In the last couple of papers we have looked at studies of how angel investors make investment decisions. This week we add a supplementary review looking at how venture capitalists make decisions, courtesy of the clearly-named paper How Do Venture Capitalists Make Decisions? by Paul Gompers, Will Gornall, Steven N. Kaplan, and Ilya A. Strebulaev in 2016. I know you want to read along: download the paper here or here.
The authors surveyed 885 venture capitalists at 681 firms, to understand what VCs do. The paper covers how VCs make investment decisions, but actually ranges much more widely (over 95 pages!), becoming a useful overview for anyone interested in all the different aspects of “being a VC”. We included this paper in the “deal selection” series because of its discussion (Section 3.2 and especially Tables 7 & 8) of investment selection – how VCs make investment decisions – so we’ll focus this review on that here.
The main concern here is that all this comes from survey data, and no-one tells the truth in surveys. That doesn’t mean the analysis is pointless, but it does mean we should treat some claims VCs make with substantial caution. Their claimed “value-add” might not, in fact, add much value. (The authors carefully recount their survey methodology and respondent selection, but the concern remains.)
With that reservation in mind, what do we learn?
Firstly, “investment memoranda do not rank the importance of the different criteria” (p.17). In an apparent divergence from the norm, at VentureSouth we do have a ranking of different company areas when evaluating an investment (with “management team” and “exit strategy” as our #1 and #2 criteria). Nonetheless, this survey required the VCs to rank their criteria, with these results:
Jockeys vs horses: Like angel investors, VCs back the jockeys, with 47% of firms ranking “management team” as the most important criteria. Early stage VCs particularly ranked team as most important (53%, vs 39% of later-stage VCs), probably because the other “business factors” have less data to evaluate in earlier deals – same as we see in the angel space. Interestingly, though, IT-focused VCs prioritized team substantially more (50%) and health-focused VCs (only 32%) – because “product” is much more important to health-focused VCs (product rated as #1 criteria by 34% of health-VCs). I can see the logic for health (either this product will work or it won’t) but still this is a bit surprising.
What about the jockeys? “Ability” is critical here – though hard to know what that means! Californian VCs value “passion” more; healthcare VCs value industry experience more – which seems understandable.
Valuation: Only about half of VCs think “valuation” is important. If you believe the power law, valuation isn’t important; perhaps believing pricing discipline matters is contrarian? Later-stage VCs cite the importance of valuation much more than early stage VCs (74% vs. 47%) – which perhaps has been less true in 2022 than it was in 2016?!
Diligence: The average deal takes 83 days to close, after 110 hours of diligence and 10 reference calls. VCs do plenty of diligence (or, at least, they did in 2016!).
So, VCs pick deals based on their evaluation of the management team’s ability, which they check into in detail. If you’re raising post-angel rounds, definitely bear that in mind.
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There really is too much information across too many subjects in this paper to do justice to everything in a blog post, which is why we stuck to discussion of investment decisions in this post. Perhaps we’ll revisit some of the other ways VCs make decisions and operate in a future review.