Covering Five Flute’s fundraising and tearing down the deck the company used to raise its $1.2 million seed round had me wondering: How the hell do investors decide whether to invest in a company at the earliest stages?
VC firm Baukunst led the Five Flute investment, and I sat down with Axel Bichara and Tyler Mincey to learn how they evaluate a potential early-stage deal. They told me that the vast majority of the deals they look at fall apart at the due diligence stage and helped me get a deeper understanding of what that process looks like from the inside.
“The decision to take a second meeting is one of the biggest decisions in venture capital because, from that [moment] onward, you are committing significant time,” Bichara said, explaining that, in his experience, they only invest in one out of every 250 deals or so that they see. Only about 1 in 40 first meetings result in a second meeting. “Everything you do after the first meeting, I consider due diligence. You’re evaluating the founders. At the stage we invest, most of our due diligence focuses on two things: The quality of the founding team and the size/attractiveness of the market opportunity. If you get those two right, everything else will fall into place, almost by definition.”
With the right team and a huge market, everything else can be figured out later, Bichara argued, saying that if you have a great “founder-market fit,” you’re off to the races.
“The right founding team will do the right thing [in that case]. They will execute well, and there will be capital-efficient market opportunities. You enter with a competitive advantage, find a niche and scale from there. If you don’t get a resounding ‘yes’ from those two, you shouldn’t invest,” Bichara explained. “All the due diligence you do is geared toward answering those two questions.”
In the case of Baukunst, the firm’s investment thesis means that for an investment to make sense, the startup needs to at least have the possibility of a $1 billion outcome or more — which means that the market opportunity needs to be big enough to enable that if the founding team executes well.
“You just work backward from there,” Bichara said, “and all the due diligence we do will be in support of that.”
Building the confidence of the investment team
Of course, there’s more to investment selection than founders and market size, but other issues are minor compared to getting the big picture right.
“There are smaller points in support of building confidence: How strong is the technology, how much capital is required to get to a minimum viable product, is there proof of the business model, etc.,” Bichara explained. “But these points are almost implicit, and they feed our conclusion. If it’s an attractive market opportunity, the other parts of the equation are a bunch of sub-bullet points. The one to emphasize the most is the team.”
It’s hard to overindex on team strength at the earliest stages of company-building. That’s great news if you have an exceptional team and awful news if you don’t. Why? Because it isn’t easy to fix: If your co-founders are lackluster, you’re going to struggle to raise money. The fact that it’s a tough fix is why investment teams focus on the team during due diligence.
But see it from the investors’ point of view: They are rejecting 250 deals for every deal they make, so why should they settle for anything less than a stellar “I want to mortgage my house and liquidate every penny I own to back these founders” opportunity? If you’re not that team, why would they invest?
The best way to determine the companies’ staying power and personal motivations is to see how they got there. If their personal story and professional background conspire to give a strong positive signal, you’re probably looking in the right direction.
“There’s usually some insight from a founder’s history or their intersectional background that gives you the origin story for their company. That’s usually a pretty clear signal,” Mincey said.
(The corollary of this point is that in order to raise money at the earliest stages, it isn’t enough to build a company just around publicly available data. The question becomes why a company hasn’t happened before, or why someone who knows the market or industry inside and out hasn’t attempted to build it. For exceptional founders, there’s often something special around the idea connecting the two.)
When performing due diligence, venture teams often spend a lot of time with the founders, working to “get into their heads” to figure out why they are doing what they are doing. How they are thinking about the business. One tool Baukunst uses is to insist on an operating plan, using it to delve more deeply into how the founders think about their business.
“I love to engage with a founder over their operating plan for the next 12 to 18 months. That helps me understand how they make decisions about hiring, product, the starting point for margin assumptions, customer focus and so forth. It helps me understand what they say yes and no to. And in a meeting or two, you understand the motivations and how the founders think,” Bichara said.
The perhaps counterintuitive thing Bichara and Mincey told me was that there’s essentially no need to prepare in any way for due diligence.
