The venture capital (VC) industry started from a humble beginning. Since then, it has become one of the most vital asset classes in the private equity space. In the last decades, many VC-backed startups have become global brands. You should know how the VCs make investment decisions if you need funding.
Why does it matter if you know how they think and the selection process?
It is simple.
Once you understand their mindset, you can prepare a better pitch. While there is no guarantee that a VC will provide funds, you can increase the odds in your favor.
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Thoughts and Processes Behind VC Investment Decisions
VCs do not just throw money into any startup with a great business idea. The reality is that many of them provide capital to only a few companies each year. So, besides the business concept itself, what else do they consider?
A complete understanding of venture capitalists, though, is not easy. For one, many of them prefer to be in the background. Nonetheless, one should never underestimate their importance to the US and global economy. In 2020, for instance, over 10,800 startups received funds from VCs. More than 1,965 VC firms managed 3,680 venture funds with approximately $548 billion in assets.
While it is impossible to determine their motivations, most think about these things when selecting investments.
1. Generating Deal Flow
Before selecting investments, VCs need to find startups that seek funding. Generating deal flow, a term used to describe this activity, is what they do all the time. Being diligent is of utmost importance to not miss potential investments that may turn into a unicorn.
Where do the VCs find opportunities for early-stage investments?
About 30% of startups they invested in are referrals from former colleagues, entrepreneurs, and other acquaintances. Meanwhile, 20% came from referrals of other investors, while 8% were referrals from existing portfolio companies. Only 10% came from cold email pitches.
Investors understand that opportunities do not often come knocking on their doors. As such, they also proactively search and reach out to startup founders. In one survey, about 30% of high-quality deal sourcing leads came from the VC initiating contact.
Based on the figures cited, it is evident that having some form of connection with VCs is essential to securing capital.
What can you do to increase the chances of getting funded?
One thing you can do is to connect with social and professional circles where there are VCs. Although your goal is to have some people refer you to VCs they know, there are other benefits. For one, you are mingling with entrepreneurs and professionals. By exchanging ideas, you could learn many new things that could prove invaluable in the future.
2. Narrowing the Funnel
Suppose you get access to a VC. There is still no guarantee of securing seed money.
For every 100 investment choices:
- 28 will lead to a meeting between the startup and the VC’s management team
- Of the 28, the VC will review only 10 startups in a partner meeting
- Of the 10, the VC will exercise due diligence on only five startups
- After due diligence, the VC will negotiate a term sheet with 1 to 2 startups
- Only one will receive funding
On average, selecting investments and deciding on a startup takes 83 days. Considering that only 1 out of 100 startups get funded, one could say that such an endeavor is exceptionally challenging. But that is not always the case. Occasionally, some founders come up with a business idea that gets the attention of several VCs. In this case, the investors would pursue such a startup.
How do VCs narrow the funnel?
Some may assume that VCs prioritize the business model and strategy. While true, it is only to a certain degree. In reality, VCs consider the founding team as they narrow down on potential investments.
What essential factors do VCs cite when narrowing down the funnel?
- 95% cite the founder
- 74% cite the business model
- 68% cite the market
- 31% cite the industry
As you can see, company valuation is not crucial as the four factors mentioned above. Before committing funds, most venture capital firms need to believe and trust a founder.
What methods do VCs use to evaluate investment opportunities?
Large companies usually use Discounted Cash Flow (DCF) analysis to evaluate investment opportunities. But only a few VCs would use that or any other standard financial-analysis techniques. Instead, most of them use Cash-on-Cash Returns. This method refers to the “multiple of invested capital” – the cash income earned on the cash investment.
The annualized Internal Rate of Return (IRR) generated by a deal is another technique used by VCs. But contrary to corporate practice, most of them also do not adjust their target returns for market risks. Surprisingly, around 20% of VCs and 31% of early-stage VCs do not forecast company financials when investing in startups.
Why do most VCs ignore the typical financial evaluation used in corporate companies?
Unlike traditional businesses that sell products and services, VCs earn real money from Mergers and Acquisitions (M&A) and Initial Public Offering (IPO). A successful exit can generate a significant return, especially when they have a unicorn. Because of that, they bet on the potential for such an exit rather than the near-term cash flows.
