How Venture Capitalists Make Decisions

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Entrepreneurs of start-up companies who have business ideas, but no capital. Who will invest in new start-ups where risk is higher? So, we often hear about venture capital firms when it comes to start-up funding. Venture capital firms is a private institutional where it finances for high-growth start-ups or new ventures. Amazon, Apple, Facebook, Google, Microsoft, and other innovative companies credit their early success to the capital and coaching provided by venture capitals. Venture capital has become an important driver of economic value. Despite all that, limited is known about what VCs do and how they make decisions.

Paul Gompers, Will Gornall, Steven N. Kaplan, and Ilya A. Strebulaev surveyed venture capital firms regarding how they source deals, structure investments, handle portfolio companies after investment, and regulate their relationships with limited partners.

Let’s discuss in detail:

 

Hunting for Deals

The first task of the venture capitalist is associating with start-ups in need of funding to generate deal flow. As per the survey, the deals come from different sources such as VCs’ former colleagues – more than 30% of deals, referrals by other investors – 20% of deals, and referrals by existing portfolio companies – 8% of deals. Cold email pitches by company management result in 10% of deals.  And about 30% result from VCs starting contact with entrepreneurs.  It is hard for entrepreneurs who are not associated with suitable professional circles to get funding.

Narrowing the Funnel

As per the survey, for each deal a VC firm closes, the firm examines, on average, 101 opportunities. 28 of those opportunities will bring about meeting with management, 10 will be analysed at a partner meeting, 4.8 will advance to due diligence, 1.7 will reach negotiation of a term sheet with the start-up, and only 1 will be funded. The company’s valuation was the fifth most-cited factor in decisions about which deals to pursue, where the DCF method is mostly utilized to assess investment opportunities.

After the Handshake

VC investment terms sheet presents a careful allocation of cash flow rights, control rights, liquidation rights, and employment terms. The deals are structured in such a manner that if entrepreneurs attain particular achievements, they hold control and if they miss those achievements, the VCs can bring in new management and change direction. VCs try to focus on how the company fits into their portfolios and not on making money.

Finding Alpha

After VCs invest in a company, they become active advisors and interact with their portfolio companies. VCs provide many post-investment services including strategic guidance, connections to other investors, connections to customers, operational guidance, help hiring board members, and help hiring employees. The top VC funds generate an impressive amount of money and deliver “alpha”, or positive risk-adjusted returns. All three, deal sourcing, deal selection, and post-investment actions created value in their portfolios. The deal selection was most important for VCs. The real success of VC portfolio companies comes from the founders and the management.

The VC Way

VCs worked longer than traditional banking hours. As per the survey, VCs normally worked 55 hours a week on the job, investing 22 hours a week networking and sourcing deals and 18 hours working with portfolio companies. VCs’ pace of investment had decreased marginally, during the peak of the Covid-19 pandemic.

 Conclusion

VCs play an important role in start-up funding and a crucial role in the economy. VC industries recognize the missed opportunities and give chance to grow start-ups by financing. VCs focus on companies that have big exit potential. VC should understand the vision of entrepreneurs and the entrepreneurs should also present themselves in the best possible way at the time of meeting with venture capital firms.

(Source:  https://hbr.org/2021/03/how-venture-capitalists-make-decisions)

Author:  Pooja S. – Jr. Analyst

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