{"id":9300,"date":"2023-11-01T09:51:00","date_gmt":"2023-11-01T04:21:00","guid":{"rendered":"https:\/\/www.tactyqal.com\/blog\/?p=9300"},"modified":"2024-04-18T17:04:40","modified_gmt":"2024-04-18T11:34:40","slug":"how-do-venture-capitalists-make-decisions","status":"publish","type":"post","link":"https:\/\/tactyqal.com\/blog\/how-do-venture-capitalists-make-decisions\/","title":{"rendered":"How Do Venture Capitalists Make Decisions?"},"content":{"rendered":"\n<p>Venture capitalists (VCs) play a crucial role in funding and growing innovative companies. Firms backed by VCs, like Amazon, Apple, Facebook, and Google have transformed industries and impacted the global economy.<\/p>\n\n\n\n<p>But how exactly do VCs decide which companies to invest in? And what factors determine whether an investment is successful or not?<\/p>\n\n\n\n<p>To find out, researchers surveyed 885 VCs at 681 firms to learn about their decision-making process. Their results provide a fascinating inside look at the VC industry.<\/p>\n\n\n\n<p>Venture capital funding plays a vital role in the growth of innovative companies. Firms backed by VCs like Amazon, Apple, Facebook, and Google have transformed industries globally. In this new NBER working paper, Paul Gompers, William Gornall, Steven Kaplan, and Ilya Strebulaev analyze how VCs make investment decisions to better understand the factors driving the industry\u2019s success.<\/p>\n\n\n\n<p>The authors surveyed 885 institutional VC investors at 681 firms to gain insights across eight key areas &#8211; deal sourcing, investment selection, valuation, deal structure, post-investment support, exits, firm organization, and LP relations. Their results highlight the importance of active network sourcing, detailed due diligence particularly on teams, simple return metrics suited for uncertainty, extensive post-investment support, and the prevalence of M&amp;A over IPO exits.<\/p>\n\n\n\n<p>Notably, the survey found that VCs focus on people over ideas, ranking management teams as substantially more important than products or markets. VCs also attribute more investment success and failure to the team than the business. Detailed financial modeling is supplanted by simple cash-on-cash and IRR metrics. And absolute fund return targets dominate over benchmark outperformance.<\/p>\n\n\n\n<p>Overall, this paper provides fascinating data on real-world VC decision-making. The results depict an industry relying on relationships, team evaluation, simple heuristics, and value-added support to generate returns. The insights should interest academics, investors, and policymakers seeking to understand VC dynamics.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">The Venture Capital Funnel<\/h2>\n\n\n\n<p>VCs consider hundreds of potential deals per year, but only invest in a handful. So they use a multi-stage funnel to filter opportunities:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>The median VC firm considers&nbsp;<strong>200<\/strong>&nbsp;opportunities per year<\/li><li>They meet management for&nbsp;<strong>25<\/strong>&nbsp;of those opportunities<\/li><li><strong>10<\/strong>&nbsp;are reviewed at partner meetings<\/li><li><strong>5<\/strong>&nbsp;undergo formal due diligence<\/li><li><strong>1.7<\/strong>&nbsp;receive a term sheet offer<\/li><li>And they make&nbsp;<strong>4<\/strong>&nbsp;investments on average<\/li><\/ul>\n\n\n\n<p>This means VCs reject <strong>99%<\/strong> of the deals they look at. The funnel gets narrower at each stage as more deals are eliminated.<\/p>\n\n\n\n<p>So where do all these potential deals come from in the first place?