Discover the secret behind successful venture capitalism with a groundbreaking research study. Over the past 30 years, venture capital has been a key player in financing innovative companies, contributing to one-fifth of U.S. public company market capitalization and 44% of R&D spending.
Almost 900 venture capitalists were surveyed to unravel the decision-making process behind their investments and portfolios. The findings reveal that VCs excel in connecting entrepreneurs with big ideas but no funds, to investors with funds but no ideas. From sourcing potential investments to adding value post-investment, it’s been delved into the ways VCs make their investments successful.
The management/founding team is deemed the most important factor, with business model, product, market and industry also playing key roles. Exits are usually via acquisition, with deal selection being the most significant contributing factor. The research design includes reviewing existing surveys and input from academics and VCs, with a focus on obtaining responses from top MBA schools.
The results offer insight into the inner workings of successful venture capitalism and the keys to investment success.
Full report available: HERE (nBer)
Below you can find key takeaways from the report:
- We surveyed 885 institutional venture capitalists at 681 firms to learn how they make decisions across eight areas: deal sourcing, investment selection, valuation, deal structure, post-investment value-added, exits, internal firm organization, and relationships with limited partners.
- Over the past 30 years, venture capital has been an important source of financing for innovative companies. Companies that have received VC backing account for one-fifth of U.S. public company market capitalization and 44% of research and development spending. We surveyed almost nine hundred venture capitalists to better understand how they make decisions about their investments and portfolios. We found that VCs are particularly successful at solving an important problem in market economies - connecting entrepreneurs with good ideas but no money with investors who have money but no ideas.
- VCs source potential investments by generating deal flow, and then sort through those opportunities to find investable deals.
- We examine how VC firms select investments. We find that the nature of the entrepreneurial team is an important component of the sourcing and screening process, and that past success as an entrepreneur is an important factor that VC firms focus on when attracting potential investments.
- We explore whether VCs use the commonly-taught discounted cash flow method or instead rely on different ones, and whether they use historical operating information and uncertain future cash flows to make their investment decisions.
- Our survey asks how VCs write contracts and structure investments, and how they make trade-offs among different investment terms. We also explore how VCs choose their syndicate partners, and how networks play an important role in bringing new skills and talent to the investment team. We ask VCs to describe in detail the ways in which they add value to their portfolio companies, including improving governance and active monitoring, replacing entrepreneurs if they are not up to the task of growing their companies, and structuring the boards of directors. We ask about VCs' exits and find that deal sourcing and investment selection are important factors in determining VC returns.
- We asked VCs to assess the relative importance of deal sourcing, deal selection, and post-investment actions in value creation in their investments. We explore issues related to internal VC firm structure, examine the relationship between VCs and their investors, and examine how our results compare to both finance theory and the results of previous surveys of CFOs and private equity investors. Our 885 survey respondents represent 681 different VC firms. Most of the deal flow comes from the VCs' networks in some form or another, with 10% coming inbound from company management.
- VCs place the greatest importance on the management/founding team, with the business model, product, market, and industry being mentioned as important factors. The company valuation was ranked as fifth most important overall. Few VCs use discounted cash flow or net present value techniques to evaluate their investments. Instead, they rely on cash-on-cash return and internal rates of return, and are relatively inflexible on pro-rata investment rights, liquidation preferences, anti-dilution protection, vesting, valuation and board control. VCs provide many services to their portfolio companies, including strategic guidance, connecting investors, connecting customers, operational guidance, hiring board members, and hiring employees.
- VCs reported exiting roughly three-fourths of their successful deals via acquisition rather than through an IPO, and that one-quarter lost money. They also reported that each of the three activities contributed, with deal selection being the most important of the three. We asked VCs what factors contributed most to their successes and failures. The average VC firm is small, with 14 employees and 5 senior investment professionals, and spends 22 hours per week networking and sourcing deals and 18 hours per week working with portfolio companies. VCs believe that their investors care about cash-on-cash returns and net IRRs, and they expect to beat the market on a relative basis.
- The paper proceeds as follows: Section 2 describes the research design and summary statistics; Section 3 describes the VCs' responses to our survey; Section 4 concludes.
- In this section, we describe the research design of our survey. We reviewed many of the existing surveys, including those targeting CFOs of non-financial firms, limited partners of PE firms, and PE fund managers, and used similar questions to compare the responses of VCs to those of PE fund managers.
