Sneak Peak of Venture Capitalists Decision Making

Venture Capitalists are somewhat a mysterious existence among other types of investors. People would rarely recognize a VC fund based on their low profile office buildings hidden in the trees. The truth is, they provide over 20% capital in the market for public companies and 44% of research and development funding. How do they select projects? How do they make money? How do entrepreneurs leverage VC to have a jump start of their business? In the long run, how does this model impact the society?

To reveal the decision making process of VC and their impacts, a group of professors from Harvard Business School, Standard Business School and Chicago Booth conducted a survey among the VC connections they know of in 2015-2016.

Connections

The first step for VC to be profitable is to identify a pool of start-ups that are seeking for funding and guidance.

Networking plays a big role here. Nearly 30% of the deals are being referred by VC‘s colleagues or alumni at school. The network of VC is exclusive with a high barrier. Thus, if the start-ups want to get VC’s help on growing their companies or ideas, it is important to get to the inner circle of the VC world, or at least understand the schools the most VCs went to.

1% Chance

Even if the business owners have made their debut at the center of the stage, the chance of getting the support of VC is rare. Multiple rounds of reviews will be conducted by VCs, including but not limited to meeting with the management, meeting with the partner, proceed to due diligence, and only 1% of the start-ups will have the chance to go onto the negotiation table with the VC.

Decision Making Considerations

Decisions are made by observing the ”Jockey” and the ”horse”. In this case, Jockey is referring to the entrepreneur team and the horse is the actual business model or product.

Per survey, VC tends to weigh jockey’s potential more than the actual horse. That explains why there are several layers of meetings and due diligence. VCs value the potential of the talent, and put faith on the excellent team rather than what they are developing or selling. For start-up owners, it provides a clearer expectation of having a robust, reliable and excellent team that work for you, if essential to attract investors and resources.

You may be surprised but VC give less attention of the financial forecast of the start-ups growth using the models that every business school teach and test heavily on, such as Discounted Cash Flow (DCF). VC rather use annualized internal rate of return (IRR) or simple cash on cash return.

To understand the logic behind it, we need to have a clear vision of what’s the main source of VC’s incoming cash. VC will significantly grow their wealth by positioning themselves in M&A deals or IPOs with the start-up owners rather than getting share of the revenue of the on-going business. Therefore, the cash flow from the operations is no longer a huge attribute. Alternatively, VC will carefully structure the agreement to bind VC and entrepreneurs with antidilution rights that secure the stability of the pricing of shares VC hold, Pro data investment rights that protect VC’s right to invest, participation rights that make sure VC have solid controls of the companies if there are anything deviating from the goals. Upon IPO or M&A, VC have achieved their goals and collect their gains from the deals. Therefore, whether option pool will change or when to sell off the stocks is no longer VC’s concern.

After the rigorous scrutiny, once the VC makes up the mind of funding the start-up, the support will be 360 degree. From funding, to actively providing advisory opinions on strategy alignments, capital usage, operations etc..

Performance of VC

It is known by the survey results that VC have beat returns of S&P 500, Russell 2000 and other indexes over the years, which indicates a strong performance of VC and how effective their capital is in pushing new business into the market and make sure their partners are all benefit from the VC. Noted that VC projects are predominately long lasting and need years of cultivation, hence constant tracking and benchmarking against the stock indexes with similar portfolio is an appropriate measurement of the VC’s performance.

Opportunities of Improvement

VC can be blindsided from their connections. Due to the fact that the deals are all from their existing network from same VC and alumni, minorities, and people from other background will easily be neglect. For VC, it is potential loss of identifying grassroots that pinpoint a broader market, which lead to missing great opportunities. Alternatively, minorities and grassroots are reaching this glass ceiling of voices not being heard.

VC can start to look for more sources to find deals, and the government can build the bridges between different groups of people in this case to improve equality of the society.

Lastly, universities have always been tightly connected with VCs, therefore, the universities cab leverage their impacts to be more inclusive in ideas, be aware of the social impact of the researches to make more talents get involved and being heard.

Reference: https://hbr.org/2021/03/how-venture-capitalists-make-decisions