How Do Venture Capitalists Make Decisions?(medium.com)
medium.com
How Do Venture Capitalists Make Decisions?
https://medium.com/pnr-paper/venture-capital-decision-making-c3258bc1b09c
32 comments
Hey op here, good feedback,
Yes factors do interact. However it was not really part of the survey.
One thing they had was the difference between most important factors and important factors
In the summary, I reported only the most important factors. If you look at the important factors here are the results, which show a bit the factors interacting:
Team 96% for early, 93% for late
Business model 84% for early, 86% for late
Product 81% for early, 60% for late
Market 74% for early, 69% for late
Industry 30% for early, 37% for late
Valuation 47% for early, 74% for late
Ability to add value 44% for early, 54% for late
Fit with the fund 48% for early, 54% for late
There are also other factors that will impact the companies valuation such as anticipated exit, comparable companies, competitive pressure and desired ownership.
For more a deeper analysis I think it would be interesting to see the survey applied to a scenario planning model like the team at the OS Fund did [1].
[1] http://osfund.co/the-osf-playbook/ [EDIT]: Formatting
Yes factors do interact. However it was not really part of the survey.
One thing they had was the difference between most important factors and important factors
In the summary, I reported only the most important factors. If you look at the important factors here are the results, which show a bit the factors interacting:
Team 96% for early, 93% for late
Business model 84% for early, 86% for late
Product 81% for early, 60% for late
Market 74% for early, 69% for late
Industry 30% for early, 37% for late
Valuation 47% for early, 74% for late
Ability to add value 44% for early, 54% for late
Fit with the fund 48% for early, 54% for late
There are also other factors that will impact the companies valuation such as anticipated exit, comparable companies, competitive pressure and desired ownership.
For more a deeper analysis I think it would be interesting to see the survey applied to a scenario planning model like the team at the OS Fund did [1].
[1] http://osfund.co/the-osf-playbook/ [EDIT]: Formatting
In the report, I didn't see much mention of traction, revenue, social proof, etc.
For technology, sure, bio-medical VCs can evaluate that, but I doubt that information technology VCs can or will.
For deal flow, a common remark of VCs is that an entrepreneur who contacts a VC direction is just "coming over the ransom" which means that they are to be ignored. From that contempt, tough to believe that VCs care much about deal flow.
A common remark is that VCs lose money on ~90 percent of their deals but that last 10 percent, or even the one best deal, makes up for all the losses and makes money besides. Okay, then, necessarily what the VCs are interested in are exceptional deals. That is, they are looking for another Microsoft, Apple, Cisco, Google, Facebook. Okay, then in their deal sourcing they have a fundamental problem: They are getting too much of their deal flow from their colleagues, and that's not promising for finding the needed exceptional deals.
For technology, sure, bio-medical VCs can evaluate that, but I doubt that information technology VCs can or will.
For deal flow, a common remark of VCs is that an entrepreneur who contacts a VC direction is just "coming over the ransom" which means that they are to be ignored. From that contempt, tough to believe that VCs care much about deal flow.
A common remark is that VCs lose money on ~90 percent of their deals but that last 10 percent, or even the one best deal, makes up for all the losses and makes money besides. Okay, then, necessarily what the VCs are interested in are exceptional deals. That is, they are looking for another Microsoft, Apple, Cisco, Google, Facebook. Okay, then in their deal sourcing they have a fundamental problem: They are getting too much of their deal flow from their colleagues, and that's not promising for finding the needed exceptional deals.
I'd say anticipated exit, comparable companies, competitive pressure and desired ownership play the role of social proof. For revenue, most likely related to the business model.
The interesting distinction in the report was between deal flow and deal selection. VCs care more about deal selection. For deal flow most of it is in their own network or through syndicates.
For the 90% fail 10% success you can look at exit multiples coupled with type of exit (M&A, IPO, failure).
My hypothesis is that most of them dont really have a proprietary deal flow and are unable to make great deal selection apart from the top VCs..
The interesting distinction in the report was between deal flow and deal selection. VCs care more about deal selection. For deal flow most of it is in their own network or through syndicates.
