A field guide to the investment process, part I
The nitty gritty on how a term sheet comes together
I often hear from the founders I've worked with that the investment process can feel extremely opaque. It’s unclear what happens on the investor's side after an initial conversation or data exchange leading up to a term sheet or decline. It shouldn’t be this way! This post will walk through a rough outline of how the investment process works for a typical deal.
The investor & founder relationship begins with an initial conversation, usually a call or video meeting, where both assess a mutual fit. In this meeting an investor usually aims to answer a few main questions:
1) what problem does the product solve?
2) is the founder someone I would want to work for (can they recruit and scale a company)?
3) does the size and stage of the company match our investment criteria?
An initial meeting builds the foundation of a relationship. If the financial side of the business is earlier than we'll invest, a deal may be a year or more out. This is actually the best case, because it provides both sides an opportunity to get to know each other. In past instances when I’ve met an interesting earlier-stage business that has momentum, I was able to start building conviction by front-running market diligence (more below) so that we could move quickly when an investment opportunity arose.
Following initial qualifying calls, diligence that precedes a term sheet falls in two categories for a software investment: market & product feedback and financial analysis.
Market and product analysis aims to answer the basic question: can the market dynamics (size, growth, stability) support a large business, and is this company positioned to beat out competitors? In the first category, we're looking for customers who rave about a product. There's no greater sign that a company has built something really special than when customers go out of their way to express their love for a solution. We look for reviews in public sources such as sites like Capterra, G2, Software Advice, app store ratings where we can find them. We speak with customers or experts in a space who can point out the best products they've used recently. This feedback is a critical predictor of long term success.
In the second category, we dig into data to understand if a company hits our core growth, profitability, and retention criteria. Accelerating month over month growth and strong retention are indicators that customers love a product and it will continue to take share. We build a simple forecast model and benchmark this data with other private company information available across our portfolio. If the necessary information is readily available, we can usually complete our analysis over a few days' time.
This combination of financial benchmarks and market feedback is taken into account to arrive at a valuation. As our analysis progresses, we often begin to relay our work to additional team members. A deal team champions an investment and shares their in-process thesis with the broader investment team for feedback. This type of collaborative investing approach pushes the deal team to think creatively and consider new perspectives; this is often beneficial for the founding team as well because they are able to learn from collective feedback across the firm, and tap into a larger network.
Following this discussion the deal team has what they need to present a term sheet. We prioritize team meetings every week so we can respond quickly to entrepreneurs, and provide feedback quickly over 1-2 weeks, sometimes sooner.