- November 17, 2022
“I'll say this: I can't think of one instance in my 20 years in venture capital in which I have wanted to sell a company before the entrepreneur.”
This quote from Douglas Leone, former Managing Partner of Sequoia Capital, one of the world’s biggest VC firms, perfectly encapsulates the importance of high-quality deals as the foundation for a VC firm’s success.
The old adage, ‘More is better,’ does not hold true for VC firms because of the very structure of the business. Every VC investment is a risk, which makes it even more important for firms to find quality leads. However, in their quest for quality, firms cannot afford to compromise on the volume of leads they generate since only a small number of leads eventually make it into their portfolio. A 2019 Harvard Business Review survey found that American VC firms explore an average of 101 opportunities before closing a deal. A reduced volume of leads would lead to a reduction in deal closures, making the business unviable.
What’s the right way to approach deal flow? Focusing solely on quality requires firms to play the odds and bet disproportionately on just a few deals. Being quantity driven, on the other hand, could lead to compromised deal quality in order to hit target numbers. The solution to this conundrum is maintaining a viable balance between quality and quantity to optimize your firm’s workflow and increase your chances of identifying the right deals at the right time.
To fine-tune this approach, it’s important to first define the concept of deal flow and understand its inherent subjectivity.
What defines deal flow?
Deal flow is a term used to define the rate at which a firm receives investment opportunities. Unlike other investment-related metrics, deal flow is both a quantitative and a qualitative measure, taking both the volume and quality of incoming deals into account. It leans heavily on the quality of the firm’s deal-sourcing pipelines. More efficient sourcing is capable of generating more leads that are better in quality, which elevates overall deal flow for the firm.
A VC firm’s deal flow depends on several operational and macroeconomic factors. Operational factors, like the efficiency of the deal pipeline and deal sourcing mechanisms, are in the VC firm’s control. However, macroeconomic factors, like global market trends, are variables that cannot be controlled as easily. For example, robust equity markets and an economy poised for expansion will help generate healthy deal flows for most firms, while a global recession, on the other hand, will make it much tougher for financiers to find good deals. Macroeconomic trends also affect factors like cash flow and risk appetite, which ultimately curtails the firm’s deal flow.
The highly variable nature of deal flow points to a lack of standard benchmarks to guide VC firms. A firm’s ideal deal flow is one that strikes a fine balance between quality and quantity of incoming deals while in service of its immediate business goals. Let’s understand this better with the help of an illustrative example.
When a new business, say a brewery, opens, the owners should focus on earning a reputation in the community to attract as many customers as possible. In this case, a range of small sales across a diverse set of customers will help the business expand its customer base and build social capital. In the future, the business can leverage this social capital in the form of goodwill, word-of-mouth marketing, and customer referrals. When this leads to adequate cash flow, the brewery can start taking larger orders from restaurants, clubs, hotels, and other dining establishments.
Similarly, when a VC firm has just launched or when an established firm is looking to scale by expanding into a new geography or sector, it can benefit from making several smaller deals to seed the market. In this case, the quantity will take precedence over quality when it comes to deal flow. However, well-known firms can afford to be choosy and invest only in a few high-quality deals.
In both these scenarios, quality and quantity do not hold equal weightage in determining the composition of the ideal deal flow. This demonstrates how ‘ideal’ deal flow is a dynamic concept subject to frequent changes, especially cyclical ones.
Finding the right deals
VCs greatly prefer deals obtained through referral networks owing to their impact on the overall revenue and reputation of the firm. Apart from often being successful, these referred deals help VCs build social capital, making the firm more attractive to startups and positively impacting the volume of leads the firm generates. Harvard Business Review’s 2019 survey on venture capital found that nearly 60% of all VC deals come through network referrals. The social credibility of referrals and the network trust factor are, therefore, essential elements of constructing the ideal deal flow.
However, it’s important to remember that the most fruitful referral networks are the result of years, even decades, of nurturing industry contacts and building goodwill. As Wharton professor Adam Grant notes in his book ‘Give and Take,’ the most effective leaders embrace a long-term, community-driven mindset. They believe in helping others meet their objectives, and in doing so, they build social capital they can leverage in the future. This suggests that VCs who proactively help fellow investors find the right opportunities often find themselves at the receiving end of similar favors. Actively engaging in goodwill-based community building can help VC firms strengthen their referral networks, which in turn helps elevate the quality of their deal flow.
Tips for streamlining venture capital deal flow
Here are a few tips to help you effectively streamline your VC deal flow.
Establish responsive deal flow processes
While there is no such thing as the perfect deal flow, your deal flow pipeline can always be refined to better align with your business needs. The first step is discovering and analyzing deal flow bottlenecks. Responsive deal-capturing and screening processes can help analysts quickly find and eliminate bottlenecks. Further, enabling companies to leave feedback can help you isolate problems in your cold outreach process.
Ensure that all companies your firm contacts are aware of your investment scope and objectives. This will help you avoid unnecessary back-and-forth communication that could result in a failed deal.
Take good care of your networks
The importance of a network built on strong relationships cannot be overstated, especially for the venture capital business. Robust industry networks inevitably result in better opportunities coming to your desk, which helps augment your deal flow.
However, it’s important to take good care of your relationships in order to derive value from them. Building on the analogy presented by Grant, author of Give and Take, being an incessant talker discourages other investors from helping you find the right deals. A VC firm that does not provide any value in exchange for the deals that come its way will sooner or later find itself isolated from other investors.
Building a good network entails replying to colleagues and business contacts on time as well as helping promising deals that are not a fit for your firm find the right investors. Actively try to build your referral networks by encouraging your employees and entrepreneurs from your portfolio companies to network at industry events.
Use a deal flow management platform
A sizable VC firm will likely be analyzing hundreds of leads simultaneously. An effective deal flow management platform can collate all your deal-related data in a single, well-organized resource to help your firm keep its eyes on the best deals amid the clutter. Such platforms are also often equipped with intelligent A.I.-backed modules that automatically filter captured leads using specified criteria. The platform’s effective feedback loops enable preliminary communication between startups and VCs, helping them avoid the hassle of interacting on long email threads.
Zapflow is a comprehensive deal flow management platform that can cater to all the needs of a venture capital firm, from organizing both inbound and outbound communication to generating easy-to-read quarterly reports and portfolio analyses. Our integration with Ocean also lets you crawl the Internet for all the possible competitors, acquisition targets, and exit opportunities related to a particular company within seconds.
Zapflow is an intelligent and intuitive productivity-enhancing tool that can give your deal flow the facelift it needs. Contact us today for a free demo.