“If you feel the need to write a script and prepare for everything to make a good impression, it’s probably not going to work. I think the best way to do it is to be yourself,” Bichara said. “And be open to not knowing answers. It’s totally OK. You can’t know everything, and often if you don’t know the answer, how you think about getting the answer is actually more interesting than the answer itself. There will be hundreds of questions you don’t know the answer to. When we invest in a startup, we are backing them in the faith that they get a good percentage of [the answer] right over the next seven to 10 years.”
“It’s not enough to be right,” Mincey added. “You have to help investors understand why you are right and how you reached your conclusions. You have to really bring people along and be a great communicator and storyteller.”
Where most due diligence fails
I was curious, in the thousands of companies the team has evaluated, where does due diligence typically fall apart? The simple answer was “low-quality founders,” but the full answer is a little more complex than that.
“The most common thing that goes wrong is when we reveal some aspect of founder-fit that is off-target. Sometimes, that can be having a plan that’s overly tactical and doesn’t really have answers to the ‘why’ once you peel back the onion,” Mincey explained.
Founder dynamics, and who has been added to the founder team, can be challenging. A mismatch there makes VCs reach for the big red “pass” button.
“Poor dynamics of the founding team or founding team members who shouldn’t be part of the team are a big red flag. If the founding team is poor, you’ve failed the first test: ‘Can you hire well?’” Bichara noted. “This week, for example, we had a call where we consider one of the founders to be the star founder. The others are more of a supporting cast. No equity split is ever perfectly fair. But it needs to have a chance to be reasonably fair for the company to have a chance to succeed for the next decade.”
Of course, lots of things come up in the due diligence process that need to be fixed, adjusted or updated, but the luxury of being in an early-stage startup is that most of those things tend to be relatively easy to fix or easy to live with. It’s the high-importance and hard-to-fix issues that kill deals.
“We often ask the ‘skeletons in the closet’ question. Something like, ‘Tell me about things you would want to know as an investor that we haven’t asked yet.’ Often, things come out of the closet,” Bichara said, explaining that it’s a really good opportunity to learn about the strengths and weaknesses within a startup team. “We’ve never walked away from a deal based on that question, and we tend to ask that question relatively late in the process.”
The investment memo
The team told me they use a template for their investment memos — they call them “deal sheets,” which include:
- Investment summary.
- A link to the deck.
- Three reasons to invest.
- Three key risks.
- Notes and concerns.
- The deal terms summary (investing how much, at which valuation, with which overall round size, with which initial ownership percentage, pro-rata and information rights).
- Whether the deal includes a board seat, and if so, which partner is taking it.
- Other (potential) investors in the round.
- Whether there’s a “hunting license” — i.e., is the firm going to try everything it can to lead or be part of this deal.
- It also includes a summary of past financings, option pool size and founder vesting schedule.
- Full cap table.
- Whether the firm has seen a complete set of liabilities the company has (ideally a balance sheet).
The deal sheet also goes into quite a bit of detail around due diligence, with sections for:
- Tech/product.
- Market size/trajectory.
- Competitive analysis.
- Business model/go-to-market/(unit) economics.
- Review notes of the operating plan.
- Market references.
- Customer references.
- Personal references.
“We have some extremely to-the-point internal investment memos,” Bichara said drily. “Really, in my opinion, only two sections really matter. It’s the key reasons to invest and the key risks to the business. You don’t do due diligence to check all the boxes — you do it to ensure that you find a small number of good reasons to invest in an exceptional founder, a crazy good market opportunity or some combination thereof. There are also usually three to five risks — reasons the company is likely to fail. If it does fail, it’s because of one of those top risks not because of the many little things. Those are pretty fixable, and you can worry about them later. In essence, the investment decision can be summarized in a few bullets. We need to find the outliers, and that’s what this whole process is designed to do.”
What about later stages?
