5 factors founders must consider before choosing their VC

Though 2021 is far from over, it’s already witnessed a record level of venture capital activity in the technology sector. With larger round sizes announced daily, founders may have their pick of term sheets — but they need to think critically and strategically about which firms to add to their cap table.

So far this year, we’ve seen $292.4 billion in venture financing across the globe, of which $138.9 billion was raised in the United States. Specific to tech companies, the capital is only accelerating: In Q2, founders raised 157% more capital compared to the same period last year, according to the latest data from CB Insights.

It’s not just that more companies are raising money — they are doing so at a higher valuation. Median seed and Series A stage valuations today stand at $12 million and $42 million, respectively, up 20% to 30% from 2020. This can be partly attributed to growing exits/M&A activity in the technology sector, a record number of IPOs and a general bullishness around technology, as well as low interest rates and liquidity in the market.

At a time when we are witnessing record VC activity, founders would be well served to go back to the basics and focus on the principles of fundraising when determining who sits on their cap table. Here are a few pointers for founders in that direction:

1. Value > valuation

Good VCs who are aligned with a startup’s vision create more value than the dollars they bring to the table. Typically, such value is created across a few distinct functions — product, sales, domain expertise, business development and recruiting, to name a few — based on the background of the partners of the fund and the composition of their limited partners (investors in the venture fund).

Further, the right VC can serve as an authentic, objective sounding board for CEOs, which can be an asset to have as a startup navigates uncertainty and the typical challenges that come with scaling a young company. As founders assess multiple term sheets, it’s worth thinking through whether they should optimize for VCs who offer the highest valuation, or for ones who bring the most value to the table.

2. A two-way street

Running an efficient fundraising process, in part, entails holding VCs accountable to their own diligence requests. While it is unfortunately common for VCs to request a lot of data upfront, startups should share information after assessing intent and appetite on the investors’ part.

For every additional data request, founders are well within their rights (and should) check with their potential investors on where the process stands and get indicative timelines for moving forward with next steps. Mark Suster said it best: “Data rooms are where fundraising processes go to die.”

3. Understand the terms well

Though early-stage financing has been fairly standardized in terms of documentation and term sheet language (read: SAFE notes), as VCs, we still come across savvy entrepreneurs who are not 100% sure of a few critical terms — liquidation preference, pro-rata rights, board observer seats, and post- versus pre-money valuation and its implication on future financing rounds, to name a few. It’s critical for founders to know their vocabulary when assessing term sheets both to protect themselves and their businesses — and to negotiate with confidence. While there are plenty of online resources available to get smarter on term sheets, we have particularly liked “Venture Deals” by Brad Feld and Jason Mendelson and recommend it to all our portfolio companies.

4. Solve for diversity on the cap table

In determining who gets to participate in an ongoing round, founders should also consider the diversity among their cap table. Here, diversity takes two forms: in assessing prior backgrounds of partners/principals at the fund, their strengths and the value they bring to the table, and in understanding the LP base of a venture fund.

Oftentimes, LPs — especially those that are strategic in nature — serve as a great avenue for business development and follow-on financings for a fund’s portfolio company, and founders should factor that in their decision-making criteria.

5. Listening to your gut and instinct

As with many things, our gut and instinct are able to evaluate situations better than our rational mind. It’s the same in going with the right investment partner. After checking off all the analytical boxes and reviewing term sheets, it’s worth stepping back and deciding which VC intuitively feels to be the right fit for the company. The answer will likely rest in the subconscious mind.

When to walk away from a VC who wants to invest in your startup