PS#029: The Venture Capital Deal Funnel

The deal funnel is the process by which venture capitalists sort through their deal flow.

Each step in the process is designed to filter out the deals that don’t fit the fund’s mandate or meet the required return thresholds. The deal funnel helps VCs remain disciplined as they review hundreds (if not thousands) of deals in a given year.    

Ultimately, after moving hundreds or even thousands of deals through the funnel, venture capitalists will invest their capital in less than one percent of all of those deals.

Less than one percent.

That means over 99% of these deals are filtered out at some point in the process. This is why a proper deal funnel, a proper decision making process matters – it drives discipline.

For today, we’re going to walk through a high-level view of the deal funnel.

The flow of the deal funnel.

The deal funnel flows from leads to investments with leads being the largest portion and investments being the final filter. 

A typical deal funnel has four main categories… 

• Leads

• First calls

• Diligence

• Investments

Each stage has its own purpose. If you understand that purpose, how deals move through, and which deals should move through, the funnel starts to make a lot more sense.

Let’s discuss each stage of the funnel in a bit more detail…   

Stages of the deal funnel.

Leads

Leads represent the very top of the funnel. These are identified startups that are relevant to your fund’s mandate. For most firms, these leads are entered into some sort of CRM or database and reviewed to see which ones look most promising (and should be advanced). 

Most firms use a combination of inbound and outbound sourcing (which we’ll discuss more in a future issue of Preferred Shares) to generate their leads. Typically, a junior venture capitalist will review the lead and advance the most promising opportunities to a first call.

This screening process is designed to make sure venture capitalists are spending time analyzing the most promising opportunities that fit within their fund mandate.

First Calls

For those startups that are advanced, VCs will schedule first calls and/or meetings with founders (or management team) to better understand the opportunity. 

We say “first calls,” but this can often be multiple calls (sometimes one call isn’t enough to gather all of the necessary details). In either case, the purpose of the first call is to get a better sense of the opportunity to decide if it is worth advancing in the funnel (into diligence). If not, it’s best to quickly pass.

Depending on the firm, this stage may have different names, such as qualified(s), deal screening, pitches, etc. In the end, it’s all about gathering enough information to decide if the opportunity is worth advancing into diligence.

Diligence

For the startups/deals that we’ve decided to advance, we move them into diligence.

Moving an opportunity into diligence is a BIG step in the process. There is a significant increase in the amount of time and resources dedicated to reviewing a startup in diligence. 

Why does that matter? Opportunity cost. 

Every day spent in diligence on one deal is a day that is not spent reviewing other startups that could be a better fit. To prevent this issue, a firm will often require some form of investment committee approval to ensure that they aren’t chasing the wrong opportunities or wasting resources. 

Firms will segment diligence between work that can be done on their own (often known as preliminary diligence) and work that requires detailed information from the company (full diligence). Work that can be done without the company’s involvement may include market sizing, competitive landscape analysis, off-sheet references, etc. In a lot of cases, this work may cause a team to pass on an opportunity before committing more time and resources. 

On the other hand, if they decide to move forward, full diligence is where the real work is done. The investment team will be focused on completing detailed analysis around the team, market, product/technology, financials, return profile, etc. to see if this is worth an investment.    

Throughout this process, firms will attempt to prioritize their diligence efforts for the biggest risks (in their opinion). This way, if they can’t get comfortable with a specific risk, they can pass on the deal sooner rather than later.

If they remain confident in the deal and are comfortable with the risks, the opportunity will move into the final stage of the funnel – deciding whether or not to invest. 

Investment

If the team decides to advance a deal through diligence, it’s time to take the deal to the investment committee. 

At the investment committee meeting, the team will present their thesis for the startup, the work they did in diligence, and why this opportunity could lead to a strong financial return for the fund. If approved by the investment committee, the team will focus on finalizing the structure and closing the transaction (i.e., signing and wiring!).

If your firm is leading the deal, a term sheet will most likely have been provided earlier in the diligence process (the exact timing will depend on the competitive nature of the round). The term sheet will provide a guide for structuring the details of the investment (the full legal document set). Just like advancing a deal into diligence, the term sheet will also need to be approved by the investment committee or a senior investment professional at the firm.

If your firm is not leading, but participating in the syndicate, then you will be focused on reviewing the structure of the deal that has been put together by the lead investor.

Once the legal documents have been reviewed and approved, it’s time to wire and close on the new investment.

Discipline matters.

At the beginning of this issue, I told you that less than one percent of the deals that enter the funnel ultimately become investments. That’s because the deal funnel is designed to be a tough and rigorous process. Its purpose is to help investors weed out investment opportunities that are not a fit for this fund.

Remember, a successful venture capital investment is the exception, not the rule. Most of these companies don’t end up succeeding. 

As investors, to combat these odds, to manage these risks, we need to be disciplined in our processes. Venture capital is a long, long game and discipline is the key to managing these risks over the long-term.  

The deal funnel helps investors remain thoughtful about potential opportunities, only focusing on those that (they believe) fit the fund’s mandate and provide the best return potential.