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May 26, 2008

VCs and Deal Flow: Seeing Everything, Doing (Nearly) Nothing

The VC business is a funny one and, in my sixth year at it, I am amazed at how much I am still learning with time.  One of the fascinating things about the business is the way VCs process deals, known in the vernacular as "deal flow".

On the one hand, a VC wants to see absolutely every start-up that is happening out there, particularly those led by high quality entrepreneurs.  Obviously, the more high quality deals you see, the more likely you will have the opportunity to select a high quality deal to do.  But there's a more subtle benefit to high volume, high quality deal flow.  Looking at as many deals as possible makes you a better investor - you learn something from every deal you see and are able to detect patterns that can help you in deal selection.  A VC with good deal flow may get an opportunity to review as many as 300-500 deals per year.

On the other hand, a VC only has the bandwidth to do one or two deals per year (assuming they are an "active" VC that joins the board of the companies they invest in - "passive" VCs who don't join the board have greater deal capacity, perhaps three or four per year).  As is the case with any sales process, there are many stages to a deal.  Typically, a deal flows from the first meeting to the follow-up meeting to the light diligence (in-person visit, a few diligence calls) to heavy diligence (extensive market, competitive and technical due diligence as well as personal references) to partnership buy-in to term sheet to close.  To beat the long odds of, say, 300:1, a deal must be compelling at every stage in the process to flow through -- VCs are always looking for ways to say "no" more than they are looking to say "yes" (see related blog post:  "Dr. Seuss and the Land of No").

As one wise old VC once told me, "the trick in this business is to spend very little time on alot of deals, and then alot of time on very few deals."  In other words, see everything to be a better investor, but exert a very tough first filter so that you only spend time on very, very few deals.  In my experience, a typical VC has the bandwidth to actively "spend time" or actively work on only one to two deals at any given time and perhaps 10-20 in a year -- as compared to those 300-500 they get exposed to.

What's surprising to me is that entrepreneurs often don't seem to know where they stand in the deal process.  Admittedly, VCs aren't known necessarily as great communicators!  But as an entrepreneur, you should know whether you are clearly one of the one or two most important new deals the VC you're talking to is working on.  If not, then you know your deal isn't going to get done and stop wasting your time.  The odds are just too long that you're stuck at the wrong end of the funnel.

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Great post Jeff. Very helpful for entrepreneurs. I'm going to share it.

Mark

Reinforces that every deal teaches you something...just don't study too hard on every single one. Helpful post, Jeff.

The fact that the venture market is hard-wired to be a buyers market is disappointing. Entrepreneurs are put in a position where they have to polish and shine so many self-evident premises, just because the VC's demand to be spoon-fed each and every bit of information. You would think their missing great deal after great deal, and losing money on deals founded on the wrong criteria would cause them to invest more in their own process of getting smart and seeking out and understanding emerging ideas.

Great write up! With reference to Wayne's comment, the demand-supply dynamic rules every market, and so it's amply visible in the entrepreneur-VC framework as well. Clearly, the entrepreneur's need is greater than that of the VC's: entrepreneurs may often be disparate, but VCs usually aren't. Given this, I think the problem that you have highlighted should be attributed more to "too many low quality, desperate entrepreneurs out there", and less to the so-called "fussiness of VCs".

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