<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Deal Sourcing<\/h2>\n\n\n\n<p>VCs use their networks to generate deal flow:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong>30%<\/strong>&nbsp;come from the VCs&#8217; professional networks<\/li><li><strong>20%<\/strong>&nbsp;are referred by other investors<\/li><li><strong>8%<\/strong>&nbsp;come from existing portfolio companies<\/li><li><strong>30%<\/strong>&nbsp;are proactively sourced by the VCs themselves<\/li><li><strong>10%<\/strong>&nbsp;come inbound directly from company founders<\/li><\/ul>\n\n\n\n<p>Personal connections and relationships are crucial for sourcing the best opportunities. VCs build up networks throughout their careers to tap into the most promising startups before anyone else.<\/p>\n\n\n\n<p>Late-stage VCs rely more on their own proactive sourcing. Early-stage VCs get more deals referred to through their portfolio companies and networks.<\/p>\n\n\n\n<p>But regardless of stage, active deal generation is far more important than passive inbound inquiries.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Investment Selection<\/h2>\n\n\n\n<p>When evaluating potential investments, VCs focus on two key elements &#8211; the <strong>jockey<\/strong> and the <strong>horse<\/strong>:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>The\u00a0<strong>jockey<\/strong>\u00a0represents the founders and management team. Their skills, experience, and abilities to execute the business.<\/li><li>The\u00a0horse\u00a0represents the business itself. The product, technology, business model, market potential, and other company attributes.<\/li><\/ul>\n\n\n\n<p>Which does the VC value more &#8211; the jockey or the horse?<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">It&#8217;s All About the Team<\/h2>\n\n\n\n<p>The survey found that VCs consider the team <strong>the most important factor<\/strong> by far when making investment decisions.<\/p>\n\n\n\n<p>95% said the team was an important consideration, and 47% ranked it as the single most important factor.<\/p>\n\n\n\n<p>They look for management teams with relevant industry experience, entrepreneurial ability, talent, and teamwork skills. But passion is also valued, especially by early-stage investors.<\/p>\n\n\n\n<p>The business model, product, and market potential ranked lower in importance compared to the team. Although still crucial factors considered by most VCs.<\/p>\n\n\n\n<p>So VCs bet on the jockey over the horse. They believe that a great team can pivot and adapt even if the initial business idea doesn&#8217;t work. But a bad team won&#8217;t get far, even with the best idea.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Due Diligence<\/h2>\n\n\n\n<p>Before investing, VCs conduct in-depth due diligence on potential opportunities.<\/p>\n\n\n\n<p>On average, VCs take <strong>83 days<\/strong> to close a deal. During that time, they:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>Spend&nbsp;<strong>118 hours<\/strong>&nbsp;on due diligence<\/li><li>Call&nbsp;<strong>10 references<\/strong>&nbsp;to evaluate the team<\/li><\/ul>\n\n\n\n<p>Late-stage VCs take longer and consult more references. They have more data to analyze with established startups.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Valuation Methods<\/h2>\n\n\n\n<p>How do VCs determine valuations and investment terms for startups that have little financial history?<\/p>\n\n\n\n<p>Surprisingly, detailed discounted cash flow analyses are rare. Only 22% of VCs use net present value methods regularly.<\/p>\n\n\n\n<p>Instead, most VCs focus on:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong>Cash-on-cash returns<\/strong>&nbsp;&#8211; 63% of VCs<\/li><li><strong>IRR<\/strong>&nbsp;&#8211; Internal rate of return &#8211; 42%<\/li><\/ul>\n\n\n\n<p>These metrics better suit companies with uncertain futures. However early-stage VCs rely on them more than late-stage.