How Do Venture Capitalists Make Decisions??>
Even though only 0.25% of companies receive venture financing, venture capital (VC) is an important source of funding that results in an out sized impact on the global economy.
While VCs fill a gap in the market by connecting entrepreneurs with investors, they are sometimes seen as a black box with little information on how they make decisions about their investments and portfolios. A surveying of almost 900 VCs on multiple areas such as deal sourcing, investment selection, valuation tools, deal structure, post-investment value add, exits, the internal organization of the firms and relationships with limited partners reveals some interesting facts:
Deal Sourcing – It’s not what you know it’s who. As we see in the table below, most of the deals come from the VCs’s networks. VC firms spend 15% of their time networking!
An average firm screen 200 companies per year and makes only four investments.
Investment Selection – The quality and experience of the management team is always the most important factor. And VCs think that the most important qualities are, in order: ability, industry experience, passion, entrepreneurial experience, and teamwork.
Valuation – Most VCs don’t really use financial techniques such as DCFs or NPV to evaluate their investments. Most commonly metrics used are cash-on-cash return, multiple of invested capital and net IRR. Another interesting finding is that fewer than 30% of companies actually meet projections.
VC Value Added – VCs are active investors and strive to add value to their companies post investment. They will improve governance through strategic guidance, by structuring the boards of directors and by helping in hiring outside managers and directors.
Further analysis can be found at The PNR Paper and the full report can be found here: How Do Venture Capitalists Make Decisions by Gompers P., Gornall W., Kaplan S. & Strebulaev (2016) — Chicago Booth