The Genius of Venture Capital (Part 1): Connecting Good Ideas with Money

The Genius of Venture Capital: connecting entrepreneurs with good ideas but no money to investors with money but no ideas.
So, how does that work? It is a mysterious process.

In this series of posts, we will penetrate that mystery. We begin with two excellent articles that explain how VC’s do that voodoo that they do so well.

The two articles are rich with insights into the VC world.

Here are three that jumped out at me.

• Networking is extremely important to VCs. On average, they spend 40% of their 55 hour week working their network to identify potential candidates to add to their portfolio.
• Few VCs use standard financial-analysis techniques to assess deals. The most commonly used metric is simply the cash returned from the deal as a multiple of the cash invested.
• While VCs focus on multiple factors, such as market potential; management capabilities; product or service uniqueness; market acceptance of a product; and the degree of competitive threat in the marketplace; the single most important criterion is management capability.

The first article, titled How Venture Capitalists Make Decisions: An inside look at an opaque process, appeared in Harvard Business Review (March–April 2021).

I was able to access a free version of the article online. If for some reason you are not able to view it, it would be well worth the cost to purchase it. Here are some highlights from the article …

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TIP: Find other interesting items by Googling venture capitalist research
One result, the second of the articles that helped me grasp how VCs add value to the entrepreneurial approach to improving human existence, appears after the HBR article highlighted below …

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How Venture Capitalists Make Decisions: An inside look at an opaque process
Paul Gompers, Will Gornall, Steven N. Kaplan, and Ilya A. Strebulaev
From Harvard Business Review (March–April 2021)
Pablo Boneu
[SELECTED QUOTES]
“These insights into VC practices can be helpful to entrepreneurs trying to raise capital, corporate investment arms that want to emulate VCs’ success, and policy makers who seek to build entrepreneurial ecosystems in their communities.”

“Our findings are useful not just for entrepreneurs hoping to raise money. They also offer insights to educators training the next generation of founders and investors; leaders of existing companies seeking to emulate the VC process; policy makers trying to build start-up ecosystems; and university officials who hope to commercialize innovations developed in their schools.”

“On average, they [VCs] put 55 hours a week in on the job, spending 22 hours a week networking and sourcing deals (40%) and 18 hours working with portfolio companies.”

“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. To pull the curtain back, Paul Gompers of Harvard Business School, Will Gornall of the Sauder School of Business, Steven N. Kaplan of the Chicago Booth School of Business, and Ilya A. Strebulaev of Stanford Business School conducted what is perhaps the most comprehensive survey of VC firms to date. In this article, they share their findings, offering details on how VCs hunt for deals, assess and winnow down opportunities, add value to portfolio companies, structure agreements with founders, and operate their own firms.”

[ EXCERPTS ]
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 “generating 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? “I’ve found that the best deals often come from my network of trusted investors, entrepreneurs, and professors,” he told us. “My peers and partners help me quickly sift through opportunities and prioritize those I should take seriously. Help from experts goes a long way in generating quantity and then narrowing down for quality.”

Breyer’s approach is a common one. According to our survey, 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. As Rick Heitzmann of FirstMark told us, “We believe that the best opportunities don’t always walk into our office. We identify and research megatrends [ EDITOR’S NOTE: research ]and proactively reach out to those entrepreneurs who share a vision of where the world is going.”

Narrowing the Funnel
Few VCs use standard financial-analysis techniques to assess deals. The most commonly used metric is simply the cash returned from the deal as a multiple of the cash invested.

What factors do VCs consider as they go through the winnowing process? One framework suggests that VCs favor either the “jockey” or the “horse.” (The entrepreneurial team is the jockey, and the start-up’s strategy and business model are the horse.) Our survey found that VCs believe both the jockey and the horse are necessary—but ultimately deem the founding management team to be more critical. As the legendary VC investor Peter Thiel told us, “We live and die by our founders.”

Interestingly, the company’s valuation was only the fifth most-cited factor in decisions about which deals to pursue. 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 techniques to assess 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 the 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 textbooks and a well-established practice of corporate decision-makers.

