Crunch Network

What Entrepreneurs Need To Know About Their VCs And How To Identify Red Flags

Next Story

Foursquare Will Tell Businesses When Their Ads Bring You Into An Actual Store

To most entrepreneurs, the road to venture capital financing is littered with criticism and rejection. Ranging from “limited traction” to “that’s a hard space,” VCs have an entire vocabulary of terms to pass on investments — and can sometimes even forgo that vocabulary with the “soft no” by ghosting the founder.

Once a founder inevitably gets a VC firm on the hook, it is only natural that they think they need to not rock the boat and close the round. However, financing is a partnership with your VC, and it often establishes a board member for your business for years to come. All too often, companies fail to do their own due diligence on their VCs before entering into this agreement.

So what do you need to know about your VC when reviewing their term sheet?

  • Where are they in their fund cycle?

After a venture capital fund has been sold and is closed to new limited partners, the firm will typically invest out of this vehicle over a three-five year window before beginning the fundraising process again. Beware the VC nearing the end of their fund cycle, as they may become more disengaged with your company, or they may not have the necessary capital available to call to invest in your company over its lifetime.

  • How are their realized returns?

Too many entrepreneurs stop questioning the track record of their investor after mention of a handful of logos. Only 7 percent of investments in unicorns have ultimately returned the entire fund that invested in them, meaning odds are high that the VC touting their “early investment in ___” may not have made the return you assume they made.

You’re not going to learn your VC’s most intimate operational detail in the first or second meeting.

Understanding the portfolio’s overall performance on a cash-on-cash basis and relative to their peer groups will give you an idea if they know what they’re talking about, and how well future fundraising efforts will go. Beware the VC with unrealized returns and looking to fundraise as they try to push you to sell your company earlier than you would like.

  • How do they mark their investments?

Many VC firms simply price the value of their positions to the most recent valuation of the company, but others mark to financial performance (using public comps or recent exits as a benchmark), or even based on internal projections.

In knowing how your VC accounts for their position in your company, you can gain a greater understanding for their incentives on your board. Boards can become challenging during times of distress, when some of your board members have marked your investment down while others continue to hold it at cost. Beware the VC that aggressively marks up their portfolio, as they may be difficult to manage in times of distress.

  • What does their employee/partner turnover look like?

VC firms typically run extremely lean, and there is a limited availability of positions and an oversupply of eager talent looking to enter the industry. While many firms “churn and burn” junior employees in two-three year pre-MBA roles, others treat their associates as “partner-track” members of the team and their departure should be seen as a red flag, as it likely is a signal of the fund’s downward trajectory or the quality of the partner team. Beware the VC that has had any general partners leave the firm.

Obviously, you’re not going to learn your VC’s most intimate operational detail in the first or second meeting, but once you’ve got a term sheet in hand, these are important questions to have answered prior to entering a long-term partnership. Beware the VC that denies this level of transparency.

Featured Image: boonyarak voranimmanont/Shutterstock