How do you DD a VC who issues a term sheet?

6 must-do steps before you raise your round

One of our portfolio company has been fundraising recently and the founder asked me this very important question: “How do I DD a VC who is about to/has offered me a term sheet?”

Firstly, it’s great that founders are asking this question. For long, founders felt that VCs had an upper hand and any money is good money. But more and more, Asian founders are becoming smarter in choosing their VC. In fact I remember attending a talk where Chua Kee Lock openly admitted that one of the big reasons he did a deal (I believe it was Grab, but I might be wrong) was because the founder was doing DD on Vertex while Vertex was doing DD on the company.

So then, how do you conduct this DD, keeping Asian ecosystem context in mind. Obviously you talk to the VCs portfolio founders. But here are six steps from my side. For all of below steps, try to talk with one portfolio company that is doing well and one that is not doing as well (of course don’t say that you want to meet this company because it’s not doing well, be subtle lah). The more similar the company’s business model to your company, the better fit to conduct DD.

1. Exit Outcome

It’s important to understand what is the fund’s ideal exit outcome? Large funds such as Sequoia push you to become a billion dollar company, because that’s the only thing that moves the needle on their funds. But smaller funds will happily exit at $100–300M. It’s important to understand what size of a company you want to build and whether the VC is aligned with this. You find this alignment by understanding fund size from which you’ll be funded (ask the VC specifically which fund and how big is it and how much is earmarked for your region) and doing quick self math around it. Thumb rule is that exit expectations would be 3–10x of fund size. You then corroborate this number during your conversations with the portfolio founders.

2. Follow-On Capability

Next thing to know is what is the fund’s follow-on capacity. Again do your math assuming 50% capital of the fund is reserved for follow-on. Ask the company that is doing well (most likely they would have raised a few rounds) whether the VC participated in all rounds so far or which round did they stop participating at. This would give you an idea of how many rounds you can depend on the VC to double down on as long as your company is doing well. Ask the company that is not doing well whether the VC ever led or co-led an internal round for them. This helps you understand how the VC will react when external fundraises are not possible.

3. Value-Add

Founders are obviously not looking for just money from the VC. Hence what is the fund’s value-add. While this is very subjective, you should specifically ask portfolio companies to give examples on each: future fund-raising assistance, capability to give advice on operations, network shared for hiring, and network shared for partnerships/business development.

4. Operating Style

Connected with value-add is the fund’s operating style. Are they hands-on or hands-off? If hands-on, how many times a month do they like to meet and what do they usually want to discuss. Will they get to know your whole management team or just the founders. And then choose which kind of VC you want for the next phase of growth. It’s preferable that you talk to companies regarding the specific manager within the fund team who’ll handle you post investment.

5. Troughs

Ask the not-so-well-company how did the fund behave if and when times were rough. It’s of utmost importance to understand that when your startup hits the rough patch, does the VC continue to be engaged or do they write-off the investment quickly and move on. You obviously want the former.

6. Brand

In my humble opinion, this is slightly less important than the above 5, but do ask a few founders from the community and maybe even other VCs who passed on you in this round that you became close to, or any next round VCs you are connected with, what they think about this particular fund. This way if there is any dirt to be dug up on the fund you’ll get to know soon enough. Take this info with a pinch of salt, as startup ecosystem is known for its gossipmongers, but it’s good to know what risks you might be taking in this new partnership. Also, you’ll get to know whether the fund closes most of the deals they take to the final stages or do they talk to almost every one and then waste time without taking an investment call.

This might not be a comprehensive list, but just going through them would take time, so get on it, your potential VC is not going to hang around for long!

P.S. Happy to hear thoughts on any thing I missed. I can add them here as edits with attribution.