- We developed a draft survey, circulated it among academics and VCs for comments, made numerous changes, and then asked eight more VCs to take our updated survey and provide further comments.
- We designed the survey in Qualtrics and solicited all survey respondents via e-mail. We obtained our mailing list from several sources, including alumni databases from the Chicago Booth School of Business, Harvard Business School, and the Stanford Graduate School of Business.
- We emailed only people that we positively identified as venture capitalists, and excluded any respondent who did not identify as working at an institutional VC fund. We acknowledge that there may be a grey area that separates late-stage growth-equity VC funds and some PE funds.
- We targeted Chicago, Harvard, and Stanford MBAs and Kauffman Fellows, and received very high response rates from those groups. This likely biases our sample toward more successful VCs, but this bias supports our investigation.
- We administered a survey to alumni from top colleges and MBA programs using the Qualtrics website between November 2015 and March 2016 and matched the survey respondents with VentureSource and other data sources. We had a large response rate from the schools and organizations with which we are connected.
- Our survey had 71 questions and took 25 - 35 minutes to complete. Most respondents took the survey seriously and devoted reasonable effort towards it, and we enjoyed high completion rates from our alumni groups.
- We received 1,110 responses, and excluded 225 respondents who did not self-report they were institutional VC investors. We used all answers from our 885 institutional VC respondents, and 565 (64%) of those respondents finished the survey. We were able to match 89% of the firms to VentureSource, including all but one of the top 10 firms by number of investments. We asked respondents whether their firms specialized in a specific stage of company, industry, or geography. Of those that specialized in a particular stage, 245 (36%) invested only in seed- or early-stage companies, while 96 (14) invested only in mid- or late-stage companies.
- Most VC firms invest in 3 or more industries, and a full 39% are generalists without an industry focus. California-based VCs write more entrepreneur-friendly contracts than other regions, and are more likely to open up new offices. We took where the venture capitalist lived from their LinkedIn profile to explore whether geography matters. We found that the perceived differences between the U.S. East Coast and West Coast have no foundation. The average fund size of the institutional VC firms represented by our survey respondents is $286 million, while the median fund size is $120 million. The sample is divided into two subsamples based on fund size: small and large.
- In our sample of VC firms, the median firm was founded in 1998, invested in 73 deals over its history, and raised its most recent fund in 2012. The average VC firm made $11 million in investments, and the median firm had 4 investing GPs.
- Most respondents are partners in their VC firms, and 82% are senior level executives. Managing Partners are typically the most senior position, while Managing Directors can be either General Partners or junior Partners.
- Table 35 describes the correlation between indicator variables. It includes averages and standard errors, and tests differences between subsamples using a two sample, equal variance t-test.
- A pipeline of high-quality investment opportunities is considered an important determinant of success in the VC industry. Most VC deals are generated through professional networks, 20% are referred by other investors, 8% are from a portfolio company, and 30% are proactively self-generated.
- Early-stage investors are more likely to generate their own investment opportunities than later-stage investors, but there is little difference between the pipeline sources of high and low IPO firms.
- VCs use a multi-stage selection process to sort through investment opportunities. After the initial evaluation, a potential investment is brought to other members of the VC firm for review, and if approved, a term sheet is presented and a letter of commitment is signed. The median VC firm closes 4 deals per year. Of the 100 potential opportunities considered by a VC firm, one in four lead to meeting the management, one-third of those are reviewed at a partners meeting, and half of those proceed onward to due diligence. VC firms may provide "preemptive" term sheets even before formal due diligence, in an attempt to lock-up a deal.
- Early-stage VC firms have more proprietary deal flow and greater competition than late-stage VC firms, and larger VC firms initiate due diligence on more firms per closed deal.
- The IT and Health subsamples show substantial differences in deal funnel, with IT firms considering twice as many companies for each investment made, although after that stage, the funnel narrows with both types of VC firms.
- VCs start with hundreds of potential investments and narrow those down to make a small number of investments. They focus on the quality of the management team, the market, the competition, the product or technology and the business model.
- VCs have different views on how to select investments. Some focus more heavily on the management team, while others focus more heavily on the business: the product, technology, and business model.
