Deal Flow Dynamics

At the risk of being tarred and feathered by a few of my VC peers, I’m going to go out on a limb here and explain (at least at a high level) some of the life blood of venture capital funds: DEAL FLOW. So why, you might be asking yourself, would VCs not want me to post this? Simple. Funds live and die by the quality and quantity of their deal flow and if everyone understood how deal flow works the quantity thereof may decrease — perhaps a stretch but it gives me something to post ;-)  While the unwritten (yet, often whispered) rule is: “Thou shall come by way of referral”…most people don’t truly appreciate why. Let me explain.

VCs find potential investments (a.k.a. deals) through a variety of sources and a certain “natural hierarchy” has evolved to help VCs manage such deal flow. Sure, you’ll here VCs complain that there is too much money chasing too few deals but the reality here is that there are an enormous amount of deals to be done…they’re just viewed relative to how few VCs there are to do them, the finite number of hours in any given day, and the amount of time it takes to do them. Essentially, managing deal flow becomes a “return on time” exercise (hence, the nature hierarchy of deal flow). So what is the hierarchy? Glad you asked. I’ll start at the widest point in the funnel and work my way up.

Off-The-Street: Off-the-street or “OTS” deals are just that. These are deals that are unsolicited and simply come to VCs either through snail mail, email, or by phone. They are generally brought to the VCs by the company founders, but are also occasionally presented to the VCs through a finder. VCs receive thousands of these types of deals any given year and most, if pressed, will admit that they have never invested in an OTS deal. Given the sheer magnitude of OTS deals, how few VCs there actually are, and the gating factor of time, most OTS deals wither and die in deal flow purgatory or are ultimately cursorily turned down without any explanation whatsoever. Okay, so why risk reducing my fund’s quantity of deal flow by explaining how low the probability of an OTS deal getting funding is? Well, my partner and I are a bit different. Our last (announced) investment was in a company that came in “off the street”, Helixis. Sharon saw the potential, helped shape the vision (and company), and we ended up syndicating the deal with a couple of larger funds… and the company is doing VERY well…

Mutual Contact: This category is also self-explanatory. These deals come to a VC through some mutual contact.  Such contact may be professional (e.g., an attorney, accountant, another VC, etc.) and/or personal (e.g., family friend, relative, fraternity brother, etc.). Before you think “great, I’ll just figure out who I know that knows said VC and have him or her make an intro”, let me quickly clarify here. Like most things in life, the strength of any such contact relationship is relative — i.e. not all contact sources are given the same weight by VCs. For example, I’m much more apt to pay attention to a deal that is referred to me by a VC I know and trust than by mother (no offense, Mom). Simply put, some sources truly understand when a deal is good and some do not. Again, there is a magnitude issue here as well. Most VCs have huge rolodexes and receive large numbers of referrals from their networks any given year…so the underlying nature of the mutual contact relationship matter… A LOT. The strength of the entrepreneur/mutual contact matters too. I may look at a deal from a very trusted source, but it doesn’t help me much if he or she doesn’t really know the entrepreneur and/or the underlying company all that well.  There is a reason why some of the more venerable funds continue to back folks that they have had success with before over “newer” entrepreneurs.
Personal / Incubated:  This applies more to early-stage, but seems to be a growing trend.  Personal deals are where a VC has an idea for a company, creates the company, funds the company, gets the company to a certain developmental level, and then brings in a management team to run it.  There are a number of funds that have done very well incubating companies and controlling them from inception on (e.g., Domain Associates).

I don’t have any statistics in front of me, but if I had to guess, I’d venture to say that ~ 90% of the deals that get funded come from mutual contact, ~ 9% are incubated, and < 1% are off the proverbial street.  If any of you have any real empirical data here, please do share with everyone…  Until next time, happy venturing.