For the 90% fail 10% success you can look at exit multiples coupled with type of exit (M&A, IPO, failure).
My hypothesis is that most of them dont really have a proprietary deal flow and are unable to make great deal selection apart from the top VCs..
> For revenue, most likely related to the business model.
You totally lost me: In the report, I just didn't see any mention of traction or revenue. I can't see that traction or revenue are part of the business model, product, technology, or anything else that was mentioned.
Business model? Sure, for some early stage, can discuss that independent of traction or revenue.
IMHO, from all I've seen, for information technology VCs and early stage, far and away, far above anything else, what VCs want to see is traction significantly high and growing rapidly. In comparison, everything else is small potatoes. The form of traction they want to see most of all is revenue, but they will also consider number of unique users per month, any COMSCORE data, number of Web pages viewed per month, etc.
My guess is that the LPs enforce the high interest in traction. Or, the LPs very much like traditional accounting, even the traditional approach of a commercial banker where a loan is against assets as counted by usual accounting. Well, for startups, the commercial banker approach won't work, so the VCs talk the LPs into accepting a substitute, a surrogate, traction. So, the asset they are investing in is the traction. For team, determination, technology, business model, etc. accountants and commercial bankers don't care about those, so LPs don't either, so VCs don't either.
Or the VCs believe in a Markov assumption: The past and future of the company are conditionally independent given the current traction and its rate of growth. Or, if the traction is good, then everything must be good. If the traction is not good, then nothing else matters.
The report mentioned that VCs can invest in ideas. My guesses are that information technology VCs regard an idea and a dime as not quite enough to cover half of a 10 cent cup of coffee. The standard remark is that "ideas are easy, plentiful, and worthless. Execution is hard, rare, and everything." Of course, by an idea what VCs have in mind is just some fast, over the back fence to a neighbor description of the project, say, as a user or customer would see it. For people in technology, an idea is something that might get a patent, be protected as a trade secret, is the crucial, core, enabling secret sauce and the main asset of the whole project. Information technology VCs won't evaluate such ideas. I can think of no sense in which a VC will invest in an idea. Moreover, I have to suspect that VCs really hate ideas that would be secret sauce from research. Why? Because the VCs know that that then would be part of the business they would not understand, and that scares them. For technology, what information technology VCs want is just some routine software that, if necessary, they could turn over to any of 20 programmers they could recruit in less than a week.
My guess about VCs is that they are looking for some special situations. So, there are, say, four co-founders. The company has traction significant and growing rapidly. But so far the company is still losing money and, really, is about to go out of business. All the credit cards are maxed out. All four co-founders are married, and all the wives are pregnant. Then, sure, a VC might give enough money for a little more runway and take a lot of control. The company is so desperate that they are ready to sign a bad business deal. The VC sees that even if the company totally flops, given the four co-founders, he could likely get his investment back from just an acqui-hire.
You totally lost me: In the report, I just didn't see any mention of traction or revenue. I can't see that traction or revenue are part of the business model, product, technology, or anything else that was mentioned.
Business model? Sure, for some early stage, can discuss that independent of traction or revenue.
IMHO, from all I've seen, for information technology VCs and early stage, far and away, far above anything else, what VCs want to see is traction significantly high and growing rapidly. In comparison, everything else is small potatoes. The form of traction they want to see most of all is revenue, but they will also consider number of unique users per month, any COMSCORE data, number of Web pages viewed per month, etc.
My guess is that the LPs enforce the high interest in traction. Or, the LPs very much like traditional accounting, even the traditional approach of a commercial banker where a loan is against assets as counted by usual accounting. Well, for startups, the commercial banker approach won't work, so the VCs talk the LPs into accepting a substitute, a surrogate, traction. So, the asset they are investing in is the traction. For team, determination, technology, business model, etc. accountants and commercial bankers don't care about those, so LPs don't either, so VCs don't either.
Or the VCs believe in a Markov assumption: The past and future of the company are conditionally independent given the current traction and its rate of growth. Or, if the traction is good, then everything must be good. If the traction is not good, then nothing else matters.
