the investor and the startup reached the middle ground, it is time to update the term sheet and finish negotiating all other items to both sides’ satisfaction. The investor will most often issue a LOC (later of commitment), formal or informal as they prefer, and formalize the intent and move to the closing stage.
Closing the Deal – Assembling all of the relevant and necessary legal documents, review, edit, renegotiate if need be, and then finalize, sign the deal, and transfer the funds.
- Followup & Governance – Establish the operational relationship as it is pre-negotiated and outlined in the term sheet and the agreement of understanding with the company as far as on-going communication, level of involvement, and the reporting structure.
So, as one can see, there is much involved in making an investment. It is time-consuming and can be challenging, at times. According to various sources, the cost of the process for the deal size of $250K and up ranges between $10-20K (Hard and Soft costs) per deal closing. Following a logical and repeatable process will ensure that you will contain the cost of the transaction as much as possible.
As we have indicated before, when you join a syndication or a group the cost and personal time/risk, per investment, is being shared by a larger number of investors, which can be reduced significantly.