It is worth noting that everything we’ve spoken about so far is about the earliest stages of a company. This is what’s often called “pre-seed” or “seed,” where angel investors or the first institutional money enter the company. It’s a very different beast than investing in, say, Color raising $100 million at a $4.6 billion valuation in a Series E round. For Series A and beyond, the investments are usually referred to as “growth capital,” and at that point, there will be significant metrics, milestones and company history (perhaps except for biotech or extremely research- or science-forward startups). This will also need to be tested via due diligence to ensure that the company isn’t double-counting some of its progress or misrepresenting parts of the business, whether through hapless tracking or straight-up fraud.
“We are oftentimes investing at company formation, sometimes pre-product and many times pre-revenue. We’re having to go on more qualitative analyses of the founders themselves,” Mincey explained of the difference. “It is very different from the business metrics you’d see at a later-stage investment. Over two-thirds of companies are generating revenue at seed these days, and later stage there will be much more tangible business metrics. At the stage we invest, those just aren’t around.”
Reference calls
Another major aspect of due diligence is the reference call. Again, the goal is to understand both the market and the founders more deeply, and VCs will often do reference calls with both. For the “team” side of the equation, this might be with co-workers, ex-bosses and people they’ve previously managed. For the market, it could be a buyer or someone who has a particularly deep working knowledge of the industry.
“For reference calls, you don’t want to take the lowest common denominator of what other people say. It’s very important to be independent-minded; the common wisdom tends to generate mediocrity, and that’s not helpful. In VC, we are looking for the outliers,” Bichara explained.
For firms that only invest at the earliest stages, the team builds a muscle to develop X-ray vision into the souls of the founders, along with expertise in the market segments or industries they focus on.
It turns out that talking to a number of a startup’s potential or actual customers is not actually the highest-leverage way to execute due diligence. Anybody can find a potential customer for just about every product in almost every market. Instead, what you are optimizing for is finding a “customer” who can be a proxy for hundreds or thousands of companies. That’s typically someone who has started or been in a similar company, or sold a similar product, with a similar value proposition, to a similar customer.
“In the case of Five Flute,” Bichara said, referring to the investment that inspired this article, “both Tyler and I have a lot of experience. We lined up world-class due diligence reference calls. I knew the industry well, and Tyler had looked at all the competitors already. There are never black-and-white answers, but this is what we do all day. We set up a bunch of calls like that, and you can form an opinion with pretty high confidence. This investment was a lot of fun, because we could do due diligence so efficiently. We were almost waiting for this deal.”
This echoes something I’ve heard from a number of VCs: When the right deal comes along, it’s almost obvious because it is such a fantastically good fit. The founders are right for the company, the product is right for the market and the investors can add tremendous value as advisers and connectors.
A mutual process
One of the oft-overlooked parts of reference calls is that they can help inform and drive strategy and important directional questions. If an investor turns you down based on something that came up, it’s 100% OK to ask for specifics about what they found and why they said no.
Be aware that you often won’t get a straight answer. That isn’t because the investors are evil, but many have grown weary of giving specific answers. Something may have come up in due diligence that is a deal-breaker for an investor, but you consider it “fixable.” The issue may not be the specifics of the issue but how coachable you are. In other words: It may be more about how you react to pushback or a challenge than the challenge itself.
“I do want to note something. So much of what we talked about is us grilling founders,” Mincey laughed.” But this process is not just about VCs projecting judgment on the founders. Most of the deals that we like, that we end up doing, are competitive, and we have to fight for them. The due diligence process is just as much about letting the founders get to know us, too, and understand how we add value. Part of the diligence process is helping them understand why we’re the best investors for them. That’s how we win deals, and that’s incredibly important. Due diligence is a mutual process.”
The unfortunate thing is that if you “fail” due diligence, it is almost by definition because something came up that isn’t fixable. Perhaps the team is not a perfect fit, or maybe the market isn’t big enough to sustain a venture-sized company, at least in the eyes of that investor. You can’t easily change your founding team, and reframing how you think about the market is on the higher end of the “how hard is this?” scale.
The great news is that every VC firm thinks about due diligence slightly differently. Everyone has different investment theses and different things they find important, so if one firm turns you down, consider it an opportunity to keep learning, keep adjusting and keep going.
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