Harvard Business Review March-April 2021 pp70-78 |ENTREPRENEUSHIP|”How Venture Capitalists Make Decisions” “ An inside look at an opaque process” by Paul Gompers, Will Gornall, Steven N. Kaplan and Ilya A. Strebulaev.
Read the article for all details.
Summary of the HBR Article
Key points
Venture Capitalists (VC) use their networks to identify “investment opportunities”. Only one in a hundred potentials considered “eventually close.” Once invested they “become active investors” believing more in the “strength of the founding team” than in the “start-up’s strategy or business model.”
Innovation
As a source of innovation there's an outsized history of VC success notably including Amazon, Apple, Facebook, Gilead Sciences, Google, Intel, Microsoft, Whole Foods etc. In 2015 public companies having had VC backing “accounted for 20% of the market capitalization and 44% of the research and development spending of U.S. public companies.”
The VC Process
Hunting for deals or “generating deal flow” is the first step for VC. Ideas filling the pipeline come from trusted advisors, entrepreneurs, and professors. Besides a passive flow there is also some active reaching out by VC and about 10% of prospectives come from "cold email pitches by company management." So it’s clear that working to get connected is key for those seeking VC backing. Firms are reportedly working to diversify access so that “networks are becoming increasingly easier to penetrate.” Potentials are then evaluated by the VC team. Narrowing the funnel. If a start-up does make contact the outcomes outlined in this article are 28% get a meeting with VC, 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 be funded. Feeding frenzy. If the VC community get excited, about a prospective start-up, they will aggressively pursue the opportunity. “The best start-ups with inspiring entrepreneurs have intense competition to fund them.” The Jockey (Start-Up Team) or the Horse (Start-Up Strategy or Business Model) are both critical but according to Peter Thiel “’We live and die by our founders.’” Ranked factors in getting funded are strength of the founders 95%, the business model 74%, the market 68% and the industry 31%. VC financial due diligence focuses on; cash-on-cash return or multiple of cash invested using IRR rather than discounted cash flow (DCF) favored by large company CFOs. Interestingly, up to nearly a third of “early-stage VCs reported that they do not forecast company financials at all when they make an investment.” Ultimately biggest returns are gained by M&A or IPO. VCs essentially are portfolio firms. “Although most investments yield very little, a successful exit can generate a 100-fold return.”
After a deal is struck, if you perform then happy returns and if not, VC will without much discretion more forcibly control the purse-strings, the company valuation, the board, liquidation rights, the employment terms including stock vesting etc. In striking a deal, VC are relatively inflexible on what might be considered standard parts of an agreement.
VC as active advisors. About one-third of companies in the VC portfolio are interacting multiple times a week. Services rendered by VC to founders may include; strategic guidance, connections to other investors, connections to customers, operational guidance, help hiring board members and even help hiring employees. According to Brian Jacobs (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.” Other factors driving success noted by VC are “timing, luck, technology, business model and industry, which they rated roughly equal in importance.” According to one VC executive…”in the end the real success or failure of a venture comes from the founders.”
How are VC organized? They typically are small-flat-organizations enabling “quick decision-making.” VC report working about 55 hours per week allocated as “22 hours a week networking and sourcing deals and 18 hours working with portfolio companies.” VC limited partners are investors with a focus on absolute returns. As it is successful VC firms outperform markets. “As of June 2020...VC funds...[active]... from 2007-2016...had outperformed the Russell 2002…by 7% a year…the S&P 500 by nearly 5% a year. Almost 75% of ... funds had beaten the Russell 2000, and roughly 60% had beaten the S&P 500.”