What explains this disregard for traditional financial evaluation? 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 a 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
Many VCs try not to focus too narrowly on financial terms during their courtship with start-ups—and give equal emphasis to how the company fits into their portfolios and why their experience and expertise can help the founding management team. As Khosla explained to us, “To attract the best entrepreneurs, it’s important to have a clear point of view beyond just making money. What are you as a venture firm trying to do, and does it align with what the entrepreneurs’ vision is?”

Finding Alpha
Once VCs have put money into a company, they roll up their sleeves and become active advisers. VCs told us that they “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 (72%), connections to customers (69%), operational guidance (65%), help hiring board members (58%), and help hiring employees (46%). Intensive advisory activities are the main mechanism VCs use to add value to their portfolio companies.

The top VC funds make a spectacular amount of money. Yet a definitive explanation for how VCs deliver “alpha,” or positive risk-adjusted returns, has yet to be articulated. We decided to ask the VCs directly—having them assess the relative importance of deal sourcing, deal selection, and post-investment actions to the creation of value in their portfolios. A plurality reported that while all three were key, deal selection was the most critical.

Although they worked more than traditional banking hours, most VCs in our survey reported that their workweek was by no means excessive. On average, they put 55 hours a week in on the job, spending 22 hours a week networking and sourcing deals (40%) and 18 hours working with portfolio companies. In a recent update to our survey, done during a peak of the Covid-19 pandemic, we found that while VCs’ pace of investment had slowed slightly, venture capitalists were allocating their time in roughly the same way—pursuing new deals, performing due diligence, closing new investments, and helping portfolio companies. [ EDITOR’S NOTE: new deals, due diligence, closing, helping ]

Finally, we asked about their interactions with their limited partners. The majority said that they believed their investors cared more about absolute performance than about relative performance. Nevertheless, the vast majority (93%) of VCs said that they expected to beat the market on a relative basis.

How can these findings be used in practice? For academics, our results offer a good base from which to further explore the nature and relative importance of deal sourcing, deal selection, and post-investment support services.

In addition, the preeminence of the founding team in the minds of VCs points to a potentially fruitful area of research for academics: Are there experiences or attitudes that define the people likely to be successful founders?

Our survey results also offer critical takeaways to entrepreneurs. Because VCs rely on their networks to source opportunities, entrepreneurs should research who belongs to a VC’s network and try to get an introduction from someone in it. Because the management team weighs so heavily in investment decisions, entrepreneurs should think carefully about how to present themselves in the best possible light when they do meet a VC. Because VCs look at more than 100 opportunities for every one they invest in, entrepreneurs should be prepared to pitch to many VCs.

Finally, many corporations have started investment arms over the past decade to try to harness the potential of entrepreneurial activity, and they can learn from the practices of the VC industry. The critical role that the management team and deal sourcing play in determining the success of investments should inform whom they choose to fund—and where and when. The many local policy makers who seek to build sustainable venture capital ecosystems to foster economic growth can likewise benefit from understanding VCs’ tactics. The ability of government leaders and officials to promote high-quality, high-potential entrepreneurs should not be overlooked. Finally, universities are often the source of innovations that end up in the portfolios of VCs. University officials can learn how to better leverage the innovative activity happening within their halls. Building relationships with leading VCs and promoting an entrepreneurial community can help spur start-up activity.
A version of this article appeared in the March–April 2021 issue of Harvard Business Review.
Free full text source: https://hbr.org/2021/03/how-venture-capitalists-make-decisions

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The second article highlighted in this post is …

