How Venture Capitalists Make Decisions

Over the past 30 years, venture capital has been a vital source of financing for high-growth start-ups. Amazon, Apple, Facebook, Gilead Sciences, Google, Intel, Microsoft, Whole Foods, and countless other innovative companies owe their early success in part to the capital and coaching provided by VCs. Venture capital has become an essential driver of economic value. Consider that 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.

Despite all that, little is known about what VCs actually do and how they create value. To be sure, most of us have the broad sense that they fill a crucial market need by connecting entrepreneurs who have good ideas but no money with investors who have money but no ideas. But while the companies that VCs fund may make headlines and transform entire industries, venture capitalists themselves often prefer to remain in the background, shrouded in mystery.

To pull back the curtain, we recently surveyed the vast majority of leading VC firms. Specifically, we asked about how they source deals, select and structure investments, manage portfolio companies post-investment, organize themselves, and manage their relationships with limited partners (who provide the capital VCs invest). We received responses from almost 900 venture capitalists and followed up with several dozen interviews—making our survey of VCs the most comprehensive to date.

To solicit respondents to our survey, we used alumni databases from the University of Chicago Booth School of Business, Harvard Business School, and the Stanford Graduate School of Business. According to a study by Pitchbook, more than 40% of the VCs with MBAs graduated from one of those schools. We also tapped the Kauffman Fellows program’s data on its VC alumni. The National Venture Capital Association generously gave us a list of its individual members. Finally, we used the contact information of VCs in the VentureSource database.

We administered the survey between November 2015 and March 2016. The survey was fully confidential, and all the reported results are based on an aggregation of many responses to exclude the possibility of inferring any specific respondent’s answers. However, the survey was not anonymous, and we matched the respondents with VentureSource and other data sources.

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.

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 and proactively reach out to those entrepreneurs who share a vision of where the world is going.”

What these results reveal is just how difficult it can be for entrepreneurs who are not connected to the right social and professional circles to get funding. Few deals are produced by founders who beat a path to a VC’s door without any connection. Some of the VC executives we interviewed acknowledged the downsides of this reality: that the need to be plugged into certain networks can disadvantage entrepreneurs who aren’t white men. Nonetheless, many VCs felt the situation was improving. For instance, Theresia Gouw, an early investor in Trulia and a founding partner at Acrew Capital, told us, “While historically there have been significant roadblocks for women and underrepresented minorities to break into these networks, the industry has begun to recognize the missed opportunities and talent these groups represent. Firms have prioritized diversifying their partnerships, and as a result these networks are becoming increasingly easier to penetrate.”

Narrowing the Funnel

Even for entrepreneurs who do gain access to a VC, the odds of securing funding are exceedingly low. Our survey found that for each deal a VC firm eventually closes, the firm considers, on average, 101 opportunities. Twenty-eight of those opportunities will lead to a meeting with management; 10 will be reviewed at a partner meeting; 4.8 will proceed to due diligence; 1.7 will move on to the negotiation of a term sheet with the start-up; and only one will actually be funded. A typical deal takes 83 days to close, and firms reported spending an average of 118 hours on due diligence during that period, making calls to an average of 10 references.

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.

Though VCs reject far more deals than they accept, they can be very aggressive when they spot a company they like. Vinod Khosla, a cofounder of Sun Microsystems and the founder of Khosla Ventures, told us that the power dynamic can quickly flip when VCs become excited about a start-up, particularly if it has offers from other firms. “The best start-ups with inspiring entrepreneurs have intense competition to fund them,” he explained. “For VCs, having a clear message about what you will and will not do, how you provide real venture assistance, and how you approach bold visions is key to winning these types of opportunities. And they matter tremendously for fund returns.”

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.”

Indeed, in our survey founders were cited the most frequently—by 95% of VC firms—as an important factor in decisions to pursue deals. The business model was cited as an important factor by 74% of firms, the market by 68%, and the industry by 31%.

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. 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.

Pablo Boneu/BABEL • SP • NY

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. As J.P. Gan of INCE Capital explained to us, “Successful VC deals take a long time to develop, mature, and exit. We very much focus on potential return multiple rather than on NPV or IRR at the time of investment. IRR is only calculated after the fact, when there is an exit for our limited partners.”

After the Handshake

To aspiring entrepreneurs, the typical VC term sheet often seems to be written in a foreign language. Of course, it’s critical for company founders to understand these contracts. They’re designed to ensure that the entrepreneur will do very well financially if he or she performs b

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