One of my goals in writing about AppDynamics journey from an idea nine years ago to our $3.7 Billion acquisition by Cisco this year is to help and inspire the next generation of founders and entrepreneurs.
Quite often, I get contacted by fellow entrepreneurs asking for advice on how to pick among the multiple VC options they have.
I remember when I was raising Series-A capital for AppDynamics in 2008, I pitched to many VCs. At first, they were reluctant to pull the trigger for any number of reasons. But once I got the first VC to make me an offer, I had multiple options in just a few days. (And in all the subsequent rounds of fundraising, there was a very similar dynamic.)
It turns out, that’s not so uncommon. Quite often, a company is either not attractive to VCs, or it is attractive to multiple VCs at the same time. So most likely, if you are a founder raising capital from institutional VCs, you will have to make decisions on which VCs to go with.
How do you ensure you pick wisely?
When I was starting out as an engineer turned first time entrepreneur, I had no idea how to go about this and made mistakes. I got better at it over time, but I wish I had known more early on. Here are some of my learnings for other first time entrepreneurs.
#1 Reach The Highest “Tier” Of VC Firms You Can — But Don’t Go Overboard Comparing Firms
After capital, the single most valuable asset a VC provides to your startup is credibility. I call this “social proof” — that is, demonstrable evidence that a renowned investment firm with deep pockets is backing your company. This can potentially have a huge impact on your business, from attracting the highest caliber talent in an insanely competitive market, to generating confidence with potential customers who might not have otherwise considered you.
Of course, there are many VCs out there. But you can roughly put venture firms into three tiers when it comes to that much-desired credibility:
- Tier 1: Normally the top 15-20 venture firms — those who consistently raise large funds of $300-500M+ and have backed multiple well-recognized startups and “unicorns” in the past. (The only other firms that will get you a similar level of credibility are emerging new funds started by well-known entrepreneurs with a strong personal credibility of their own — like Andreessen Horowitz in the early days, or SaasTr Fund by Jason Lemkin, etc.)
- Tier 2: The next 20-25 funds — smaller with some moderate past success but not multiple “unicorn” exits yet.
- Tier 3: Everyone else.
Your goal is simple: get to the highest tier you can, but don’t overthink it after that. Every firm will try to convince you that they are special relative to other firms in the same tier. The firms that had the best returns in the last five years will try to convince you they are better than the firms with lower returns and so on. Rankings are fluid and change with the times as firms have good or bad exit years. At the end of the day, firms within a given tier aren’t all that different.
#2 What Really Matters – Partner, Partner, Partner
Let’s say you have offers from Partner A in Firm X, and Partner B in Firm Y. If both firms are broadly in the same tier, stop investing time in comparing Firm X with Firm Y. Instead, focus 100% on comparing Partner A with Partner B.
The reason is simple: that partner will be on your board for years. Many years. And he or she will impact your company’s trajectory far more than will the choice of the firm. (What’s more, within a tier 1 VC firm, the difference between the quality of the best 2-3 partners and the next 3-4 partners can be quite high. You will need to pay strong attention to that, too.)
Bear in mind that this isn’t like hiring an employee. If you hire an employee (even a very senior executive) and it all goes wrong, you can fire the person and correct it. Not so with your VC board partner. Changing the partner who is on your board is close to impossible. (Getting a divorce is probably easier!) You will most likely be stuck with that partner for the life of your company.
So now how do you identify which are the right VC partners?
#3 Look For “Believers”
Many times, a VC will make an offer to invest in your company because you are a “hot deal.” You want to avoid those and instead go with the VCs who want to invest in you out of their own deep conviction in your market, in your offering and in you and your team.
A startup journey is hard and goes through many ups and downs. Most startups will adjust course and pivot as they go. You want your key investors and board members to have a fundamentally strong conviction in what you do as a company and in you as an entrepreneur.
So, ask VCs:
Why do you want to invest in my company?
Walk me through the investment thesis you presented to your partnership.
If you find the thesis is long-term and well-considered, those are good signs. If you find the thesis poorly considered, they are likely investing because of FOMO or “fear of missing out,” and that’s not a very good sign.
When your startup goes through inevitable tough times, having believers around you is much easier than spending your time convincing the non-believers.
#4 Understand What Kind Of “Advisor” They Are Going To Be
VCs aren’t just investing money in your company. They are likely going to be on your board of directors. Many times they control the majority of preferred voting shares and can exercise control over any business decisions. As part of that, they play an important role advising you and the company as you build and grow your business.
But unfortunately, this is a dual-edged sword and quite often the biggest source of friction between founders and their VC board members.
So, when it comes to evaluating a VC partner, there are two dimensions to evaluate:
- Are they “soft advisors” or “hard advisors”? As an entrepreneur, you do want advice and opinions from your board members and investors. Some VCs like to give advice but trust you to do whatever you want with that advice — I call them “soft advisors.” Some VCs really want you to follow their advice even if you don’t agree with them — I call them “hard advisors.”
- “Qualified CEO advisor” or “Not-so-qualified CEO advisor.” Some VCs are very capable and qualified to give you advice as you build your company. Many aren’t. VCs who are experienced entrepreneurs themselves and have been in your shoes as founder CEOs are the most obviously qualified. Sometimes, VCs who haven’t been entrepreneurs themselves could also be very qualified, but that will be harder to judge. Your test though is really simple — would you consider hiring this person as an independent advisor to you as CEO if they were not an investor in your company?
The best VC partner in your board will be someone who is a “qualified CEO advisor” AND a “soft advisor.” The second best (and more common) will be “not-so-qualified CEO advisor” BUT a “soft advisor.”
The worst — you guessed it — will be a “not-so-qualified CEO advisor” AND a “hard advisor.” You want to avoid those —especially if you are also giving up some key amount of control in the company.
#5 The Personality Test
You will be working with your VC partners closely for 5-10 years as business partners. You want to make sure they have the right personalities to do business with for the long-term. Here are the three personality traits you should look for:
- Emotionally even-keeled: Startup journeys are hard and full of huge ups-and-downs. There are many tough periods when you have to make hard decisions, calmly. Your VC partners will play a key role during those times as board members and investors, and you want steady and calm steering hands.
- Upfront and direct: You want people who are direct and upfront, who will tell you things clearly without beating around the bush. The last thing you want is to spend time deciphering what your investors think or want. You want people who say clearly what they are going to do, and do what they say.
- Respectful and low ego: In the fundraising process, look for yellow/red flags with VC partners who are rude, have high egos or are disrespectful, including those who show up late all the time. The chances are you are not going to enjoy working with them.
Don’t hesitate to reference check the VCs, just as they will reference check you. See if the founders they have backed in the past are willing to recommend them wholeheartedly.
As an entrepreneur, you will have to make the best out of the cards you are dealt and find a way to succeed. But when you have the option of picking cards, picking the right ones will make your journey a lot smoother.
Good luck in your entrepreneurial journey!
Read more: Inc42