<\/p>\n\n\n\n<p>Expected exit valuations are also crucial and considered important by 86% of VCs.<\/p>\n\n\n\n<p>And 20% of VCs don&#8217;t forecast cash flows at all for early-stage investments. The uncertainty makes detailed modeling unhelpful.<\/p>\n\n\n\n<p>So traditional valuation methods don&#8217;t fully apply to nascent startups. VCs use simpler metrics better suited for high-risk, high-reward investments.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Investment Terms<\/h2>\n\n\n\n<p>VCs structure investment deals to balance risks and incentives. Standard terms favor VCs, like:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong>Pro rata rights<\/strong>&nbsp;&#8211; Rights to invest in future rounds<\/li><li><strong>Liquidation preferences<\/strong>&nbsp;&#8211; Senior payout priority<\/li><li><strong>Participation rights<\/strong>&nbsp;&#8211; Downside protection plus upside share<\/li><\/ul>\n\n\n\n<p>But VCs won&#8217;t compromise on certain key terms like pro-rata rights and board control. Others like dividends are more flexible.<\/p>\n\n\n\n<p>Healthcare deals include more VC-friendly terms than IT deals. This suggests IT is more competitive with more bargaining power for founders.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Post-Investment Value-Add<\/h2>\n\n\n\n<p>VCs provide extensive support to their portfolio companies:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong>87%<\/strong>&nbsp;provide strategic guidance<\/li><li><strong>72%<\/strong>&nbsp;connect companies to future investors<\/li><li><strong>69%<\/strong>&nbsp;make customer introductions<\/li><li><strong>65%<\/strong>&nbsp;give operational guidance<\/li><li><strong>58%<\/strong>&nbsp;help hire board members<\/li><\/ul>\n\n\n\n<p>Many VCs take board seats to closely oversee the startups they invest in. This active involvement aims to increase the likelihood of deal success.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Exits<\/h2>\n\n\n\n<p>For VCs to make money, their portfolio companies need successful exits:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>15% of investments exit through&nbsp;<strong>IPOs<\/strong><\/li><li>53% exit through&nbsp;<strong>acquisitions<\/strong><\/li><li>32% end in&nbsp;<strong>failure<\/strong><\/li><\/ul>\n\n\n\n<p>So while the media focuses on VC-backed IPOs, most exits happen through acquisitions.<\/p>\n\n\n\n<p>Early-stage VCs have fewer IPOs and more failures compared to late-stage. Late-stage companies are lower risk and closer to a liquidity event.<\/p>\n\n\n\n<p>The best investments return 10x the capital or higher. But many startups fail, with 24% losing money for the VCs. So outcomes are highly variable.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Drivers of Success<\/h2>\n\n\n\n<p>What factors are most crucial to investment success and failure according to VCs?<\/p>\n\n\n\n<p>Predictably, the team topped the list again with 96% citing it as important for success.<\/p>\n\n\n\n<p>Company business factors ranked lower but were still considered important like:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>Technology<\/li><li>Business model<\/li><li>Market<\/li><li>Industry<\/li><\/ul>\n\n\n\n<p>Luck and timing were also frequently cited as success factors, especially by early-stage investors.<\/p>\n\n\n\n<p>However, VCs seldom attribute success to themselves or the board of directors.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">Inside VC Firms<\/h2>\n\n\n\n<p>How are VC firms organized behind the scenes?<\/p>\n\n\n\n<p>The average VC firm has:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>5 senior investment partners<\/li><li>14 employees total<\/li><\/ul>\n\n\n\n<p>Partners specialize in areas like deal flow, fundraising, or portfolio support. They spend:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>22 hours per week networking and sourcing deals<\/li><li>18 hours helping portfolio companies<\/li><\/ul>\n\n\n\n<p>Despite small teams, VC firms make investment decisions quickly. 