The report mentioned that VCs can invest in ideas. My guesses are that information technology VCs regard an idea and a dime as not quite enough to cover half of a 10 cent cup of coffee. The standard remark is that "ideas are easy, plentiful, and worthless. Execution is hard, rare, and everything." Of course, by an idea what VCs have in mind is just some fast, over the back fence to a neighbor description of the project, say, as a user or customer would see it. For people in technology, an idea is something that might get a patent, be protected as a trade secret, is the crucial, core, enabling secret sauce and the main asset of the whole project. Information technology VCs won't evaluate such ideas. I can think of no sense in which a VC will invest in an idea. Moreover, I have to suspect that VCs really hate ideas that would be secret sauce from research. Why? Because the VCs know that that then would be part of the business they would not understand, and that scares them. For technology, what information technology VCs want is just some routine software that, if necessary, they could turn over to any of 20 programmers they could recruit in less than a week.
My guess about VCs is that they are looking for some special situations. So, there are, say, four co-founders. The company has traction significant and growing rapidly. But so far the company is still losing money and, really, is about to go out of business. All the credit cards are maxed out. All four co-founders are married, and all the wives are pregnant. Then, sure, a VC might give enough money for a little more runway and take a lot of control. The company is so desperate that they are ready to sign a bad business deal. The VC sees that even if the company totally flops, given the four co-founders, he could likely get his investment back from just an acqui-hire.
> Will you do it now that Steve Jobs is back from the dead and has agreed to be the CEO?
No. I've watched too many movies where this ended badly.
No. I've watched too many movies where this ended badly.
Is it a perfect team, with a complete working product, massive user base and sales and no risk and lots of other investors wanting in? We're in!
Else, "Your company is not a fit for us right now but keep us in the loop."
Else, "Your company is not a fit for us right now but keep us in the loop."
Mostly ;)
Marc Andreessen wrote a good article on the layers of risks that VCs are looking into [1]. Most of them want to maximize the upside while minimizing the downside..
[1] http://pmarchive.com/guide_to_startups_part2.html
Marc Andreessen wrote a good article on the layers of risks that VCs are looking into [1]. Most of them want to maximize the upside while minimizing the downside..
[1] http://pmarchive.com/guide_to_startups_part2.html
Most of the time is is just the last factor at work - everyone wants to date the hot guy even if he is only “hot” because everyone wants to date him.
As a founder, my observation of seed stage fundraising is that there's a high degree of randomness, or at least most of the factors involved are outside of your immediate or near-term control. Decisions are mostly based on the excitement investors have for the team and idea. Since excitement is emotional, this can really vary. Decisions can be made based on how the investor's day has gone so far.
You would think that success is mostly about your pitch, and if you have great slides, meaningful graphs, and nail the delivery then you get money. It's not like this at all. VC fundraising is not Shark Tank. It's market timing, it's people, it's emotions.
There's a saying that seed funding is easy and the money grows on trees, and things don't get hard until the Series A. I think the more nuanced explanation is that when seed funding is successful it is usually easy (the stars aligned!), otherwise it's impossible. This leads to successful founders telling stories about easy seed rounds, but there are probably fifty times as many founders who have failed to raise that just don't talk about it.
Here's what Aaron Harris of YC said this year:
"Unfortunately, fundraising takes up a lot more time and thought than it should, because it seems like something that should be systematic but is actually chaos, which really confuses people, especially people who are logically brained." (source: https://www.youtube.com/watch?v=5ZXU84_sGXo )
Not terribly actionable information, but good for founders to know.
You would think that success is mostly about your pitch, and if you have great slides, meaningful graphs, and nail the delivery then you get money. It's not like this at all. VC fundraising is not Shark Tank. It's market timing, it's people, it's emotions.
There's a saying that seed funding is easy and the money grows on trees, and things don't get hard until the Series A. I think the more nuanced explanation is that when seed funding is successful it is usually easy (the stars aligned!), otherwise it's impossible. This leads to successful founders telling stories about easy seed rounds, but there are probably fifty times as many founders who have failed to raise that just don't talk about it.
