How VCs Really Pick Teams to Invest In - Part 1 the Founder and CEO

When it comes to investing their money, VCs have to weigh up a huge number of competing and sometimes contradictory factors. But as Marc Andreessen, cofounder of Andreessen Horowitz, once said during an interview – ‘the decision ultimately is and should be around people.’

In fact, he reckons it carries about 90% of the decision-making process. That’s a lot of emphasis on the importance of people in fundraising (and in how successful VCs reckon your entire business is likely to be!)

There are, as always, some obvious caveats. You could have the world’s most incredible team and it wouldn’t matter if your Total Addressable Market was going to be too small to generate VC-appropriate returns. You also want a solid business plan if you actually intend to prove you are the right team for the job. But when it comes down to it, a business is nothing more than its people + any material assets it creates or owns.

So working out what VCs are actually looking for is vitally important.

The Background

Over time, VC expectations for founders have changed a lot.

Back in the 90s, most tech founders had tech rather than business backgrounds. As a result, it was pretty common for VCs to replace or demote the founder once the business had reached a certain size, in favour of a professional CEO with a business and sales background.

When the tech bubble burst, this technique was partly blamed, because it resulted in a lot of businesses with great branding but weak products. You can check out this Harvard Business Review article from 2001 for an analysis of the ways investor activity and misunderstandings helped exacerbate the crisis.

Nowadays VCs actually spend a lot more effort trying to keep founders involved in their businesses until as late a stage as possible. Instead, early-stage funds encourage founders to balance their profiles by finding or hiring co-founders with complementary skill sets to ensure the business will have the right support to scale.

This often goes against some founders’ expectations.

Common mythos places all the emphasis on the idea of the visionary founder – a lone wolf whose genius carries the whole business with them. But even leaving aside the general VC preference for co-founders now, you can be sure VCs are interested in the whole team and not just the founder. In the words of Brian Jacobs, co-founder of Emergence Capital, ‘I have never seen a venture success for which one person deserves all the credit. The winners always seem to be the founders who can build a kick-ass team.’

Even boards play a major role in investor decisions, making and breaking many deals.

But let’s not get ahead of ourselves and start at the beginning. What do VCs actually think constitutes a good founder?

Founders and CEOs

One of the first things to say about what makes a great founder, is that this is often considered different at different stages of the business’s journey.

At an early stage, when the business constitutes only a small team, the most important founder skill is generally considered the ability to execute. After all, the business will go nowhere if the founder doesn’t possess the skills to turn it from an idea into something people are actually willing to buy (and do).

However, as the business grows, the founder actually needs to start delegating a lot of their early responsibilities, or bottleneck the company’s growth to what they themselves can achieve. They have to become a CEO (or hire one!).

Responsibility for execution has to be dispersed across the company – diminishing its reliance on the skillset of the founder – otherwise all those new team members will be rendered obsolete by the fact the founder is still doing their jobs.

This means that leadership is actually by far the most important skill, and one that grows in importance rapidly and from a much earlier stage than most founders expect. Balderton warns that ‘You have to lay the foundations for building your executive team before you find yourself in dire need of them’, but too many businesses are always a few steps behind the curve and can experience massively curtailed growth as a result.

After all, if a leader is great at execution, but terrible at enabling other people to execute, their potential will always be limited to the things they can execute themselves. This is what Forward Partners have christened the Early Founder Growth Gap – the lag between where founders think their skills need to be versus where they should be, and the consequent problems caused when they have to try and build these skills in a very short amount of time.

Without the right leadership, growth tends to either stall completely once the business reaches the upper limits of the founders leadership skills, or will slow as talented team members pick up as much slack as the imperfect leadership structure can support. This is why founders are sometimes replaced as CEO by more experienced individuals. If you want to make it to true scale, sometimes the founder is just not the right person for the job.

