One question I get surprisingly often is “how do you find companies to invest in?”. Surprisingly, this isn’t just an LP kind of question, I actually get this a lot from founders or even just friends who are not directly involved in the startup community.  I did a session with the partners of the Dorm Room Fund a few nights ago, and that was the first question that came up.

Sourcing VC investments may seem kind of like black magic, I suppose. Most people realize that we are no longer in the days where VC’s can hang back and just wait for great entrepreneurs to knock on their doors. But it’s such a foreign world to most people that it’s hard to make sense of what a VC does to get in front of the best opportunities.

For me, the simple, unifying thought is that the sourcing function of a VC is exactly the same at the marketing (and sometimes sales) function of any company.  In particular, you can think of it like the marketing function of a company selling business facing software.  There is no magic bullet about how a great software company markets.  It’s mostly about having a great machine to leverage and optimize many (if not all) marketing channels that are important.

The stock answer from most investors is that they get most of their deal flow from referrals. Not surprisingly, the most powerful channel for a software company’s growth is usually from referrals as well.  Great referrals comes from having a great product, and so the most important part of effective deal flow is having a great “venture capital product” that fits the needs of founders and exceeds their expectations.

That said, no great software company just sits back and lets referrals happen.  If that were true, then there would be no one working in the sales and marketing departments of these companies.  No, the best software companies do a lot of work to drive this machine, and almost every standard marketing practice of a software company has a parallel in VC.  For example:

• Software companies might create incentives to drive more customer referrals (eg: dropbox).  VC’s have developed scout programs that give founders some economics for any deal they bring in.
• Software companies nurture potential leads, and use drip campaigns or retargeting to bring along prospects that are considering their product.  When VC’s “catch up for coffee” or get you to sign up for their newsletters, they are effectively working a drip campaign.
• Software companies sometimes have a freemium strategy where they offer a lightweight version of their product for free with the hopes that some percentage of users eventually move up into their core product.  Some VC’s have created investment programs that put small dollars at risk (usually in a price insensitive way) to give them reach among a much wider group of companies that are not their core customer (but might one day become one).
• Software companies sometimes have inside sales teams that work the phones hard.  VC’s (especially growth stage VCs) hire small armies of analysts and associates to bang the phone to connect with founders and then track them for months or years before they actually invest.  Both often leverage software to help them identify the most promising potential customers and then point their sales machine at those prospects.
• Software companies will sometimes decide to start entering new market segments, and will start to shift their market resources, positioning, and tactics to this new segment.  VC investors will occasionally start exploring a new thesis or market area, and shift their own personal branding and sourcing efforts towards this new segment as well.
• At the top of the funnel are activities that seem more familiar.  Software companies leverage content, events, PR, and other marketing channels to drive awareness.  VC’s do the same. Some companies also do broad based  TV brand advertising.  Most VC’s don’t do that.  But wait… maybe in a way they do.  I’m still waiting for this year’s First Round holiday video 🙂

Framing things in this light may seem a bit sterile.  But again, this is no different than any other business.  Nobody likes the feeling that they are being marketed to, and I think customers in a broad set of industries are increasingly sensitive to this.  When you think about the companies that you are most enthusiastic about, many of them do a lot of marketing, but do so in a way that you truly believe that they understand their customers, care about their problems, and work like mad every day to delight them.  At our best, this is what VC’s hope entrepreneurs think of them too.