venture capital

What investors should look for in a venture capital firm

Startup founders aren’t the only ones who have to thoroughly vet venture capital firms. Investors who commit capital to fund deals, need to be very careful to do their due diligence as well. 

Investing in startups is risky business. It’s riddled with uncertainty with too many variables that could determine success. Is the company in a high-growth segment? If so, will the team be able to supply the growing demand? Will the industry top out before you can make an exit? How resilient is the company to economic downturns? It isn’t any wonder that only one or two of every 10 investments succeed. 

As an investor, how do you align with the right venture capital firm to increase your chances of realizing healthy returns? As it turns out, success breeds success, and aligning with a firm with a history of wins is one way to improve your odds. But, it’s not the only indicator. Before investing, there are several fundamentals to consider.

Does the firm have a strong track record?

There’s a general phrase that past performance is no guarantee of future results. But venture capital can be the exception to that rule. In fact, a study released last year by two professors from the Yale School of Management explored why firms that performed well in one period continued that track record into the next period. While ability to choose the right industry played a role, they found that the VC’s reputation ultimately led to greater success. The reason being VCs with a history of wins have greater access to deal flow and often more attractive deals. After all, founders and entrepreneurs seeking investment want those VCs involved in their companies. 

Ideally, investors should seek out venture capital firms that have a high percentage of successful investments and at least several lucrative exits to point to. Even one is not enough. There are firms that invest in such a high volume of startups that a few are sure to pan out. But if you truly want to feel like your money is in the right hands, look for venture capital firms that have demonstrated repeated success.

One of the best ways to evaluate a firm’s track record is its gross internal revenue, or IRR. IRR has become the industry standard way to measure the performance of venture capital firms on an annual basis. When comparing multiple venture capital firms, look for ones who have higher IRR over a longer period of time to know that you’re in good hands. 

Do you align with their investment strategy and thesis?

Most VCs build funds, pools of money collected from a variety of investors, that a fund manager will generally invest into a collection of startups. Funds can reduce risk if investments are spread across multiple startups. But funds also take freedom away from investors because they are forced to invest in every startup in the fund. Furthermore, capital within funds typically has to be deployed over a defined timeline, which might put pressure on managers to make investments they otherwise might not. 

By contrast, other VCs invest in startups individually. This gives limited partners the choice and flexibility to decide which deals to participate in. It also allows VCs to take the approach of sourcing the right deal first before pooling the capital. While this approach gives limited partners more freedom, they can still avoid volatility by investing smaller amounts of money in a greater number of deals. 

It’s also important to consider how often a VC firm invests. Do they invest in five startups per year or just one? VC firms that invest in fewer startups are generally able to provide the necessary time, effort, resources and energy to make sure it succeeds. 

What is the background of the managing partners?

The managing partners are the ones who source and vet the investment, serve on boards, and advise the founders. They have a lot of influence on whether the investment is a success or not. Naturally, you want partners who are experienced, successful, and trustworthy people. 

Some of the most successful partners are those who’ve built successful startups of their own. They understand what it takes to scale and exit a business and can offer invaluable strategic guidance to startup founders. For the same reason former professional athletes are often hired as coaches after their playing careers are done, former founders make the best investors: They’ve been there before and know what it takes to achieve results. 

If you don’t personally know the managing partners, get to know them. Make sure they are the type of people you feel comfortable entrusting your money to. Get references from people who worked with them before and talk to those individuals. Don’t limit this to the investors who’ve realized great returns, also talk to those whose outcomes weren’t favorable. You want to get an idea of how they respond when investments begin to go south.

Do the partners put their money where their mouth is?

I don’t know about you, but I’d feel more comfortable if the people investing my money had some skin in the game. While most reputable venture capital firms will work hard to properly source investments and guide the company to a successful exit no matter what, having their own money on the line will add extra motivation. 

At the very least, putting a significant amount of their own money into the deal shows the partners are confident in it. And if they have confidence, why shouldn’t you? 

Are you in good company?

In addition to looking at the background of the managing partners, look at who the other investors are.

One signal that you are investing in the right venture capital firm is if a lot of the investors have invested in previous deals with the firm. It can indicate a positive experience with the partners and lucrative returns. Actions speak louder than words, so there is no better referral than previous investors reinvesting their money. 

Another positive sign is if any of the firm’s past portfolio founders are reinvesting with them. That can signal they develop strong relationships with founders, helped produce a successful outcome for the startup, and that the founder believes and trusts in the approach and deal selection. 

At the end of the day, when investing in startups, you do have to be ok with potentially losing it all, but you can mitigate a lot of risk by selecting the right VC firm. When the stakes are this high, take time to investigate the firm’s overall track record and reputation, their story or thesis, and evaluate your confidence in the partners.