How consumer VCs make investment decisions: inside the black box

What VCs looks for in start-ups is well-storied but the process by which they get to a decision less so. Even as someone who lives and breathes venture fundraising every day, I’m relatively oblivious to the finer details of how my peers at other funds go about their due diligence (DD) processes.

DD is the ultimate ‘black box’ in venture. Making ‘good’ investments (whatever that means) boils down to the holy trinity of sourcing, selection and luck. Sourcing is most VCs’ favourite conversation topic; it’s fairly public-facing and relatively easy to see how successful your sourcing strategy is, by tracking how many of your peers’ investee companies you saw at the same time or beforehand. In other words, it’s easy to benchmark your approach and results. When it comes to luck, there’s not much I can do other than ask VCs whether they were wearing their lucky underpants at the time of making an investment.

The selection stage remains the great mystery. Recently, with the help of a number of peers, I embarked on a study to understand how consumer VCs conduct their DD processes. Specifically, I’ve looked at what many VCs would call the ‘commercial DD’ phase. This is where VCs are assessing the overall attractiveness of a company and an investment opportunity, covering areas like the strength of the product, competence of the team, competitive landscape, financial performance and exit prospects. Commercial DD gets most funds to a decision (i.e. to term sheet stage if they’re leading the round). After that, the majority of funds will undertake ‘legal DD’ (checking of insurance policies, employment contracts, supplier agreements, etc.) in parallel with the negotiation of long form legal docs.

Reputable VCs regard legal DD as confirmatory. In other words, they’ll only pull out due to legal DD if a skeleton is found in the closet. In fact, VCs pride themselves on converting 100% of signed term sheets to investments. The other area where it could break down post-term sheet is, in theory, over the long form legal docs, but this is rare in practice as the key terms are agreed in the term sheet.

The results of the survey are fascinating, both for VCs looking to optimise their DD processes, and founders who want to know the gauntlet that lies before them when kicking off a fundraise.

I want to say a big thank you to the VCs who’ve helped me in trying to demystify the fundraising process. For too long, the specifics of DD processes have been well-guarded secrets. We’ll only move the industry forward through collaboration and transparency.

In all, this survey incorporates data from 8 funds investing at pre-seed, 14 investing at seed, 14 at Series A and 4 at Series B.

Many thanks to Manuel Lopo de Carvalho & Rachel Muzyczka (both dmg ventures), Lilac Watt (Venrex), Jimmy Dietz (V3 Ventures), Anna Faulkner (Highland Europe), Billy Fox (Active Partners), Lucas Giacomelli (Pentland Ventures), Sarah Kreik (DN Capital), Hugo Sunnucks (Velocity Capital), Bill Corfield (Love Ventures), Christopher Gale (Yeo Valley Associates), Nico MacDonagh (VGC Partners), Anurag Agarwal (Create Impact Ventures), Jack Folland (Freston Ventures), Fred Ursell (Pembroke), Louis Kerschen (DLF Venture), Otto van Wassenaer (Slingshot Ventures) and Geordie Hadden-Paton (Rianta Capital).

😎 Getting to the commercial DD stage

It’s worth saying that just getting to commercial DD is an achievement. Most funds take 2 meetings with a founding team before progressing to commercial DD, which usually starts with a review of the data room.

All funds take between 1 and 3 calls prior to commercial DD. Interestingly, there is no clear trend across investment stages here.

Given funds filter out a lot of opportunities before and after the first call, getting to commercial DD means that you’ve come a long way already and your chances of receiving investment from the fund in question are greatly increased. However, don’t celebrate just yet, there’s still a way to go!

🕙 The length of commercial DD

There can be a plethora of external factors which impact the length of a commercial DD process. A VC might be waiting for their next investment committee (IC) meeting before carrying out the next phase of work, the start-up may be focusing their time on potential lead investors if the fund in question is a follower, someone might take a holiday, a company might enter its peak season and pause the fundraise, etc.

