- November 17, 2022
Mono channel VC deal flows often become stagnant and ineffective after a point. Only acquiring certain types of deals restricts investment portfolios to narrow market niches, which makes it more difficult for VCs to scale up when necessary and mitigate market risks effectively.
Restrictive deal flows also hinder effective network building and limit the development of what’s the most important asset a VC firm can own - social capital. For these reasons and several others, investment teams need to follow a diversified deal-sourcing approach. Apart from effective risk mitigation, a diverse deal flow can also help VC firms make their deal flow more dynamic and effective. This can be understood better with the help of an illustrative example.
Let’s say two VCs, X and Y, both manage investment portfolios of roughly equal sizes. However, X’s portfolio includes startups of all sizes from several different sectors, whereas Y exclusively invests in seed-stage fintech companies. When the fintech bubble bursts during a rough financial quarter, Y’s portfolio naturally dips in value. X, on the other hand, is able to offset losses on the back of a strong performance from its real estate companies. Further, it would be much easier for X to scale up and create dedicated teams for scouting up-and-coming real estate startups, given that they already have investment experience and extensive market contacts in the sector. Y, on the other hand, would find it much harder to find credible real estate leads because its referral network is virtually non-existent outside of fintech.
Diversifying your firm’s deal flow pipeline can help strengthen your portfolio and make your deal flow processes more scalable and efficient. To understand how you can diversify your deal flow pipeline, it is important to understand what the process entails. Diversification is a standard yet broad investment term whose exact definition is subjective to each investor.
What does deal flow diversification entail?
In VC, diversification is the process of including several different types of companies in one portfolio. Diversification is primarily seen as a risk mitigation measure where VCs attempt to counter market-specific risks by limiting their exposure to companies from a single sector. It can also be seen as a hedging strategy where investors attempt to offset potential losses by making companion investments.
Firms can also choose to subjectively define what they mean by adding ‘different’ kinds of startups to their portfolio. The diversity that a VC seeks may be based on several different financial, operational, or social parameters. The choice almost entirely depends on current portfolio performance and what the partners and other key decision-makers believe can be done to provide impetus to it. Financial and operational diversity in a portfolio help VCs mitigate investment risks and set up broad, reliable referral channels which can be leveraged to obtain better leads. Social diversity, on the other hand, is usually aimed at bringing in new perspectives that help VCs understand entrepreneurs and their unique cultural/social problems better. Entrepreneurs from underrepresented communities are capable of catering to their specific product needs better. This allows them to tap into a new, diverse consumer base and scale their operations up. Greater social diversity also helps VCs connect with an entirely new network of entrepreneurs and investors who can help bring in better, more diverse leads for their portfolios.
How can you diversify your deal flow
Diversifying your deal flow pipeline primarily entails setting up more diverse and expansive deal-sourcing channels that can bring you startups from several different market sectors. A few other ways in which you can effectively diversify your deal flow pipeline are:
Leverage your existing referral networks
As mentioned, social capital is one of the most important assets a VC can have. Not only does it help firms get more and better quality deals, it also helps them expand their existing networks and use these connections to break into new market sectors. Leveraging your existing referral networks to get access to more diverse investment circles is an excellent way to diversify your deal flow. You can ask your employees and other associates to keep an eye out for companies and entrepreneurs from specific communities and market sectors. These connections can then be used to expand your reach within these communities further and establish a strong, trusted referral network that can be leveraged whenever you’re looking to scale.
Diverse referral networks also help promote mutual goodwill and trust among VCs. Going back to our example, let’s say VCs X and Y establish contact through a mutually trusted business associate. X can now help Y diversify its portfolio and invest in more real-estate companies as a risk-management strategy. Y can help X in return by sending across viable fintech leads that it believes might be a good fit for X. This example is just one of the many ways in which having access to a diverse referral network can help VCs streamline their deal-sourcing efforts.
Set up scouting programs
Well-connected venture scouts are another great resource that VC firms can use to diversify their deal flows. VC referral networks, no matter how diverse, are only capable of penetrating underrepresented and marginalized communities to an extent. The talent pool in any community or business sector can in no way be considered to be confined to established startups that already have some industry connections and are actively looking for investors. Scouts help VCs spot budding entrepreneurs and encourage entrepreneurial innovation across communities.
London-based VC firm Ada Capital chose a similar path to deal flow diversification when it set up a special scout network back in 2018. The network was specifically designed to help the firm access a diverse deal flow. Founding partner Check Warner describes the first step in the process by saying, “The first 10 scouts were chosen for their connections to underrepresented communities — they were either leaders of or heavily involved with these communities.” After the success of the first stage of its scouting program, Ada put out a form on its website in 2019 inviting applications from venture scouts. The only criterion for selection was that the scouts should have credible access to groups or regions of the UK that Ada doesn’t currently have access to.
Use online platforms to look for opportunities
An increasingly high number of investors and investment firms now use social media platforms to exchange information about viable deals. Research conducted by Harvard Business Review has found that VCs who are more active on social internet platforms more than make up for what they lose in competitive edge when they divulge information about their deal-sourcing processes to fellow investors. Social media platforms, gated online communities and special online groups/organizations for entrepreneurs can help investors get access to diverse startups that would make a great fit for their portfolios. Because of how important business relationships have become in the modern VC landscape, investors are now compelled to be more transparent about their deal flows and investment strategies.
Managing a more diverse deal flow
A more expansive and diverse deal flow would make it necessary for you to switch to better, more efficient deal management processes. Acquiring more leads from different channels requires you to have a robust digital deal management solution that can capture and collate all of this data onto one well-organized platform. Your deal sourcing and screening methods would also need to be tailored around certain parameters to actively allow more diverse deals to enter and pass through the deal pipeline.
Intelligent deal flow management platforms like Zapflow can help you do this. Zapflow allows VCs to obtain data from several different sources like referral networks and webforms and organizes it all onto one easy-to-use module. All your employees can then use the software to easily contact selected entrepreneurs, exchange relevant information with them and upload it onto the database without having to go through the hassle of sorting through long email threads.
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