Chapter 1: The Role of Venture Capitalists

I recently came across an insightful study by Gompers et al. (2020) that delves into the decision-making frameworks employed by venture capitalists (VCs) when selecting entrepreneurs to back. This process is characterized by a set of meticulously chosen and stringent strategies, from which several noteworthy conclusions can be drawn.

Venture capital continues to serve as a vital source of funding for entrepreneurial ventures. Given the high demand for VC funding, these investors adhere to specific methods to determine how to allocate their financial resources and oversee their investments. The stringent nature of these tactics is notable; on average, a VC evaluates 200 businesses but invests in only four within a year.

VCs typically offer a range of services to the startups they back, including networking with investors, operational advice, strategic guidance post-investment, management recruitment, and customer connections.

For entrepreneurs, it is crucial to forge and nurture relationships with innovation networks and investors. During the VCs' search for investment opportunities, the majority of candidates originate from their professional contacts or referrals from other investors. Specifically, over 30% of potential investments are sourced from professional networks, while another 20% come from investor referrals. This underscores the importance of building strong connections in the entrepreneurial ecosystem.

During the selection phase, which VCs rank as the most significant aspect of value creation, they assess various criteria including market attractiveness, competitive landscape, product or service strategy, customer adoption, deal terms, and the quality of the management team.

Among these, the characteristics of the management team are deemed the most critical, with VCs placing substantial emphasis on any prior entrepreneurial success of its members. Essential qualities of a strong management team include capability, industry experience, passion, and effective teamwork.

Thus, we can assert that successful entrepreneurs are distinguished not only by their individual qualities and capabilities but also by their previous entrepreneurial achievements and relevant industry experience. Additionally, they must demonstrate teamwork, passion, and a high level of motivation. Successful founders also need to exhibit adaptability, as they navigate an ever-evolving landscape. Beyond leadership skills, they must be willing to make necessary changes in team structure and ownership to capitalize on potential valuations and exit strategies that could secure the venture's future success.

In terms of business-related factors, while several aspects are deemed less critical, the business model ranks highest at 83%, followed by product (74%), market (68%), and industry (31%).

To assess investment prospects, most VCs rely on the Multiple of Invested Capital (MOIC) as their primary metric, followed by the Internal Rate of Return (IRR). Notably, VCs typically do not forecast cash flows due to the high level of uncertainty present in the early stages of a venture.

When it comes to determining the valuation they will propose, VCs prioritize exit strategies, followed by valuations of comparable companies and desired ownership stakes.

During the contracting phase, VCs design agreements that allow them to regain control if the entrepreneur does not perform adequately. They can achieve this by reallocating control rights, cash flow, liquidation rights, and employment conditions, with a focus on vesting. Interestingly, their success rate in closing deals is around 60%, meaning they issue approximately 1.7 term sheets for each deal finalized.

In the post-investment phase, VCs concentrate on enhancing governance and actively monitoring the venture. They play a significant role in professionalizing the business, and if necessary, do not hesitate to replace underperforming entrepreneurs. They also contribute to forming the management team and may assist in external recruitment when required.

Spinelli and Adams (2016) identify the characteristics of "superdeals," which are ventures that meet the high standards set by VCs. These characteristics often mirror those of successful entrepreneurs, who should be industry leaders with proven entrepreneurial, managerial, and profit-and-loss experience. They should possess innovative or marketing/technology mindsets and have additional complementary skills. Furthermore, they should be committed, resilient, resourceful, creative, and uphold high integrity.

Luis Perez-Breva (2017) asserts that a crucial trait of successful entrepreneurs is their exceptionally low tolerance for failure, which is particularly relevant in the realms of innovation and entrepreneurship that inherently involve risk.

Chapter 2: Key Considerations for Entrepreneurs When Choosing VCs

Spinelli and Adams (2016) recommend that entrepreneurs diligently vet potential VCs to ensure they:

• Can provide the necessary capital
• Are willing to assist ventures at their current growth stage
• Have a solid understanding of the relevant industry
• Can offer essential support
• Are ethical, fair, and reputable
• Maintain a successful track record

References

Gompers, P.A., Gornall, W., Kaplan, S.N., & Strebulaev, I.A. (2020). How Do Venture Capitalists Make Decisions? Journal of Financial Economics, 135(1), 169–190.

Luis Perez-Breva (2017). Innovating: A Doer's Manifesto for Starting from a Hunch, Prototyping Problems, Scaling Up, and Learning to Be Productively Wrong. The MIT Press.

Spinelli, S., & Adams, R. (2016). New Venture Creation: Entrepreneurship for the 21st Century (10th ed.). McGraw Hill.