50% require unanimous partner approval before investing in a startup.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\">VC-Investor Relationships<\/h2>\n\n\n\n<p>VCs raise capital for their investment funds from limited partners (LPs) like pension funds, endowments, and other large institutions.<\/p>\n\n\n\n<p>VCs believe LPs focus on fund performance metrics:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li>84% say cash-on-cash returns are important to LPs<\/li><li>81% say IRR is important<\/li><\/ul>\n\n\n\n<p>But LPs likely care more about absolute fund returns versus benchmark outperformance.<\/p>\n\n\n\n<p>Despite volatility, 93% of VCs still expect to beat public market returns over time. Their confidence highlights VC performance historically.<\/p>\n\n\n<h3 class=\"crp-list-title\">Related Posts<\/h3><ul class=\"crp-list\"><li class=\"crp-list-item crp-list-item-image-left crp-list-item-has-image\"><div class=\"crp-list-item-image\"><a href=\"https:\/\/www.tactyqal.com\/blog\/guide-to-deal-flow-in-venture-capital-private-equity\/\"><img loading=\"lazy\" decoding=\"async\" data-pin-nopin=\"true\" style=\"max-width: 50px; height: auto;\" width=\"50\" height=\"50\" src=\"data:image\/svg+xml;charset=utf-8,&lt;svg xmlns%3D&#039;http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg&#039; viewBox%3D&#039;0 0 150 150&#039;%2F&gt;\" class=\"attachment-50x50 size-50x50 ld-lazyload wp-post-image\" alt=\"Deal flow in venture capital\" data-src=\"https:\/\/tactyqal.com\/blog\/wp-content\/uploads\/2023\/06\/deal-flow-in-venture-capital-150x150.jpg\" data-aspect=\"1\" srcset=\"\" \/><\/a><\/div><div class=\"crp-list-item-title\"><a href=\"https:\/\/www.tactyqal.com\/blog\/guide-to-deal-flow-in-venture-capital-private-equity\/\">A Guide to Deal Flow in Venture Capital<\/a><\/div><\/li><li class=\"crp-list-item crp-list-item-image-left crp-list-item-has-image\"><div class=\"crp-list-item-image\"><a href=\"https:\/\/www.tactyqal.com\/blog\/adventure-capitalist-embracing-risk-and-reward\/\"><img loading=\"lazy\" decoding=\"async\" data-pin-nopin=\"true\" style=\"max-width: 50px; height: auto;\" width=\"50\" height=\"50\" src=\"data:image\/svg+xml;charset=utf-8,&lt;svg xmlns%3D&#039;http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg&#039; viewBox%3D&#039;0 0 150 150&#039;%2F&gt;\" class=\"attachment-50x50 size-50x50 ld-lazyload wp-post-image\" alt=\"adventure capitalist\" data-src=\"https:\/\/tactyqal.com\/blog\/wp-content\/uploads\/2023\/09\/adventure-capitalist-150x150.jpg\" data-aspect=\"1\" srcset=\"\" \/><\/a><\/div><div class=\"crp-list-item-title\"><a href=\"https:\/\/www.tactyqal.com\/blog\/adventure-capitalist-embracing-risk-and-reward\/\">Adventure Capitalist: Embracing Risk and Reward<\/a><\/div><\/li><li class=\"crp-list-item crp-list-item-image-left crp-list-item-has-image\"><div class=\"crp-list-item-image\"><a href=\"https:\/\/www.tactyqal.com\/blog\/angel-investing-vs-venture-capital\/\"><img loading=\"lazy\" decoding=\"async\" data-pin-nopin=\"true\" style=\"max-width: 50px; height: auto;\" width=\"50\" height=\"50\" src=\"data:image\/svg+xml;charset=utf-8,&lt;svg xmlns%3D&#039;http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg&#039; viewBox%3D&#039;0 0 150 150&#039;%2F&gt;\" class=\"attachment-50x50 size-50x50 ld-lazyload wp-post-image\" alt=\"angel investing vs venture capital\" data-src=\"https:\/\/tactyqal.com\/blog\/wp-content\/uploads\/2023\/07\/angel-investing-vs-venture-capital-150x150.jpg\" data-aspect=\"1\" srcset=\"\" \/><\/a><\/div><div class=\"crp-list-item-title\"><a