How do venture capitalists make decisions?

A recent study by Ivy League scholars investigated how 885 institutional Venture Capitalists (VCs) from 681 firms make decisions about their investments and portfolios. The average VC firm in the sample analyzed more than 400 companies per year but made merely five investments during the same period. The main finding is that VCs regard the management/founding team as the most important factor driving their decisions.

The researchers assessed 8 types of decisions, namely: deal sourcing; investment selection; valuation; deal structure; post-investment value-added; exits; internal firm organization; and, relationships with limited partners. They also looked at potential variations in VC practices across industries, stage, geography, and past successes.

The authors observed that most of the deals emanated from the VC’s own networks - more than 30% of deals were generated from professional networks, another 20% referred by other investors, and 8% from companies already on their portfolio.

Overall, VC’s investment selection was primarily driven by perceptions about the management team, followed by business factors (such as the business model, product, market, and industry) and company valuation. Notwithstanding, the authors found some variations, namely that the management team tends to be the most important factor for early-stage and IT investors but for late-stage and healthcare investors business factors outweigh the importance of the management team. Interestingly, the fund’s fit and ability to add value to the deals was perceived as the least important factor overall.

Another relevant finding is that few VCs use discounted cash flow or net present value techniques to evaluate their investments. Instead, the most commonly used metric is cash-on-cash return or the multiple of invested capital. However, some do use the internal rate of return (IRR) as an evaluation metric.  Concurrently, very rarely do VCs adjust their target returns for systematic risk. Curiously, 9% of the overall respondents and 17% of the early-stage VCs do not use any quantitative deal evaluation metric.

In relation to the deal structure, the researchers found that VCs were relatively inflexible on pro-rata investment rights, liquidation preferences, anti-dilution protection, vesting, valuation, and board control though they appeared to be flexible in relation to the option pool, participation rights, investment amount, redemption rights, but mostly about dividends.

On the other hand, VCs do provided a significant number of services in the post-investment stage, primarily consisting of strategic guidance, connecting customers, operational guidance, and hiring of board members and employees.

In terms of exits, the data suggested that VCs exited about 75% of their deals through acquisition, instead of IPOs. About 10% of the deals made 10 times their investment but about 75% of the remaining lost money.

The average VC firm on this study’s sample had 14 employees and 5 senior investment professionals which on average spent 22 hours/week networking and sourcing deals, and 18 hours/week working with the firms on their own portfolio. Lastly, the performance of VCs was primarily evaluated by cash on cash returns and net IRRs, and most of those surveyed were confident in their ability to generate above market returns.

 

Reference:

Gompers, Paul A. and Gornall, Will and Kaplan, Steven N. and Strebulaev, Ilya A., How Do Venture Capitalists Make Decisions? (August 1, 2016). Stanford University Graduate School of Business Research Paper No. 16-33; European Corporate Governance Institute (ECGI) - Finance Working Paper No. 477/2016. Available at SSRN: http://ssrn.com/abstract=2801385

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