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Venture Capital-2008 Proceedings-Small Business Institute Research Review.pdf
Venture Capitalists’ Investment Criteria-40 Years Of Research
Dmitry Khanin, Cal State, Fullerton J. Robert Baum, University of Maryland Raj V. Mahto, Cal State, Fullerton Charles Heller, Annapolis Capital Group
[ EXCERPTS ]
ABSTRACT
In this paper, we review the literature on venture capitalists’ (VCs’) investment criteria from its early beginnings (Wells, 1972; Poindexter, 1975) to current studies (Silva, 2004; Khanin, 2006). We identify the most important decision criteria of investment in new ventures discussed in the literature, such as top management team, market, product, risk, deal and competition. In addition, we focus on the ongoing debate that can be traced in the literature as to whether management characteristics or product/market attributes play the most prominent role in impacting VCs’ decision to invest. We show that while VCs themselves typically believe that management capabilities matter more than any other factor, in-depth studies of VC decision making show that other characteristics, such as market growth rate and entrenched competition, may play a more important role. Furthermore, VCs often couple the criterion of management capabilities with that of the level of protection from competition. EXECUTIVE SUMMARY In this paper, we summarize the evolution of the VC investment literature from the earliest dissertations on the subject written in the 1970s (Hoffmann, 1972; Wells, 1974; Poindexter, 1977; Hoban, 1976; Benoit, 1975; Dorsey, 1977) to the most recent publications (Shepherd and Zacharakis, 2002; Silva, 2004). Throughout this review, we are asking two main questions: (1) what are the main groups of investment criteria utilized by VCs to make the decision whether or not to finance a new venture? (2) Which of these criteria plays the most prominent role? We conclude that the VC investment literature is split between those who argue that in contemplating their investment decision VCs mostly rely on the criterion of management capability and those who propose that market size, growth rate and product quality play a more important role than management capability. Furthermore, the criterion of management capability often is not used on its own but rather is tightly linked with some other important parameter, typically, with competition.
INTRODUCTION
Extant research has identified a number of key investment criteria used by VCs for evaluating entrepreneurs’ business proposals, and has established their relative importance. Specifically, these studies have shown that the size and attractiveness of the market (Tyebjee & Bruno, 1984); management capabilities and functional skills (Wells, 1974); the uniqueness of a product or service (Fried & Hisrich, 1994); market acceptance of a product and the degree of competitive threat in the marketplace (MacMillan et al., 1985; 1987: Muzyka et al., 1996) are among the topmost investment criteria in a VC’s repertory.
In this paper, we summarize the main findings of the VC investment literature and analyze their practical implications for VCs. We also make suggestions as to ways of improving the quality of literature dedicated to VCs’ investment criteria in ways that would make it more relevant to investors – from VCs to business angels (wealthy individuals providing seed money) and corporate units specializing in financing of new ventures.
THE MAIN INVESTMENT CRITERIA IDENTIFIED IN THE REVIEWED STUDIES
Top Management Team (TMT)
Many studies singled out a plethora of management-related investment criteria that VCs use to decide whether to provide a venture with initial funding. Thus, most studies have shown that VCs evaluate whether senior management is competent. Some scholars (Wells, 1974) differentiated among management functional skills: general, marketing, financial and manufacturing. Others focused on management expertise and capabilities (Fried & Hisrich, 1994). Scholars have argued that VCs often choose not just competent but also seasoned managers (Robinson, 1987; Knight, 1994) on the basis of their track record, experience and references from prior places of employment. In addition, researchers have demonstrated that VCs consider top management’s psychological characteristics and cognitive capabilities, such as perseverance, commitment, attention to detail, and high risk tolerance (Wells, 1974 Kumar, 2003). Separately, many studies have discovered that VCs are concerned about the ability of senior management to act as leaders and be recognized as leaders by their team members (Robinson, 1987; Kaplan & Stromberg, 2000). According to some studies, VCs typically assess the quality of a management team, for instance, VCs prefer when a management team is balanced, i.e. it is composed of people with complementary functional backgrounds, competencies and skills (Muzyka et al., 1996, Bachher, 2000).
Market and Market Growth