href=\"https:\/\/www.tactyqal.com\/blog\/angel-investing-vs-venture-capital\/\">Angel Investing vs Venture Capital<\/a><\/div><\/li><li class=\"crp-list-item crp-list-item-image-left crp-list-item-has-image\"><div class=\"crp-list-item-image\"><a href=\"https:\/\/www.tactyqal.com\/blog\/how-to-start-your-own-vc-firm\/\"><img loading=\"lazy\" decoding=\"async\" data-pin-nopin=\"true\" style=\"max-width: 50px; height: auto;\" width=\"50\" height=\"50\" src=\"data:image\/svg+xml;charset=utf-8,&lt;svg xmlns%3D&#039;http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg&#039; viewBox%3D&#039;0 0 150 150&#039;%2F&gt;\" class=\"attachment-50x50 size-50x50 ld-lazyload wp-post-image\" alt=\"How to start a VC firm?\" data-src=\"https:\/\/tactyqal.com\/blog\/wp-content\/uploads\/2023\/07\/how-to-start-vc-firm-150x150.jpg\" data-aspect=\"1\" srcset=\"\" \/><\/a><\/div><div class=\"crp-list-item-title\"><a href=\"https:\/\/www.tactyqal.com\/blog\/how-to-start-your-own-vc-firm\/\">How to Start Your Own VC Firm?<\/a><\/div><\/li><li class=\"crp-list-item crp-list-item-image-left crp-list-item-has-image\"><div class=\"crp-list-item-image\"><a href=\"https:\/\/www.tactyqal.com\/blog\/why-irr-most-important-metric-venture-capital\/\"><img loading=\"lazy\" decoding=\"async\" data-pin-nopin=\"true\" style=\"max-width: 50px; height: auto;\" width=\"50\" height=\"50\" src=\"data:image\/svg+xml;charset=utf-8,&lt;svg xmlns%3D&#039;http%3A%2F%2Fwww.w3.org%2F2000%2Fsvg&#039; viewBox%3D&#039;0 0 150 150&#039;%2F&gt;\" class=\"attachment-50x50 size-50x50 ld-lazyload wp-post-image\" alt=\"IRR most important metric for VCs\" data-src=\"https:\/\/tactyqal.com\/blog\/wp-content\/uploads\/2024\/01\/IRR-most-important-metric-for-VCs-150x150.jpg\" data-aspect=\"1\" srcset=\"\" \/><\/a><\/div><div class=\"crp-list-item-title\"><a href=\"https:\/\/www.tactyqal.com\/blog\/why-irr-most-important-metric-venture-capital\/\">What is IRR and why is IRR the most important metric for Venture Capitalists<\/a><\/div><\/li><\/ul>\n\n\n<h2 class=\"wp-block-heading\">Key Takeaways<\/h2>\n\n\n\n<p>Some key lessons on VC decision-making:<\/p>\n\n\n\n<ul class=\"wp-block-list\"><li><strong>Networks are king<\/strong>&nbsp;for deal sourcing and due diligence<\/li><li>VCs bet on&nbsp;<strong>founders over ideas<\/strong>&nbsp;when investing<\/li><li>The&nbsp;<strong>team<\/strong>&nbsp;determines the likelihood of success or failure<\/li><li>VCs provide&nbsp;<strong>extensive post-investment support<\/strong><\/li><li>Simple return metrics and valuations suit startup&nbsp;<strong>uncertainty<\/strong><\/li><li><strong>Exits via M&amp;A<\/strong>&nbsp;are more common than IPOs<\/li><li><strong>Absolute returns<\/strong>&nbsp;drive VCs more than benchmark outperformance<\/li><\/ul>\n\n\n\n<p>Understanding the VC perspective provides founders, investors, and industry observers valuable insights into this influential realm of finance fueling innovation globally.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>Venture capitalists (VCs) play a crucial role in funding and growing innovative companies. Firms backed&#8230;<\/p>\n","protected":false},"author":2,"featured_media":9302,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"footnotes":""},"categories":[1,72],"tags":[73],"class_list":["post-9300","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-uncategorized","category-venture-capital","tag-venture-capital"],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v24.9 - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>How Do Venture Capitalists Make Decisions? - Tactyqal<\/title>\n<meta name=\"description\" content=\"VCs bet on founders over ideas when investing. The team determines the likelihood of success. 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