How do venture capitalists evaluate potential investments?

Venture capitalists are busy people. When they’re not raising money or promoting themselves on social media, at events, or as thought leaders in blog posts, they need to occasionally invest in companies.

How do VCs find companies and how do they evaluate them? 

To understand that question, first we need to have a better sense for how VC firms operate.

VCs are focused on assets under management

The primary business of the venture capitalist is to raise and grow assets under management. 

You might think that they’re in the business of investing, so that their priority would be finding and identifying startups that are most likely to deliver big bang returns. That’s true, but indirectly.

The first thing that you need to know is that the biggest driver in pay for the partners at a venture capital firm are the assets under management. They receive management fees and incentive fees, both of which correlate with assets under management. Put another way, the best-performing fund could have triple-digit returns, but if these returns are generated on a small amount of funds, it doesn’t translate to an attractive dollar amount of profits for the VC.

The indirectness of their business dependence on investment success is that prior performance, the so-called “track record,” enables them to raise sequentially larger investment funds.

Venture Capital company XYZ will start by raising its first fund, call it XYZ Opportunities I LLP. Maybe they start with $25 million, led by a family office they know. This will be a seven-year fund, in which they have three or four years to put the money to work initially, followed by several years of waiting for the investment to play out. 

At some point during the life of the first fund, typically during or in anticipation of the second period in its life cycle, the VCs will begin to raise a second fund, XYZ Opportunities II LLP. They will use the example of the portfolio companies in Fund I to showcase their ability to find and invest in high-quality deals. Ideally, none of their portfolio companies has failed by this point. (One way to ensure this is to start fundraising for Fund II sooner rather than later in the life of Fund I.) If they’re lucky, the second fund is larger, say $50 million. 

Rinse and repeat. After a few iterations of this, Fund IV or Fund V could be upwards of several hundred million dollars.

The beauty of this model is that the VC’s costs for Fund I aren’t that far off their costs for Fund IV.

The VC’s performance cannot fall below a certain threshold, typically determined by the market cycle, macro conditions, and the performance of their peer group. If they can deliver double-digit internal rates of return in an environment in which pension funds, family offices, and endowments are starved for yield, then the VC is golden. Low single-digit returns mean the partners at the VC firm should fold up shop and start anew.

A fantastic public profile as an industry thought leader is key to fundraising success. 

Deal flow is the lifeblood of VCs

Every year, a professional VC may look at hundreds or thousands of potential targets before investing in a handful, perhaps as few as one or two. It’s daunting to look at so many companies, but the great fear of the investor is to miss out on that one thing that turns out to be a home run. They need to turn over as many rocks as possible.

VC firms will have several layers including partners, principals, and associates. Associates are out in the field, trying to find startups and doing the initial vetting. They will cold call companies. They will find them at conferences. They will buddy up with accelerators and incubators. They will search services such as Pitchbook or Crunchbase for information on who is raising money or has raised money in the recent past. 

They will filter the candidates and write brief summaries for the internal consumption of others within their firm.

Principals do this outreach as well, but they also run deals, including the negotiation of terms with the portfolio companies and firming up the due diligence on prospects. This vetting process may include checking customer references, investigating the competitive landscape, talking to other investors about the target, or trying to obtain intelligence about management teams.

Principals and associates, often grouped in teams, report to partners. An individual partner will be responsible for an investment. Practically, for each company in a fund’s portfolio, there will be one partner at the fund responsible for the investment. This is the partner whose team identified, vetted, and negotiated the deal.

Practically, one can see that partners at the investment firm are in competition with one another for the fund’s limited capital resources. If the fund invests in a company sourced by partner A, then that is capital no longer available for investment by partners B, C, or D.

A partner’s compensation may depend on their individual contribution, exacerbating this tension.

Partners meet on a weekly basis to review the existing portfolio, but also to debate the merits of investing in companies suggested by individual partners. These meetings can be anywhere on a spectrum from collaborative to competitive. 

The partner proposing an investment must convince the other partners that the investment in question is in their best interests. Some firms look at interests collectively; partners at other firms are more individualistic in orientation, over and above the behaviour stemming from the compensation scheme.

Some partners are more equal than others in that they can get their deal across the line with minimum objection given their relative power in the venture capital management firm.

At the intersection of power and deal flow is the notion of access. The true giants in the venture capital world seem to get all the great deals. Firms with names like Sequoia or Andreesen Horowitz or Benchmark or GGV Capital or Accel. These are the people who invested in the Series A or Series B round of some of the most successful startups in recent memory, like Slack. These VCs have a much greater success ratio than the garden variety VCs. Perhaps it’s because the best startups have their pick of the litter and they want the association. Or, and the VC firms will say this, it’s because the VC can bring the most value to the table in terms of customer introductions, governance, and management advice.

That might even be true.

So, a venture partner at a fund that is not in the top tier but who has access to the best VCs through personal or professional relationships can get cut into deals that appear to have an enhanced likelihood of success. It’s literally the golden ticket. Partners with those kinds of connections have the most power because collectively the partners will benefit from enhanced returns and, most importantly, higher assets under management.

Of course, one way to get on the inside track is to bring one of these homerun startups to the top tier VC, by doing a superior job of knowing what the top tier VC is looking for. (This, in turn, reinforces the strength of the top tier VC who gets to see the premier selections from the next several tiers of VC who are lobbying them for a relationship).

What makes a good startup for venture capital?

The first, necessary condition for a venture capitalist is that the company needs investment now and is likely to need further funding down the road. The more money the target startup requires, the greater the opportunity for the VC firm to build a meaningful position.

What does this mean? The VC doesn’t want to invest in a company that raises a small amount of money and then five years later exits with a massive upside, as much as they would prefer to invest a large amount of money over sequential rounds in a company that has massive upside. 

A big piece of a big pie is better than a small piece of a big pie, especially if the injection of funds along the way increases the size of the pie compared to its independently funded, bootstrapped version.

The second condition for a venture capitalist is that the size of the potential exit must be massive. They are swinging for the fences. (Of course, there are some investors who play for a three to five times return over a couple of years, but they are more likely to be angel investors given the smaller dollar amounts involved at either end.) See our earlier comments on the differences between a startup and a small business.

VCs may try to reduce the dimension of the problem by targeting a particular theme or set of themes. This way they don’t have to chase every startup; they just need to hunt down a subset of the startup universe. 

For example, a theme might be “Future of Work.” A VC may look for companies that are changing the way in which companies will organize and utilize their employees. A fund like this might be looking for remote work technologies or other solutions that can help enterprise buyers reduce their commercial real estate footprint. 

The third condition for a venture capitalist is the target company must have a decent chance of getting to a profitable exit. This involves assessing the risks and opportunities associated with the technology, the business process, the competitive landscape, and the management team. Most importantly, the management team.

The VC has to be able to make a credible case for himself, but more importantly for his current and prospective limited partners, from whom he gets his capital, that the balance of risk and reward highly favours putting money into the target company. Plausibility is critically important in telling this story, internally and externally.

This is the fourth of a series of articles about startups and venture capital, where we’ll explain some of the concepts people might see discussed in the press. We’ll talk about how VCs decide on whether to invest and at what price in an upcoming article. We’d love to hear your feedback.

2 months ago