How Do Venture Capitalists Make Decisions?

Will Gornall is an Assistant Professor of Finance at the Sauder School of Business at the University of British Columbia. This post is based on a recent article, forthcoming in the Journal of Financial Economics, by Professor Gornall; Paul A. Gompers, Eugene Holman Professor of Business Administration at Harvard Business School; Steven N. Kaplan, Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business; and Ilya A. Strebulaev, the David S. Lobel Professor of Private Equity at the Stanford Graduate School of Business. Related research from the Program on Corporate Governance includes Carrots & Sticks: How VCs Induce Entrepreneurial Teams to Sell Startups(discussed on the Forum here) and Do VCs Use Inside Rounds to Dilute Founders? (discussed on the Forum here), both by Jesse Fried and Brian Broughman.

Our article, How Do Venture Capitalists Make Decisions?, describes the results of a survey of almost nine hundred venture capitalists (VCs). We asked VCs about eight different topics: deal sourcing; investment selection; valuation; deal structure; post-investment value-add; exits; internal organization of firms; and relationships with limited partners.

We first consider how VCs source their potential investments—a process also known as generating deal flow. The average firm in our sample screens 200 companies and makes only four investments in a given year. Most of the deal flow comes from the VCs’ networks in some form or another. Over 30% of deals are generated through professional networks. Another 20% are referred by other investors while 8% are referred by existing portfolio companies. Almost 30% are proactively self-generated. Only 10% come inbound from company management. These results emphasize the importance of active deal generation.

We also examine VC investment selection decisions. There is a great deal of debate among academics and practitioners as to which screening and selection factors are most important (e.g., Kaplan, Sensoy, and Stromberg, 2009). We find that in selecting investments, VCs place the greatest importance on the management/founding team. The management team was mentioned most frequently both as an important factor (by 95% of VC firms) and as the most important factor (by 47% of VC firms). Business related factors were also frequently mentioned as important with business model at 83%, product at 74%, market at 68%, and industry at 31%. The business-related factors, however, were rated as most important by only 37% of firms. The company valuation was ranked as fifth most important overall, but third in importance for later-stage deals.

We then explore the tools and assumptions that VCs utilize in evaluating the companies they select. Like PE investors (as shown by Gompers, Kaplan, and Mukharlyamov, 2016), few VCs use discounted cash flow or net present value (NPV) techniques to evaluate their investments. Instead, the most commonly used metric is MOIC or, equivalently, cash on cash return. The next most commonly used metric is IRR. At the same time, unlike PE investors, many VCs report minimal use of quantitative metrics, with 9% of the respondents reporting that they do not use any quantitative deal evaluation metric. And 20% of VCs reported that they do not forecast cash flows when they invest. This is consistent with the large uncertainty at the early stage making it difficult to make such analyses.

After exploring pre-investment activities, we consider how VCs write contracts and structure investments. Kaplan and Stromberg (2003) study VC contracts and conclude that they are structured to ensure both that the entrepreneur does well if he or she performs well and that investors can take control if the entrepreneur does not perform. Less is known, however, about which of these terms are more important to VCs and how they make trade-offs among them. In our survey, we ask the VCs the extent to which they are willing to negotiate different terms. We find that the VCs are relatively inflexible on prorata investment rights, liquidation preferences, anti-dilution protection, vesting, valuation, and board control. They are more flexible on the option pool, participation rights, investment amount, redemption rights, and particularly dividends.

We move from contracts and structuring to examine how VCs monitor and add value to their portfolio companies after they invest. Part of the added value comes from improving governance and active monitoring. This often means replacing entrepreneurs if they are not up to the task of growing their companies. For example, Baker and Gompers (2003) find that only about one-third of VC-backed companies still have a founder as chief executive officer (CEO) at the time of IPO. VCs generally responded that they provide a large number of services to their portfolio companies post-investment—strategic guidance (87%), connecting investors (72%), connecting customers (69%), operational guidance (65%), hiring board members (58%), and hiring employees (46%). This is consistent with VCs adding value to their portfolio companies.

Having looked at all aspects of VC involvement, we then consider which of those activities are more important for value creation. Sorensen (2007) studies how much of VC returns are driven by deal sourcing and investment selection versus VC value-added. He concludes that both matter, with roughly a 60/40 split in importance. We further explore this issue by asking the VCs directly to assess the relative importance of deal sourcing, deal selection, and post-investment actions in value creation in their investments. A majority of VCs reported that each of the three—deal flow, deal selection, and post-investment value-added—contributed to value creation with deal selection being the most important of the three. Deal selection is ranked as important by 86% of VCs and as most important by 49% of VCs. Post-investment value-added is seen as important by 84% of VCs and as most important by 27% of VCs. Deal flow is ranked as important by 65% and as most important by 23%. These results extend and inform Sorensen (2007) by distinguishing between deal flow and deal selection.

We then asked VCs what factors contributed most to their successes and failures. Again, the team was by far the most important factor identified, both for successes (96% of respondents) and failures (92%). For successes, each of timing, luck, technology, business model, and industry were of roughly equal importance (56% to 67%). For failures, each of industry, business model, technology, and timing were of roughly equal importance (45% to 58%). Perhaps surprisingly, VCs did not cite their own contributions as a source of success or failure.

We explored issues related to internal VC firm structure and activity to understand how VCs allocate their time to different activities. When possible, we discuss how the organization and structure relate to VC decision-making. The average VC firm in our sample is small, with 14 employees and five senior investment professionals. Consistent with the importance of both deal sourcing and post-investment value-added, the VCs report that they spend an average of 22 hours per week networking and sourcing deals and an average of 18 hours per week working with portfolio companies out of a total reported workweek of 55 hours.

Finally, we asked VCs about their interactions with their investors. Surprisingly, and like the PE investors surveyed by Gompers, Kaplan, and Mukharlyamov (2016), the majority of VCs mention that they believe their investors care more about absolute performance measures like cash on cash returns and net IRRs, rather than relative performance measures. VCs also show confidence in their ability to generate above-market returns, with nearly three quarters answering that they expected to beat the market.

The complete article is available here.

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