- Table 7 shows that the management team was ranked as the most important factor by 95% of the VCs, and that business related factors were also frequently mentioned as important, but were rated as most important by only 37% of the firms.
- There is some interesting cross-sectional variation in the importance of team and valuation among investors. Early-stage investors are more likely to focus on team and valuation, while late-stage investors are more likely to focus on business model and valuation.
- Table 7 indicates that management team is consistently the most important factor VCs consider when choosing portfolio companies. Ability, industry experience, passion, entrepreneurial experience, and teamwork are the most mentioned factors.
- VCs devote substantial resources to conducting due diligence on their investments, and the average deal takes 83 days to close. Late-stage firms call more references than early-stage firms.
- VC firms invest using convertible preferred equity, which gives them cash flow rights and an ownership stake in the company.
- In the survey, VC firms ranked exit considerations as the most important factor in deciding on the valuation they offer a company, with comparable company valuations ranking second and desired ownership third. Competitive pressure exerted by other investors was markedly less important than exit considerations.
- We asked VCs whether they set valuations using investment amount and target ownership. Half of investors use this simple decision rule, but early-stage investors are more likely to use more sophisticated methods.
- We asked respondents how important financial metrics such as internal rate of return, cash-on-cash return, or net present value are in making investment decisions. The results are similar to those for private equity investors, who rely primarily on internal rates of return and multiples to evaluate investments.
- 17% of early-stage investors do not use any financial metrics, and almost half of VCs admit to often making gut investment decisions. Late-stage and larger VCs require lower IRRs of 28% to 29% while smaller and early-stage VCs have higher IRR requirements.
- 64% of VC firms adjust their target IRRs or cash-on-cash multiples for risk, and half adjust for time to liquidity. 23% of VC firms use the same metric for all investments, indicating that they do not make any adjustments for risk, time to liquidity or industry conditions.
- VC firms appear to make decisions in a way that is inconsistent with predictions and recommendations of finance theory. They adjust for idiosyncratic risk and neglect market risk, and use the same metric for all investments.
- 20% of VC firms do not forecast company cash flows, and the prevalence of non-forecasting varies by the stage of company the firm targets. For early-stage companies, forecasting and discounting cash flows arguably would generate very imprecise estimates of value.
- VCs report that fewer than 30% of their portfolio companies meet their projections, and early-stage VCs require a higher IRR to offset greater risk.
- We asked VCs whether they had invested in unicorns and whether they thought they were overvalued. No significant difference was found between VCs who invested in unicorns and VCs who did not.
- VCs negotiate contracts that give them cash flow, control, and liquidation rights. These terms favor the investor over the entrepreneur and are used in 81% of investments, 53% of the time, and 45% of the time, respectively. Investor-friendly terms are less common, but can be useful. Cumulative dividends accumulate over time, full-ratchet anti-dilution protection gives the VC more shares if the company raises a future round at a lower price, and liquidation preference gives investors a seniority position in liquidation.
- There is substantial cross-sectional variation in the use of terms. IT VC firms are more founder friendly than healthcare VC firms, and California VC firms are less likely to use participation rights, redemption rights, or cumulative dividends.
- We asked survey respondents to indicate the terms that they are more or less flexible with when negotiating new investments. They rated their flexibility on a scale of not at all flexible, not very flexible, somewhat flexible, very flexible, and extremely flexible.
- The VCs are not overly flexible on their terms, with most terms scoring between not very flexible and somewhat flexible. Dividends, redemption rights, option pool, investment amount, and participation are the most flexible terms for the VCs.
- Healthcare VC firms are less flexible on many features than IT VC firms. This is consistent with Healthcare companies being more susceptible to internal risks.
- VC firms routinely invest with other firms as part of a syndicate. Capital constraints, complementary expertise, and risk sharing are all important factors in syndication decisions, with capital constraints being the most important for 39% of VC firms. Early-stage VC firms care more about risk sharing and future participation in deals than do larger VC firms, and small VC firms care more about capital constraints.
- Table 20 shows that expertise and past shared successes were identified as important factors by the most VCs, while reputation, track record and capital were less likely to be most important.
- Previous empirical work finds that VCs add value to their portfolio companies after they invest. In this section, we ask VCs how they interact with their portfolio companies after investment, particularly activities in adding value to portfolio companies.