Negating these externalities, I asked my peers how long commercial DD takes them if there are no major distractions, aside from handling other smaller workstreams in parallel. As you’d expect, timeframes are longer the later the investment stage, as there’s more data to look at and the money at stake is larger. 88% of pre-seed funds and 57% of seed funds claim to take four weeks or less, compared to 50% of Series A and Series B funds. Indeed, 25% of pre-seed funds take just 1 to 2 weeks. On the other end of the scale, 25% of Series B funds take 2–3 months to work through commercial DD.

Asked which areas of analysis take the most time, VCs at all stages are spending a significant portion of time on financial analysis. The assessment of the team takes up a greater proportion of time for earlier stage investors, whilst Series B investors are focusing on the competitive landscape, exit analyses and the product more than their earlier stage counterparts.

On the flipside, when VCs need to rush to a decision faster than they’d like, they often look to save time in their evaluation of company culture, though the willingness to do this is lesser at an earlier stage. Series B investors are more prepared to save time around customer sentiment, distribution strategy and product than their early stage cousins, whilst pre-seed to Series A VCs are more likely to condense their exit analyses than Series B funds.

All funds claim to have at least 2 people working on any 1 commercial DD process. Given the subjective and emotional nature of venture investing, it’s important for multiple people to look at an opportunity. In most cases, it will be 2 people working on an investment opportunity, but some funds run processes involving 4 or more members of the investment team.

🙋 VCs’ use of third parties

Consumer VCs of all shapes and sizes like to lean on people outside their fund during the DD process, whether that be other investors, operators or entrepreneurs.

100% of funds say that they make use of external experts at least some of the time, whilst the propensity to use third party experts all of the time increases from 26% among pre-seed VCs to 50% among Series B VCs. The likelihood that a VC pays external experts also increases with the investor stage, with 26% of pre-seed VCs paying vs. 35% at seed, 50% at Series A and 75% at Series B.

Nearly all VC funds look to source experts from their existing network, whilst later stage funds are more prepared to go through other channels to find experts. In fact, 50% of Series B funds use ‘expert’ marketplaces like GLG and AlphaSights, as well as directly identifying and approaching experts they’ve not met before.

Where possible, all VCs prefer to use experts who are operators or founders in the industry in question, as opposed to sector-specialist VCs. Interestingly, the majority of VCs prefer operators (here used as a shorthand for non-founders, likely functional heads) over founders. There’s also an increasing preference for operators from a corporate background over those with a start-up focus as you go from pre-seed, to seed, to Series A, to Series B. 50% of Series B funds seek out experts with a corporate focus as a first choice, compared to just 13% of pre-seed VCs. This is likely reflective of a company’s growing need for maturity as they progress through the funding rounds.

Third party experts primarily consult with investment teams on how they should be looking at a given company. A material proportion of funds (between 29% and 63%, depending on the stage) also get experts to speak with management teams to assess their competence directly. Notably, 25% of Series B funds also leverage external experts to help write their investment papers.

Experts are advising funds on a wide range of matters during the DD process. Although, notably, no funds are enlisting experts to support with financial analysis. Areas where experts commonly support are the competitive landscape, market (size / trends) and product. Again, Series B funds tend to behave a little differently from pre-seed to Series A investors. They are more likely to receive expert support on distribution strategy, exit analysis and team, and less likely to seek support in their assessment of the competitive landscape.

Though VCs don’t regard other VCs as the ideal third party experts, they love to team up. Every VC surveyed compares notes during the commercial DD process with other funds at least some of the time. Interestingly, the ratio of funds comparing notes ‘sometimes’ (as opposed to ‘rarely’) or more frequently increases through the funding rounds, with 100% of Series B funds doing so compared to 62% of pre-seed VCs. This is surprising given earlier stage VCs are usually considered to be more collaborative and transparent than their later stage counterparts.

Despite VCs’ liking for sharing notes with third parties, the vast majority still take pride in owning all areas of commercial DD in-house, though this drops from 86%-88% among pre-seed and seed funds to 71%-75% of Series A to Series B funds.