3. Coming to an Agreement
In practically all cases, the term sheet offered by VCs contains a provision that the startup must be profitable. If not, they can take over the company.
VCs can do that by:
- Allocating cash flow rights to incentivize the founder to perform
- Board control and voting rights, so the VC to intervene if they deem it necessary
- Liquidation rights, so the VC can distribute the payoff if the company is not profitable and likely to fail
- Employment terms, including giving incentives to the entrepreneurs for performing and staying with the company
In most deals, startup founders can retain control of the company if they hit predetermined milestones. But if they cannot hit those targets, the VC can change the company’s direction. They can also bring in a new management team.
Are VCs flexible during negotiations?
VCs are usually flexible on matters that do not have a significant effect on the potential returns, such as:
- Option pool
- Participation rights
- Investment amount
- Redemption rights
But if the terms can affect the potential returns, most VCs consider them non-negotiable. These include:
- Pro-rata investment rights, allowing the VC to acquire more stake in a company
- Liquidation rights that they may exercise if the company is floundering
- Antidilution rights to protect their possible economic upside
- Vesting the founder’s equity
- Board control
- Company valuation
Are there other things that VCs think about during the courtship or negotiation with startups?
As mentioned, VCs place great importance on founders and the management team. Such attitude makes sense as the success of startups rests on the founding management team. No matter how promising a business idea is, it cannot fly with a mediocre team.
But competency alone or expertise may not be enough. Many VCs, for instance, also consider factors outside of the financial realm. They want to understand matters such as the vision and goal of founders. For them to invest, they have to share similar dreams.
What Happens After Investing in a Startup
VCs have vested interests after funding startups. And so, many of them want to have an active role. One example of that is their insistence on having control rights. It is one of the ways they can protect their investments.
In most cases, though, they take the role of advisers. For sure, their experience and expertise are a huge plus for entrepreneurs. But VCs do follow the principle of diversification. Be that as it may, they would need to manage their time too regarding interacting with the companies in their portfolio.
Generally, VCs interact with these percentages of their portfolio companies:
- 60% of their portfolio companies at least once a week
- 28% of their portfolio companies several times a week
What do VCs do for startups?
For sure, they do not provide the same level of services to all companies. But generally, these are the percentages of portfolio companies that receive their services:
- Strategic guidance (87%)
- Connecting with other investors (72%)
- Connecting with customers (69%)
- Operational guidance (65%)
- Help hire board members (58%)
- Help hire employees (46%)
As you can see, the involvement of VCs in the companies they invest in is primarily advisory. It is, in a sense, their means of adding value to startups.
Why do VCs spend more time and effort on some and not all companies?
Even after doing their due diligence and investing in startups, VCs understand that not all ventures will be successful. And so, they have to prioritize their time and resources. Hence, they will be most active with companies that lets them deliver positive risk-adjusted returns (or simply the “alpha” in investment terms).
Why a VC Would Choose to Invest in Your Startup
Getting backed by a VC comprises three main activities – deal sourcing, selection, and post-investment actions. Based on their collective experience, most VCs agree that deal selection played the most significant role in a positive outcome.
To be more specific, the founding management team contributes the most to success or failure. And during the selection process, VCs scrutinize the founders. Once the company starts operation, the founders’ ability to hire the right people comes into play. No person can succeed alone, so assembling a great team is of utmost importance. For this reason, many VCs assist in finding talented employees.
Knowing the activities involved, what would you do?
- Deal Sourcing. Instead of relying on sending cold emails to potential investors, you should also involve yourself in social and professional circles where you might meet VCs. Not only that, you could get a lot of exposure from platforms like Allianse, which uses advanced AI to match you with the right investors.
- Deal Selection. By now, you have a better understanding of the characteristics most VCs seek. Ask yourself if you are that kind of person. Ideally, the VC is someone you know on a personal level. But if that is not the case, the next best thing to do is ask for referrals. VCs are more likely to invest if there is some form of connection between them and you.
After getting funded, the VC will do their best to assist you in becoming successful. They will because they arguably have more stake than you, especially if the seed money is enormous. But it is your time to perform and deliver on the promises of your pitch.