Here's what Aaron Harris of YC said this year:
"Unfortunately, fundraising takes up a lot more time and thought than it should, because it seems like something that should be systematic but is actually chaos, which really confuses people, especially people who are logically brained." (source: https://www.youtube.com/watch?v=5ZXU84_sGXo )
Not terribly actionable information, but good for founders to know.
So they report the factors they weigh, then self-report the factors they think contributed to success?
That feels like fertile ground for confirmation bias.
That feels like fertile ground for confirmation bias.
I have a foot in the engineering research, the educational research, and the business research camps.
The level to which I trust the findings in business research is basically this order:
1) Educational Research
2) Engineering Research
3) A guy on the corner saying 'trust me'
4) Business Research
The issue is simply down to the level of trust they seem to place in their data. The data is treated as invariant and highly positivist, and their trust in experts self-reports (because they are self-reports) is staggering. You should be really cautious at an epistemic level of taking anything business researchers tell you about how people make decisions.
The level to which I trust the findings in business research is basically this order:
1) Educational Research
2) Engineering Research
3) A guy on the corner saying 'trust me'
4) Business Research
The issue is simply down to the level of trust they seem to place in their data. The data is treated as invariant and highly positivist, and their trust in experts self-reports (because they are self-reports) is staggering. You should be really cautious at an epistemic level of taking anything business researchers tell you about how people make decisions.
Agreed, I look at about 10 business paper a week and quality of statistical analysis is frequently missing.
What I liked about this one is that they are pretty transparent on the methodology so you can see the surveyed VCs biases. They also cross check the sources with other data..
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yes most likely confirmation bias which is in sync with their reported ability to outperform but they dont usually.. this was the shadiest part of the survey for me.. failure data looks similar to
Yikes. Look institutionalized. The big money is made during the troughs when hand shacks work: 70s, early 90s, early 00s.
At the end of the day, most VC valuations are pulled out of a hat. There's a reason why $1B has become a sexy handle: people ascribed some type of value to this valuation.
At the end of the day, most VC valuations are pulled out of a hat. There's a reason why $1B has become a sexy handle: people ascribed some type of value to this valuation.
The first table, which shows where deals are sourced from, was most interesting. I was surprised that VCs reported that 22% of leads were proactively sourced.
Beyond that, I don't think the trust VCs to self report. In particular all VCs say "team" is really important. But in my experience they don't really probe the team very much, or get to know them and their background well.
Possibly what they mean is "has previously been CEO of successful startup" or something similar.
Overall, I think VCs build up a qualatitive feeling of how comfortable they are with a play. And critically, how well it can be justified as being a reasonable decision if things don't go well.
Beyond that, I don't think the trust VCs to self report. In particular all VCs say "team" is really important. But in my experience they don't really probe the team very much, or get to know them and their background well.
Possibly what they mean is "has previously been CEO of successful startup" or something similar.
Overall, I think VCs build up a qualatitive feeling of how comfortable they are with a play. And critically, how well it can be justified as being a reasonable decision if things don't go well.
Good research, thanks for sharing.
Kauffman has interesting content.
This write-up is wrong and incorrect.
At the seed stage, VC's actually do not make decisions this way.
I am going to give you a simple example: if a VC were presented with an opportunity and they knew for a fact that this was proprietary dealflow and if they did not invest, the company certainly would die, i.e. had precisely zero viability but for their (and only their) investment, are there conditions under which they would invest?
The actual demonstrable answer at the seed stage is "no."
This proves that the write-up is incorrect. Not how VC's make decisions.
At the seed stage, VC's actually do not make decisions this way.
I am going to give you a simple example: if a VC were presented with an opportunity and they knew for a fact that this was proprietary dealflow and if they did not invest, the company certainly would die, i.e. had precisely zero viability but for their (and only their) investment, are there conditions under which they would invest?
The actual demonstrable answer at the seed stage is "no."
This proves that the write-up is incorrect. Not how VC's make decisions.
Can I drop you a mail, I would be interested to explore where its incorrect.
Also please remember that the survey simplifies the reality by putting everything in the same model of deal selection.
From a practical standpoint I have some VCs friends that use a model similar to this and others dont.
Also please remember that the survey simplifies the reality by putting everything in the same model of deal selection.
