Approximately 80% of all VC returns come from 20% of the deals. This underscores the importance of separating the wheat from the chaff; it’s essential for VCs to quickly identify superior deals that can contribute significantly to their bottom line. This begs the question - what’s the most efficient way for a VC firm to find excellent investment opportunities? That’s where referral networks come in.
A referral network is a peer group of angel investors, VC funds, and acquaintances who share leads and exchange valuable information on investment opportunities among themselves. VCs prefer deals that come through a strong referral network because they are pre-vetted by trusted sources and are more likely to be high-potential matches for their investment criteria. Referrals help improve and quicken the deal flow process and dramatically increase the conversion rate of leads into deals.
A 2019 survey conducted by the British Business Bank revealed that in London, referrals account for almost 60% of the total deal flow and that referred companies have a 50% better chance of receiving investment. In this article, we’ll explore how referral networks are the best way for VCs to find worthwhile investment opportunities.
What Does a Referral From a Trusted Source Mean?
The adage ‘Your network is your net worth’ is unequivocally true for the venture capital industry. VC firms with a robust industry network are much better positioned to receive referred investment leads that translate into successful outcomes.
Referrals from trusted sources help a VC firm’s deal flow in several ways:
- They reduce strain on the screening and vetting processes. Companies that come through network referrals have undergone basic evaluation and vetting by the referrers who are putting their reputations at stake in a sense.
- Companies that come through referrals generally match the VC firm's criteria, such as deal size, location, and industry focus.
- Referrals often come from committed investors who need co-investors to fulfill the total fundraising ask. If the referrer has already committed to investing, odds are that their investment team has met with the founders and vetted the opportunity, i.e., the company is vouched for to some extent.
Sources of Referrals
As a VC firm, it’s important to receive the right referrals for increased chances of success. The three main referral sources you can leverage are:
- Referrals from other investors: Investment firms and angel investors often seek opportunities to invest alongside other investors. Their reasons could include both risk mitigation as well as meeting a minimum funding ask to help the company get off the ground or reach scale. Such referrals are usually trustworthy, being pre-vetted by seasoned investors.
- Referrals from existing portfolio companies: Having gone through your firm’s investment process, your portfolio companies are aware of your investment preferences and will only refer companies that are a good fit for your criteria. Existing portfolio companies understand your firm's values and investment thesis, so the referrals they make are likely to reach the deal closure stage.
- Referrals from service providers: Service providers include banks, consultants, accountants, or lawyers who have worked with your firm. As trusted business partners, these service providers are well-versed with your investment thesis and are keen to add value to cement their relationships with your firm, so it’s worth your time to carefully consider their referrals.
The Importance of Referral Networks in Venture Capital
Increasing inbound deal flow is one of the most arduous tasks undertaken by a venture capital firm. Finding investment opportunities is even more challenging if your fund invests in underdeveloped or developing markets that come with their own investment hurdles like lack of liquidity, increased political turmoil, and unequal distribution of important resources like transportation channels.
That’s why it’s essential for venture capital firms to rely on referral networks to meet their investment targets. Leads from a referral network significantly improve your deal flow in the following ways:
- According to a Harvard Business Review survey, 30% of deal flow leads for a VC firm come from work acquaintances and former colleagues. Another 20% come through referrals from other investors, while 8% come as tip-offs from their own portfolio companies. In this way, almost 60% of a firm’s deal flow is generated through referrals made by its network of professional acquaintances, fellow investors, and portfolio companies.
- For high-potential startups, early-stage funding rounds often close without ever being formally opened. That’s because VC firms in the know refer the opportunity to others in their network. For promising startups, funding rounds are often oversubscribed through a “who knows who” network before anyone outside those tight circles gets wind of the opportunity. A great example of investment through referrals is Airbnb, which was originally funded by Y Combinator. One of the firm’s founders, Paul Graham, personally referred the company to Fred Wilson of Union Square Ventures and several other venture capitalists in his network.
- Investors can afford to ascribe greater value to a startup if it’s referred by a trustworthy individual from their network. VC firms can evaluate leads with a greater degree of confidence if they come through referrals from a well-regarded entrepreneur, investor, incubator, or accelerator.
- As a VC, you have two resources at your disposal: the capital you have raised from LPs and the time of the investment professionals you have hired. Given that only 10% of deals come to VC firms through cold email pitches, referrals can help you save a significant amount of time and money. By making network referrals work for your firm, you can use the time you save to devote to your portfolio companies or to do diligence on the leads you are pursuing.
- With a good network in place, you can avail of opportunities to join an investment syndicate that shares high-potential deals among its members. The popular investment platform AngelList offers investors the ability to register and run syndicates. The advantages of investing through a syndicate are the ability to invest on a deal-by-deal basis; there is no upfront commitment required.
Syndicates offer new investors unparalleled access to coveted deals while investors running the syndicate can participate in larger deals with additional investment support from syndicate members. Syndicates also inspire confidence in new investors based on the network trust factor and the fact that the investor running the syndicate has conducted due diligence on the opportunity.
How to Build a Referral Network
Referral networks are built on a foundation of trust and backed by a track record. Here are a few best practices to follow when building your own trustworthy referral network.
- Be open: Being open with fellow investors you trust helps foster close professional relationships that could pay off handsomely in terms of deal flow. When you trust investors in your network with information about deals you are considering, you gain their valuable insights that could help you determine whether to invest in them. They will likely reciprocate by sharing deal information, too, giving you the opportunity to build mutually beneficial long-term alliances.
- Focus on non-competing investors: Working on live deals with late-stage investors, angel investors, and follow on investors can significantly enhance your deal flow.
- Give it time: Great relationships are not formed overnight, and there’s limited time you can spend networking. Focus on a wide range of contacts that include fellow investors, entrepreneurs, and startup lawyers. While your networking efforts might not yield fruit immediately, they can have huge payoffs in the long run.
Switch to a Deal Flow Management Platform
With hundreds of deals for you to evaluate, it’s easy to lose sight of the best ones amid the clutter. Deal flow management solutions like Zapflow can help you avoid this problem.
As an intuitive deal flow management platform, Zapflow handles all aspects of a VC firm’s operations - from optimizing inbound and outbound communication to generating spot-on portfolio analyses. VC firms can leverage the power of AI and business intelligence through our Explorer Module, which provides competitor information, takeover targets, and exit opportunities for deals.
Zapflow’s solutions help investment firms across 35 countries make better investment decisions and improve productivity and efficiency at all stages of growth. Get a leg up on the competition by contacting us for a demo today.