The area of commercial DD most frequently outsourced across all investment stages is product. A small portion of earlier stage funds also outsource the evaluation of company culture and customer sentiment, whilst later stage funds outsource some work around the supply chain and team.

👋 How many times you should expect to meet a VC

VCs love a meeting. My calendar is always choc full of them. There’s a good reason for it too when it comes to evaluating a company. Yes, in theory, VCs could extract all the objective data they need from email back and forth. A meeting, though, yields so much more. Firstly, the spontaneous nature of the responses, as opposed to asynchronous email responses, makes for much more candour. You can also get a great feel for things like team dynamics and founders’ ability to sell, both crucial factors when investing at an early stage.

All VCs surveyed typically have a minimum of 3–4 meetings with founders prior to deciding to invest. The proportion of VCs who like to meet founders just 3–4 times decreases gradually through the investment rounds, from 75% at pre-seed to 50% at Series B. Interestingly, there’s an inverse correlation between the investment stage and the proportion of VCs looking to meet founders 10+ times, with 13% of pre-seed VCs meeting this threshold. Perhaps, the increasing levels of data a company can provide at later stages makes the investment process more formulaic, narrowing the range of VCs’ desired number of meetings. Whichever way you slice it, founders should be prepared to spend a significant amount of time talking to VCs (you have my sympathies!) during fundraising, beyond just first meetings.

VCs also like to meet other members of the team, to get a feel for the performance of different business functions, founders’ ability to attract top talent and company culture. In fact, 65% of VCs, across stages, like to have as many or more meetings with other members of the teams than founders. However, a small proportion of pre-seed to Series A funds only look to have 1 to 2 meetings with other members of the team, whereas no Series B VCs have this few meetings with other team members before committing to invest.

Overall, founders and their teams are probably looking at 5–10 meetings with each VC that decides to invest.

In addition, all funds look to carry about between 1 and 4 reference calls focused on the character and skillset of the founders.

📏 How different areas of a company are assessed

Time for the juicy stuff. VCs evaluate various aspects of a start-up in all manner of ways, and they all do it differently. As you might expect, later stage funds are more exhaustive. When asked to select all methods by which one assesses a given component of a company, later stage funds are selecting noticeably more options.

When it comes to gauging product-market fit, all funds look at target company traction data, covering things like top line revenue, customer acquisition costs, AOV and customer retention.

The next most popular method was looking at surveys carried out by the target company, followed by assessing the product or service’s appeal to the investment team and looking at competitor traction data.

There’s a marked difference in how earlier and later stage funds assess product-market fit. VCs are more likely to look at competitor traction data the later the stage they’re investing at (75% of Series B funds compared to 25% of pre-seed funds) while the opposite is true of funds using surveys carried out by the start-up.

One less common method for evaluating product-market fit is VCs running their own surveys, though this is more popular with later stage funds (21% of Series A funds and 25% of Series B funds). This is an area where dmg ventures’ due diligence process stands out. We run surveys with dmg media’s audience to see what people think and feel about a product, brand or sector.

Interestingly, no VCs surveyed take into account the personal opinions of family and friends when considering product-market fit.

Competitor analysis is undertaken in a variety of ways. Most Series B funds are carrying out most of the options suggested in the survey. Nearly all funds are conducting desktop research on competitors, whilst around 75% of funds across all stages are speaking with investors who’ve invested in competitors. A material portion of VCs are also reaching out to competitors for a call, or comparing the target company with competitors they’ve spoken with previously, with these approaches more likely at a later stage.

Around 75% of funds, regardless of stage, treat target company financial models in the same way. They take time to understand it and flex the assumptions to create a (typically, more conservative) reforecast. However, the behaviour of the remaining 25% varies by stage. This portion of earlier stage funds is more likely to simply take time to understand a model (without creating a reforecast) whilst the remaining 25% of later stage funds like to build their own financial model from scratch.

