Business study: Demystify Venture Capitalists’ Decision-Making Process

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Over the past 30 years, venture capital has been a vital source of financing for high-growth start-ups. Amazon, Apple, Facebook, Gilead Science, Google, Intel, Microsoft, Whole Foods, and the list goes on.  Those innovative companies owe their early success in part of the capital and coaching provided by VCs. Venture capital has become an essential driver of economic value. Consider that in 2015 public companies that had received VC backing accounted for 20% of the market capitalization and 44% of the research and development spending of U.S. public companies. 


Despite all that, little is known about what VCs actually do and how they create value. To be sure, most of us have the broad sense that they fill a crucial market need by connecting entrepreneurs who have good ideas but no money with investors who have money but no ideas. But while the companies that VCs fund may make headlines and transform entire industries, venture capitalists themselves often prefer to remain in the background, shrouded in mystery. 


To pull back the curtain, this article will briefly introduce how the capitalists source deals, select and structure investments, manage portfolio companies post-investment, organize themselves, and manage their relationships with limited partners (who provide the capital VCs invest).


Hunting for deals

The first task a VC faces is connecting with start-ups that are looking for funding – a process known in the industry as “general deal flow.” Jim Breyer, the founder of Breyer Capital and the first VC investor in Facebook, believes high-quality deal flow is essential to strong returns. What’s his primary source of leads? His network of trusted investors, entrepreneurs, and professors. 


Breyer’s approach is a common one. According to Harvard Business Review (HBR), 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. Just like most things in life, the best opportunities don’t just walk into the office. They are identified and found. Most VCs would proactively reach out to the entrepreneurs who share a vision of where the world is going.


Conversely, this approach also introduces difficulties for entrepreneurs who are not connected to the right social and professional circles to get funding. Few deals are produced by founders who beat a path to a VC’s door without any connection. 


Narrowing the funnel

Even for entrepreneurs who do gain access to a VC, the odds of securing funding are exceedingly low. One average, for each deal a VC firm eventually closes, the firm considers 101 opportunities. Usually 28 of those opportunities will lead to a meeting with management; 10 will be reviewed at a partner meeting; 4.8 will proceed to due diligence; 1.7 will move on to the negotiation of a term sheet with the start-up; and only 1 will actually be funded. A typical deal takes 83 days to close, and firms reported spending an average of 118 hours on due diligence during that period, making calls to an average of 10 references.


Though VCs reject far more deals than they accept, they can be very aggressive when they spot a company they like. This can quickly flip the power dynamic. The best start-ups with inspiring entrepreneurs have intense competition to fund them, and for VCs, having a clear message about what they will and will not do, how they provide real venture assistance, and how they approach bold visions is key to winning these types of opportunities.


What factors do VCs consider as they go through the windowing process? One frame work suggests that VCs favor either the “jockey” or the “horse.” (jockey = entrepreneurial team, horse = start-up’s strategy and business model). However, HBR believes that most VCs believe both the jockey and horse are necessary – but ultimately deem the founding management team to be more critical. 95% of VC firms consider the founding team as the most crucial. 74% of VCs think the business model is the most crucial part.


Intuitively, one would think a start-up’s valuation is the most important factor for VCs. But interestingly, NO. According to HBR, valuation is only the fifth most important factor for VCs. indeed, while CFOs of large companies generally use discounted cash flow (DCF) analyses to evaluate investment opportunities, few VCs use DCF or other standard financial-analysis to assess the deals. Instead, by far the most commonly used metric is cash-on-cash return or, equivalently, multiple of invested capital – simply the cash returned from the investment as a multiple of the cash invested. The next most commonly used metric is annualized internal rate of return (IRR) a deal generates. Almost none of the VCs adjusted their target returns for systematic (or market) risk – a mainstay of MBA textbook and a well-established practice of corporate decision-makers. 


Why is evaluation not a crucial factor? VCs understand that their most successful M&A and IPO exits are the real driver of their returns. Although most investments yield very little, a successful exit can generate 1 100-fold return. Because exits vary so much, VCs focus on finding companies that have the potential for big exits rather than on estimating near-term cash flows. 


After the handshake

To aspiring entrepreneurs, the typical VC term sheet often seems to be written in a foreign language. Of course, it’s critical for company founders to understand these contracts. They’re designed to ensure that the entrepreneur will do very well financially if he or she performs but that investors can take control of the business if the entrepreneur doesn’t deliver. Prior studies of VC investment terms show that VCs accomplish that through the careful allocation of cash flow rights (the financial upside that gives founders incentives to perform), control rights (the board and voting rights that allow VCs to intervene if needed), liquidation rights (the distribution of the payoff if the company flounders and has to be sold), and employment terms, particularly vesting (which gives entrepreneurs incentives both to perform and to stay at the company). In general, deals are structured so that entrepreneurs who hit specific milestones retain control and reap monetary rewards. If they miss those milestones, however, the VCs can bring in new management and change direction.


VCs as advisors

Once VCs have put money into a company they roll up their sleeves and become active advisers. VCs usually interact substantially with 60% of their portfolio companies at least once a week and with 28% multiple times a week. They provide a large number of post-investment services: strategic guidance (given to 87% of their portfolio companies), connections to other investors, connections to customers operational guidance, help hiring board members, and help hiring employees. Intensive advisory activities are the main mechanism VCs used to add value to their portfolio companies.


With that, hopefully you the readers learned something about how VCs make their investment decisions and they operate. This knowledge will be crucial if you want to build your own start-ups.