It’s a problem that affects VCs at every stage of growth. Forward Partners explicitly discuss the challenge of finding founders that will be able to cope and succeed that much further down the line from seed and pre-seed. At the other end of the spectrum, Bessemer Venture Partners discuss the shortcomings of a founder at Series C in their investment memo for LinkedIn:

Reid Hoffman is discussed as a talented founder who has quite ably grown the platform to Series C, but whose weaknesses as a leader makes him a potential liability going forward. However, the important point for BVP in this case, is that the founder is self-aware enough to know this, and has already begun the search for someone better suited to the CEO job.

This self-awareness is vital. Lots of founders look great on paper, but realistically no entrepreneur is an expert on everything and will inevitably have weak areas. By showing awareness of his shortcomings and working to do what’s best for the business, Reid proved that these shortcomings would provide no more risk for the business than that normally associated with a leadership change. In this case, it certainly worked out well for both BVP and Reid Hoffman, with Reid moving to Chairman and President of Products and LinkedIn going on to be valued at $3.4b at IPO.

Sometimes investors might accept a less-than-ideal CEO in the short-term if the opportunity is too enticing and the operational risk of removing the current leadership is too high. But it’s more likely that investors will simply choose not to invest at all, no matter the success of the business, because they predict that the business will not be able to scale much further.

Lots of VCs, particularly those at the seed stage, provide advice on the qualities that they think make great leaders. Unfortunately the quality of this advice varies a lot, depending on how quantifiable it actually is – though it always provides a valuable look into how that individual VC actually assesses opportunities. For example, Andreessen Horowitz advocates ‘courage’ and ‘genius’, which are admirable qualities but very difficult to build or define. Forward Partners provides some more actionable advice here on key skills founders can develop to improve and their odds of completing the journey to scale. They highlight three main qualities to demonstrate leadership potential:

1. Resilience
2. Clarity of thought
3. Emotional intelligence

You can see these in action by looking at BVP’s investment memo for Shopify. They are dealing here with a young, first-time founder who would likely have been replaced in the 90s tech boom.

As you can see from the original analysis (and the extra commentary provided in the blue box), BVP were concerned about the relative greenness of the founder. Crucially, however, Tobi had demonstrated the qualities identified earlier of a great potential leader:

1. Resilience – by staying on at the business after the loss of his co-founder
2. Clarity of thought – as demonstrated by his clear vision for the business
3. Emotional intelligence – shown by his awareness of his own shortcomings, and presumably how well he communicated with the partners at the pitch

The commentary then shows that in Tobi, these qualities came together to provide a ‘fantastic’ CEO who ‘recruited and built an outstanding team who are still there today.’ In 2022, Shopify is valued at $75.5b and took approximately $4.6b in revenue last year.

As with the LinkedIn memo, the Shopify analysis notes that the founder still has areas of weakness – in this case, a team-wide deficiency in sales and marketing experience. But given the strength of the product, the business’s remarkable success at attracting customers despite this, and the relative immaturity of the business all work to their advantage. It is a testament to the strength of the product, rather than a criticism of the business’s potential, and the founder has been judged sufficiently talented to lead with the help of some more experienced marketing specialists.

VCs frequently have to take chances on less-proven leaders like Tobi. Serial founders are fairly rare and in high demand, so knowing how to spot potential is integral to good deal-flow. But where do investors look for these deals?

Finding great founders

Harvard Business Review found that

…more than 30% of deals come from leads from VCs’ former colleagues or work acquaintances. Other contacts also play a role: 20% of deals come from referrals by other investors, and 8% from referrals by existing portfolio companies. Only 10% result from cold email pitches by company management. But almost 30% are generated by VCs initiating contact with entrepreneurs.

This means that, while the lion’s share of deals go to businesses that had a warm introduction, a significant number of businesses are also searched out by VCs. The graph shows that this is much more effective than cold emailing investors (particularly when you take into account the very large number of cold emails VCs will receive, relative to the small slice of funding that eventually goes to these firms). So why might VCs open communication themselves?