From a practical standpoint I have some VCs friends that use a model similar to this and others dont.
Your VC friends only claim to use a similar model as this and it is not true. It is also falsifiable empirically - you could verify it experimentally if you really wanted.
You can email me at the email in my profile if you wanted. (I am not affiliated with YC and I'm not a VC, though.)
However a good starting point for how investors actually make decisions is here: http://www.foundersatwork.com/1/post/2012/10/what-goes-wrong... under the "investors" section.
It is a much better summary of how they actually make decisions (as opposed to what they report). I won't try to summarize it, just read those 11 paragraphs - but I will quote "If you remember one piece of advice about investors, it's that you've got to create some type of competitive situation."
This is entirely absent from the article (which is wrong.) "Table 2: Important Factors for Investment Selection" is entirely, laughably wrong.
It is simply not the way VC's actually make their investment decisions. At all. (Certainly at the seed stage.) Completely wrong. Sorry.
You can email me at the email in my profile if you wanted. (I am not affiliated with YC and I'm not a VC, though.)
However a good starting point for how investors actually make decisions is here: http://www.foundersatwork.com/1/post/2012/10/what-goes-wrong... under the "investors" section.
It is a much better summary of how they actually make decisions (as opposed to what they report). I won't try to summarize it, just read those 11 paragraphs - but I will quote "If you remember one piece of advice about investors, it's that you've got to create some type of competitive situation."
This is entirely absent from the article (which is wrong.) "Table 2: Important Factors for Investment Selection" is entirely, laughably wrong.
It is simply not the way VC's actually make their investment decisions. At all. (Certainly at the seed stage.) Completely wrong. Sorry.
This sounds a little too cynical, and possibly autobiographical.
I have counterexamples. So, who's right?
I have counterexamples. So, who's right?
if you have counterexamples then you are right and I am wrong.
I shot you an email asking for details of your counterexamples and will write in a reply if in my opinion they falsify my claim. (Or you can include them here if they're public.)
I'm open to the idea that I was wrong.
I shot you an email asking for details of your counterexamples and will write in a reply if in my opinion they falsify my claim. (Or you can include them here if they're public.)
I'm open to the idea that I was wrong.
As of 8 hours later I did not receive your mail. If the email in your profile is not correct you can mail me at mine.
I am scientific and made a strong claim above: if you have a plurality of counterexamples I would like to update my comment stating I was wrong.
So far I have just a statement from you that you know of counterexamples. I do not.
Thank you.
I am scientific and made a strong claim above: if you have a plurality of counterexamples I would like to update my comment stating I was wrong.
So far I have just a statement from you that you know of counterexamples. I do not.
Thank you.
Update: I received an example via email that included approximately 40 investors passing and not being interested, until the seed round began to be put together at which point it snowballed. I would say this strengthens my conviction that the levers listed in the article are not how VC's make their decisions: because those listed levers did not change to cause the change in investor decision.
I was cofused. In the one chart, 0% of VCs reported that their own controbution contributed to success, then father down 27% of VCs reported that value add was an important factor in value creation. Anyone have additional insight?
The way the data was structured is they were asked what is the MOST important factor (you can only chose one) whereas other parts of the survey were what are the important factorS.. Might create the confusion.
Based on booty, both kinds.
this was an awesome read. archived for future ref: http://archive.is/XM2BO
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"...the attractiveness of the market, strategy, technology, product/service, customer adoption, competition, deal terms and the quality and experience of the management team."
I feel that there is another layer of analysis that is being missed which is the interaction.
Q: Would you invest in AirBnb at 31B?
Hypothetical response: No, there is so much competition from the hotels, and competing sites. I think they have liability risk.
Q: How about at $1B value?
Hypothetical: Are you kidding me? Of course!
The valuation interacts with the other criteria.
Q: Would you invest in my personal device company at $100 million?
Hypothetical answer: No way. I think the market is saturated.
Q: Will you do it now that Steve Jobs is back from the dead and has agreed to be the CEO?
Hypothetical answer: duh! Of course!
Again, the "team" has now changed things around.
I can't think of any situation where these factors don't interact with each other.