Editor’s note: Bo Peabody is an entrepreneur and investor, and is currently a Venture Partner at Greycroft Partners. He has founded several companies including Tripod Inc., one of the original social networks. Bo is also the author Lucky or Smart.
After spending 20 years building companies, first as an entrepreneur and then as a venture capitalist, there’s one thing I’ve learned about the industry: venture capital firms understand much more about the startups they invest in than startups understand about the venture capital firms they partner with.
That information gap is bad for both sides.
I began talking with my partners at Greycroft about this dynamic and we quickly agreed that Greycroft should be an “Open VC” — that we should strive to give entrepreneurs access to more information about how our firm works. In fact, we should be proactive in suggesting questions entrepreneurs should ask us (or any venture firm they interact with) so that what they know about Greycroft matches what we know about them. We think it will improve returns across the board.
It’s commonly accepted that a venture capital firm’s job is to get to know a startup inside and out. That’s important before an investment is made, but becomes even more important after the deal is done. We need to understand its product, team, and market almost as well as the entrepreneur does. But it’s less accepted that a startup should get to know the venture capital firm they’re considering as a partner.
Entrepreneurs feel it’s important to get to know the individual that’s sponsoring their deal, but that’s only half the story. By agreeing to sell equity to a venture capital firm an entrepreneur is no more partnering with one individual than that individual is partnering only with the entrepreneur.
We meet with every member of a company’s executive team, call three to five references on each and also vet every employment agreement, stock option agreement, corporate formation document, and contract that the company has ever signed. Nothing is left un-reviewed.
It’s not just the sponsor of the deal. At Greycroft, and at most well-run firms, every single person on the investment team is expected to have a high level of knowledge and exposure to every deal.
Here is Greycroft’s standard due diligence data request:
- Customer references
- Management references
- Company financials (historic)
- Financial model (projections)
- Usage and traffic stats
- Cohort and churn analysis
- Capitalization table
- Previous term sheets and stock purchase agreements
- Sales pipeline
- Sales deck and other sales materials
- Product roadmap
- All substantial contracts
- All company formation documents
- Executive team biographies (all key players)
- Hiring plan
- Full team turnover data
By contrast, entrepreneurs and their teams know precious little about the venture capital firms they partner with. They might ask some general questions about investment philosophy and decision-making structure, but no documents are passed from the venture firm to the startup, almost ever.
What entrepreneurs need to understand is that they’re making an investment in the venture capital firm as much as the venture capital firm is making an investment in the entrepreneur. The stakes are the same on both sides (you could argue higher for the entrepreneur) and the informational playing field should not be so uneven.
I understand that there are very good reasons it is, and why this uneven playing field has persisted for so long. Venture capital firms have leverage because they have the capital that entrepreneurs need and almost always have multiple entrepreneurs in any given industry vying for that capital.
There are relatively few cases where the entrepreneur has similar leverage; where multiple venture firms are fighting to get into one deal, and the startup can make the same demands of venture capital firms that the firms make of startup (though we’ve seen it happen and it’s very cool). There’s also a simple issue of time: entrepreneurs and their teams don’t have enough, and certainly not enough to study all of the firms they’re likely talking to.
So the playing field is uneven because venture capitalists have the leverage. That’s good for venture capital, right? What incentive do we have to change it?
Actually, the incentive is simple, and the same for both sides: higher returns on invested time and capital.
In the public markets, there’s a much higher degree of transparency. When a private company is preparing to go public it can select, with extraordinary accuracy, the firms (mutual funds, hedge funds, etc.) that will most likely be the best owners of its stock, and therefore its best partners for the next stage of its growth.
The company can see exactly what stocks the firm has bought, how much of each stock, how long they’ve held each position, and other more technical details important at that stage of a company’s growth. There isn’t much that isn’t fully disclosed and this level information playing field allows better matches to be made between the companies selling their stock to the public for the first time and the firms looking to buy it.
There’s no question that entrepreneurs need capital, but there is undeniable data that suggests that the price of that capital beyond the equity sold – namely, (1) sharing influence over the direction of your company and (2) granting investors real governance and legal control over decision-making – is very high. Companies fail for a lot of reasons, but too many fail due to a miscorrelation between entrepreneurial teams and the venture capital firms they partner with.
At Greycroft we take a very open approach and believe we should do everything we can to level the informational playing field between our firm and the startups we support.
We want entrepreneurs and their teams to get to know us well. The more they understand about us and our business the better the relationship will be, and the more returns we’ll all make.
With that in mind, here are some questions that every entrepreneur should ask and get answered before accepting an investment from a venture firm.
We urge entrepreneurs to ask these questions of us, and we’ll do our best to provide clear and straightforward answers. Use the list to inform your conversations with other venture capital firms, too. Strong firms should not react negatively to these questions (and if they do it’s a bad sign).
- How big is the particular fund that your startup will be part of and where is that fund in its lifecycle?
Note: If you are getting a $1mm investment from a $1b fund, you should know why. If you are the last investment in a fund, or the first, you should understand how that dynamic could affect you.
- What is the investment strategy of the firm? What are the sizes of its investments and average ownership percentages? What is the firm’s reserves strategy?
Note: As an entrepreneur you should look for patterns and ask questions if things don’t make sense to you. If you are taking $5mm from a firm that generally writes $2mm checks it might be a good sign or an odd one. Does the firm own 5% or 25% of most of its deals? Why? Some firms reserve a lot for deals and some reserve less. There are good and bad reasons to do both but you should understand the firm’s perspective on this issue.
- What is the decision-making structure of the firm and where does your deal sponsor fit into that structure?
Note: Funds have a variety of decision-making structures. No structure is necessarily bad but you should know what the structure is and where your sponsor fits into it.
- Who are the LP’s in the fund?
Note: Typically, a fund with a lot of university endowments and foundations is stronger and one with a lot of individuals is weaker. However, if the individuals are people who can help you and the fund can provide real access to them, it might be the right fit for you.
- What is the compensation structure of the fund and how does your sponsor fit into that?
Note: Strong funds have a more equal distribution of economics and weak funds tend to have skewed economics to a bunch of people at the top who don’t add much value.
- What is the firm’s policy and culture around corporate governance? Do they seek board seats or not? If so, what is their in-person attendance record at board meetings.
Note: There are good and bad reasons that venture capital firms seek seats on the boards of the companies they invest in. The best way to really get to the bottom of this one is to call entrepreneurs in the firm’s existing portfolio.
- What is the firm’s own view of the returns likely to be generated from your deal? How does it all break out?
Note: Every firm does a liquidation analysis showing who will make what money under different exit scenarios. It flows through all the structure in any deal to get to what the real returns will be. At Greycroft, we happily show it to entrepreneurs so they can see how we all make money together.
- How have previous funds performed and how will that affect future fundraising?
Note: You’ll probably have a good sense of the answer to this one given the firm’s reputation but don’t be afraid to ask for some numbers. Fundraising can be a major distraction for a venture firm and strong past performance yields quick fundraises and less distraction.
- How does the firm handle re-caps and private-to-private mergers?
Note: Winning and losing is easy. It’s the middle that’s hard. If a firm does the middle well it’s a good sign.
10. How many repeat entrepreneurs does the firm have?
Note: A lot will depend on the age of the firm and its investing strategy but if any firm that has invested over $200M has even three repeat entrepreneurs it is a good sign.
These are the items every entrepreneur should know about a venture capital firm before they decide to accept an investment. We hope all entrepreneurs will ask these questions and get the transparency they deserve when making this important decision.