To pass or invest? Decisions, decisions
In our last post, we discussed a typical VC Monday Partners Meeting and the dynamics around the ways teams decide to invest. So what happens after an investment committee talks through a startup opportunity? The team must decide on that particular company, and there are three outcomes for a startup founder:
- The VCs will choose to pass on the investment.
- They will determine they need more information to make a decision.
- They will decide to invest and begin negotiations.
If a startup made it far enough in the process to meet the investment committee, there is typically a high chance the investment will happen. Let’s walk through each of these scenarios and best practices for VCs in each position.
The Hard Pass
There are many reasons a firm could choose to pass on the investment. Maybe the market isn’t large enough? Or perhaps the founding team isn’t strong enough? In truth, VCs should have weeded many of these things out in the initial conversations and diligence process. In any case, when a VC passes on a deal, there is a right and wrong way to do it.
Be upfront; you should tell them at the get-go you are passing. Also, it’s always best to deliver hard news with positivity first. The beginning of your note should explain things that you like about their business and pitch. The best thing you can do for a founder is to present specific reasons you are passing and a couple of tips on improving their future chances. The beginning of your note should explain things that you like about their business and pitch. Lastly, keep the door open for future opportunities. Rejection is hard, but you want to keep the door open for future deal flow from that founder. It’s crucial in the VC world to never underestimate anybody.
An example of this would be:
“Dear Founder X,
After discussions between our partners, we have decided that this is not the right investment opportunity for us at this time.
We think you have a great founding team with domain expertise, and your personal experience with this problem and drive to solve it has turned us into big fans of you. We respect and admire your passion and dedication to your vision.
Our primary concern with this opportunity is the competitive landscape. Your top competitors are currently well-funded and have a headstart in this market both in product and team. We believe that these will be headwinds for you to build a large enough company needed for our portfolio returns.
My recommendation would be to take a bootstrap approach and sign up several customers at $200K for a multi-year prepaid license for your platform. You can use the cash you generate from these deals to hire a development team and build out your product. This approach will allow you to retain equity and position you for a more powerful negotiation position for future funding.
Please feel free to keep us in the loop on your progress and let me know if there is some way I can assist you on your company’s journey. We look forward to you proving us wrong.”
The Soft Yes
This response is basically yes, but the partners need more information or time to increase their conviction. Sometimes, this will result in another meeting and round of questions for the founder. Other times, the partners need to conduct more independent research to confirm the market, product, and problem. Considering VC is a conviction business, and often firms will have specific theses on particular marketplaces and niches, this outcome is less likely to occur.
The Hard Yes
This answer is the result all founders want. The VCs believe that the company will generate massive returns, and this founder will be the one to execute. Although this is yes, there are still a few steps that need completion: Due Diligence and Term Sheet negotiations.
VCs have likely done much diligence on the founder, product, market, and company already, but they still need to dot their i’s and cross their t’s. Also, term sheet negotiations can be contentious if both parties don’t prepare. We will deep dive into the due diligence process and focus on negotiating term sheets in the coming weeks.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.