The Genius of Venture Capital (Part 5): Deal Selection

According to a Harvard Business Review article (How Venture Capitalists Make Decisions: An inside look at an opaque process (https://hbr.org/2021/03/how-venture-capitalists-make-decisions) the purpose of venture capitalists (VCs) is to connect people with good ideas and no money, to people with money and no ideas.

Based on a survey of VCs conducted by the article’s authors, the way VCs accomplish this task can be broken down into two major sub-tasks …

1. Deal flow, i.e., generating a stream of ventures that look promising
2. Deal selection, i.e., sifting through the companies generated by deal flow to determine the handful that might be worth pursuing

Do you have an MBA? Good for you. But it probably won’t be much help in deal selection. Quoting again from the article …
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.

Here are a few more quotes from the article …

TIP: Read the entire article. Unlike so many academic articles, it is more than a simple literature search. The insights provided are based on a survey of 900 VCs, followed up by dozens of interviews.

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How Venture Capitalists Make Decisions: An inside look at an opaque process
by
Paul Gompers, Will Gornall, Steven N. Kaplan, and Ilya A. Strebulaev
From Harvard Business Review  (March–April 2021)
[ EXCERPTS ]
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. Strikingly, 9% of the respondents in our survey did not use any quantitative deal-evaluation metric. Consistent with this, 20% of all VCs and 31% of early-stage VCs reported that they do not forecast company financials at all when they make an investment.

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.

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.”

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.

We also asked VCs what contributed most to the success or failure of their portfolio companies. Again, the management team was identified as the most important factor by far. As Brian Jacobs, a cofounder of Emergence Capital, told us: “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.”

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.

Source: https://hbr.org/2021/03/how-venture-capitalists-make-decisions
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Jean Steinhardt served as Librarian, Aramco Services, Engineering Division, for 13 years. He now heads Jean Steinhardt Consulting LLC, producing the same high quality research that he performed for Aramco.

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