Extant studies have revealed that VCs are primarily concerned about whether there is sufficient access to the market targeted by a venture (Tyebjee & Bruno, 1984); whether a venture satisfies an existing market need or stimulates a new need in an existing market (MacMillan et al., 1985; 1987); whether a market is sufficiently large so that a venture has a chance to achieve profitability and/or whether the market is growing fast enough (Muzyka et al., 1996). In addition, Shepherd (1999) and Shepherd et al. (2000) have derived several concepts regarding market conditions from the economics literature, and demonstrated that VCs may utilize such criteria as “key success factor stability” (VCs examine if requirements necessary for achieving success in the market change slowly or rapidly).
Product
Many studies have established that VCs carefully evaluate the quality of a venture’s product using the following criteria: is the product unique or sufficiently differentiated compared to competitors’ offerings (Muzyka et al., 1996)? Is the product proprietary (MacMillan et al., 1985; 1987; Zacharakis & Meyer, 1998)? Does a functioning prototype of a product exist (MacMillan et al., 1985; 1987)? Will a product allow a venture to obtain a competitive advantage due to its apparent superiority over the competitors’ products or services (Fried and Hisrich, 1994; Zacharakis and Meyer, 1998)?
Risk
Scholars have established that in evaluating prospective investments VCs identify various types of risk they may need to tackle with regard to a particular venture. Thus, MacMillan et al. (1985) have identified five types of risk typically examined by VCs: 1/ competitive risk; 2/ bail out risk; 3/ investment risk; 4/ management risk; 5/ implementation risk. MacMillan et al. (1987) outlined five somewhat different types of risk: 1/ management risk; 2/ competitive exposure; 3/ inexperience risk; 4/ viability risk; 5/ cash-out risk.
Returns
Numerous studies have demonstrated that VCs are extremely concerned about whether the projected returns from investment in a venture will be sufficient to justify a venture’s funding (Poindexter, 1975). At the same time, some scholars have pointed out that VCs do not quite trust entrepreneurs’ “overoptimistic” projections regarding future returns, and pay more attention to the market’s estimated growth rate and whether a product satisfies an existing or emerging market need (MacMillan et al., 1985; 1987; Zacharakis, 1995).
Exit
A number of studies have shown that VCs investigate some conceivable exit choices before they invest (Tyebjee & Bruno, 1984). Since VC funds have a limited life span (typically, up to ten years), VCs are concerned whether or not they will be able to timely liquidate their investment (MacMillan et al., 1985). Thus, VCs may or may not fund a venture depending on their estimates of the likelihood and timing of anticipated exit alternatives (Kaplan & Stromberg, 2000).
Deal
Another important consideration for VCs is the quality of the deal. Thus, according to several studies, VCs may be keen on a venture, but will invest in it only if they are guaranteed a certain equity stake at an attractive price (Poindexter, 1975; Muzyka et al., 1996).
Strategy
MacMillan et al. (1985; 1987) have first shown that VCs separately analyze a venture’s strategy (for instance, its positioning vis-à-vis competitors) as one of their investment criteria. Other researchers have similarly observed VCs using venture strategy as a criterion (Muzyka et al., 1996).
Customer
Most extant studies of VCs’ investment criteria did not include customer’s approval as a separate investment criterion. Instead, scholars have stressed the role of market acceptance of product (MacMillan et al., 1985; 1987). Some more recent studies, however, have emphasized that VCs separately analyze the customer’s perspective (Silva, 2004), that is, whether customers in a particular sector will be likely to endorse a product and whether senior management has developed a true understanding of their prospective customers.
Competition
Several studies have established that VCs carefully assess the extent of competitive threat in an industry sector before they decide to invest. Thus, MacMillan et al. (1987) discovered that two underlying factors have been consistent predictors of VCs’ financing decisions: a) market acceptance of a new product; and b) the degree of competitive threat. Hisrich and Jankowicz (1990) pointed out that VCs consider the odds that a venture will be able to hold off competition and whether competitors would be likely to immediately target a venture as soon as it enters a market sector. In addition, Zacharakis (1995) showed that VCs take into account the number and relative strength of competitors in a target market. Shepherd et al. (2000) demonstrated that management competence and the degree of competitive rivalry are two most important criteria in VCs’ evaluations of new ventures. Similar results have been shown to hold true in more recent studies (Khanin, 2006).
Full text source: http://www.smallbusinessinstitute.biz/Resources/Documents/Proceedings/2008%20Proceedings.pdf
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