- VCs interact frequently with their portfolio companies, and there is little variation across subsamples. There is also little difference in the frequency of interactions between early-stage and late-stage VCs, perhaps because all companies go through critical phases that require regular involvement of investors. Table 22 looks more deeply into VC interaction with their portfolio companies by asking what type of value-add VCs provide. It shows that VCs help companies connect with investors, connect to customers, and provide operational guidance, as well as help with hiring board members and employees. One out of five respondents described their activities as helping with liquidity events, mentoring, fund raising, and product development.
- VCs are active investors and add value to their portfolio companies by helping with customer introductions, operational guidance, and board governance. The timing and type of exit is critical to VC investment success.
- The average VC firm reports that 15% of its exits are through IPOs, 53% are through M&A, and 32% are failures. It is possible that some M&A events are disguised failures in the VC industry.
- We compared survey responses with data matched from VentureSource to ascertain whether there is an appreciable bias in the data. The results suggest that the VCs are, on average, reporting their experience truthfully.
- Empirically, it is difficult to measure the exact returns earned by VC firms using commercially available datasets. The results indicate that there is a wide dispersion of financial outcomes for VC investments and further supports the notion that there is a wide distribution among of outcome for M&A transactions.
- VCs exert effort and expend resources on deal sourcing, deal selection and post-investment value-add. In Table 25, we ask VCs how important they believe deal sourcing, deal selection, and VC value-add are in contributing to value creation. Deal selection is assessed as the most important factor for all of the sub-categories, and is relatively more important for the high IPO firms.
- 96% of VC firms identified team as an important factor, and 56% identified team as the most important factor for success (failure). The business-related factors were more important for later-stage and healthcare VCs, and timing and luck also mattered. Few VCs ranked their own contribution or the board of directors as the most important factor for success or failure.
- The emphasis on team as critical for success is consistent with the emphasis on team in selection, and the lack of emphasis on own contribution is less consistent.
- VCs mention several factors more often as having importance in success rather than failure, including luck, timing, own contribution and technology.
- The average institutional VC firm employs 14 people, 5 of whom are senior partners in decision-making positions. Healthcare VC firms are more likely to have venture partners, potentially because healthcare and biotech industry investments require specialized skills that non-full time venture partners (such as 32.
- The composition of VC firms is relatively uniform, although larger and more successful funds are, of course, larger. Partners in 60% of the funds specialize in different tasks, with 44% of partners being generalists, 52% being responsible for fund raising, and 55% being responsible for deal making. VCs spend 18 hours per week working with their portfolio companies, and 15 hours per week sourcing potential deals. They spend 7 hours per week networking, and 8 hours per week managing their firms and 3 hours per week managing LP relationships and fundraising. In the VC industry, partners are responsible for each portfolio company. Alternatively, firms may choose to compensate partners based on time use.
- Table 31 reports that 74% of VC firms compensate their partners based on individual success, and that 44% of VC firms give partners an equal share of fund capital.
- The relationship between compensation of VCs, their contracts with their investors (LPs), and outcomes is not explored in detail in academic research. Understanding how funds make initial investment decisions could be an interesting avenue for future research.
- We conclude our survey by asking VCs a set of questions concerning the interactions they have with their limited partner investors. The results indicate that most LPs are motivated by absolute rather than relative performance, and are not concerned with performance relative to VC funds or the S&P 500.
- Table 34 shows that VC firms market a net IRR of 24% to their LPs, and a cash-on-cash multiple of 3.5, which is similar to the IRR private equity investors market to their LPs.
- The vast majority of VCs expect to beat the public markets, and 71% are similarly optimistic about the VC industry as a whole.
- In this paper, we survey 885 institutional VCs at 681 firms to learn how they make decisions across eight areas: deal sourcing, investment selection, valuation, deal structure, post-investment value-added, exits, internal VC firm issues, and external VC firm issues. The results show that VCs favor the jockey view of investing over the horse view.
- VCs do not use the net present value or discounted cash flow techniques taught at business schools, and rely on multiples of invested capital and internal rates of return.
- Table 12: Required IRR and Cash-on-Cash Multiples for Investments Table 15: Forecasting Period Table 19: Factors That Lead to Syndication Table 22: Activities in Portfolio Companies
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