I asked the participating funds how they most commonly benchmark metrics to ascertain ‘what good looks like’. There’s no clear correlation between the approach and the stage of investment. The most common method across stages was to compare metrics against those of companies with vaguely similar characteristics, which is what we most frequently do at dmg ventures. Specifically, we keep a database of metrics captured from each company we go through the commercial DD process with. The KPIs captured in this database mirror the list in this blog.

Founders’ character and ability is assessed in a variety of ways. The most popular method is solicited referencing, followed by unsolicited referencing and getting a general sense from calls with founders. Later stage funds are more likely to do unsolicited referencing (79% Series A, 100% Series B) than earlier stage funds. A material proportion of funds are also having meetings with founders focused on their skillset and character, and organising social outings with founders. In all, it’s fair to assume that VCs will probe you from all angles to try to get to the crux of your character and ability.

VCs’ approach to evaluating company culture is even more varied. Common approaches include visiting the office, asking founders and other members of the team, working with the team for a few hours, and assessing the employee churn rate. There’s a clear difference in approach here between later and earlier stage funds. Later stage funds are more likely to work for a few hours with the team and visit the office, whilst they spend less time asking former employees.

‘Tech DD’ is an oft-overlooked element of commercial DD where the strength of a company’s hardware or software (front-end or back-end) is assessed in detail. According to the survey responses, around 25% of funds at all stages do not bother to carry out tech DD. Of the remaining 75%, all only undertake tech DD if the ‘tech’ is a core part of the business. For instance, these funds wouldn’t carry out tech DD on a standard apparel brand.

VCs are more likely to outsource tech DD the later the stage they’re investing at. This is probably explained by the lower cost of performing tech DD relative to funds’ management fees and ticket sizes at a later stage.

All elements of your company should be ready to withstand questioning from VCs in all kinds of ways. Though there is significant overlap, every fund will have a unique approach for interrogating your company.

🚀 Repeat vs. first-time founders

Though there’s perceived to be a significant difference in risk profile when investing in a first-time founder vs. a serial entrepreneur, the commercial DD process is run very similarly in either case. The level of referencing was the only area flagged by surveyed VCs as something they do differently here, though it can work both ways. Some VCs claimed to do more referencing when it came to serial entrepreneurs, to validate the storytelling around previous ventures, whilst other VCs carry out more referencing with first-time founders, to get a better feel for their capacity to run a business.

⚙️ The decision-making mechanism

Most VCs use a Word document or similar when compiling their commercial DD findings to present to their respective investment committees, although the proportion reduces from 88% at pre-seed, to 71% at seed, to 64% at Series A and to just 25% at Series B. Conversely, the percentage of funds using PowerPoint or Excel, or similar, increases through the investment rounds.

I’m heartened to see that no funds are using Notion or similar to present their investment findings. Though the use of Notion pages for data rooms has become fashionable recently, I find it to be really impractical for the sharing and handling of data.

Around 50% of VCs across investment stages are writing 3k-5k words for their final investment papers. The average number of words creeps up through the rounds, although probably not by as much as you’d expect. 38% of pre-seed funds write 5k words or more, compared to 50% of Series B funds, though 25% of Series B funds write 20k+ words, compared to no pre-seed funds. A small proportion of pre-seed and seed funds write 1k-3k words, with no VCs writing fewer than 1k words per investment paper.

With each VC, expect to have to get through between 1 and 4 IC meetings before getting to a decision to invest. The proportion of funds carrying out just 1 IC before coming to an investment decision gradually reduces through the rounds, from 63% at pre-seed to 25% at Series B. 40%-50% of funds have 2 ICs per company, whilst some later stage funds go through 3–4 ICs to get to a decision (14% seed, 14% Series A, 25% Series B).

Just getting to the commercial DD phase is an achievement. Once you’re there, you’re probably looking at somewhere between 2 weeks and 2 months of uninterrupted commercial DD with each fund.

You should be prepared for your company to be scrutinised in all kinds of weird and wonderful ways, and you should also be aware that many funds seek second opinions from other funds and experts. Fundamentally, fundraising remains a painful, archaic process, but it may help just a little bit to know what’s coming your way.