Firstly VCs will actively seek out businesses that are operating in market areas they would like to move into. For example, FirstMark likes to research megatrends and then reach out to founders with businesses in that space. They might also look for and start building relationships with people graduating from accelerators, other famous startups, and well-known universities or MBAs.

Founders who have done one of these things are frequently perceived as a safer bet. This is particularly the case when founders have worked for other famous startups, often irregardless of how much relevant experience the role has actually provided. Atomico emphasises the importance of older startups in producing new founders, and in 2021 they calculated the average unicorn as having produced more than 135 founders. These high-profile startup alumni, such as the Paypal mafia, have encouraged investors to favour these types of founders, even where the business is operating in a very different area or at a very different stage.

The importance of networking in funding (shown in the graph above) also increases the probability of these founders receiving a warm introduction to VCs.

Yet, while these founders might have a leg-up on getting funded, statistically speaking they don’t seem to have a greater probability of business success than founders without this. Ali Tamaseb, a partner with deep-tech fund DCVC observes that ‘The biggest signal I observed in the data is that a bunch of things don’t matter, like age and university and being technical and this kind of stuff […] What matters is having a history of having generated value, even if that value was small.’

There are a lot of successful founders out there who came from Stanford or graduated Y-combinator, but once you adjust for career history, these factors may not reveal anything significant beyond where a lot of founders originate.

For example, new research has revealed that universities investing in their own alumni are actually experiencing below-average returns, with fewer successful exits. By the old logic, a university taking advantage of its access to new founders ought to have an advantage – not a disadvantage.

Of course, universities might choose to support alumni for more than just direct financial returns, but investment theory gradually seems to be changing to reflect this new data.

So what qualities are VCs actually looking for?

Different VCs do things differently – it’s part of their secret sauce, the thing they have curated in an attempt to pick the best deals and beat the market averages. And when it comes to evaluating the potential of founders there is a wide range of investing philosophies on display.

You can particularly see this with founder due diligence – that is due diligence done by the VC firm on founders.

If you look at the graph below, you can see how VCs differ widely in approach and purpose:

From Northzone’s choice to compare potential founders to traits they have observed in the best founders, to Entrepreneur First’s decision to evaluate against the peer group, to EQTs use of occupational psychologists to develop personality assessments, even this small subsection shows a lot of range.

However, these are essentially all just ways of measuring founders for the same qualities. Leadership, willingness to learn, self-awareness, communication skills. The difficulty VCs have is that it’s difficult to quantify these skills – instead founders need to find ways to prove they possess them.

VC expectations of founders and CEOs have changed a lot over time and are likely to change even quicker as more data becomes available, but knowing how they are assessing you is the first step in a successful funding round. The next step? Knowing how they are assessing the rest of the leadership team.

After all, the founder and CEO is only half the story, so what do VCs look for in the rest of the team? Check out part 2 – The Team.

Resources

Founders, here’s how top VCs are doing due diligence on you | Julius Bachmann, Sifted

Discovering the next unicorn founder with data, not gut instinct | Alexander Davis, Pitchbook

The Early Founder Growth Gap | Natalie Falconer, Forward Partners

Why Startups Fail? A Data Analysis by Autopsy | Autopsy

Hiring a Co-Founder | Natalie Falconer, Forward Partners

How Do You Measure Leadership? | Ali Rowghani, Y-Combinator

You Can’t Get There On Your Own | Bernard Liautaud, Balderton

Want to Outperform in VC? Don’t Invest in Alumni | Alicia McElhaney, Institutional Investor

Marc Andreessen on Big Breakthrough Ideas and Courageous Entrepreneurs | Stanford Graduate School of Business

How Venture Capitalists Make Decisions | Paul Gompers Et.al, Harvard Business Review

Venture Capital Due Diligence: The Management Team | GoingVC

What Makes Great Founders Stand Out? | Michael Seibel, Y-Combinator

The Memos | Bessemer Venture Partners

The 5 ‘T’s to a Successful Start-up with Sam Bernards | Tatyana Gray