A survey conducted on 885 institutional venture capitalists (VCs) at 681 firms by researchers from Harvard Business School, Stanford Graduate Business School, Chicago Booth School of Business and University of British Columbia revealed interesting insights into how VCs make decisions across eight areas: i). deal sourcing; ii). investment selection; iii). valuation; iv). deal structure; v). post-investment value-added; vi). exits; vii). internal firm organization and vii). relationship with limited partners.
I found it to be extremely helpful in gaining an overarching understanding of how VCs work. In the spirit of sharing, I’ve summarized 100 facts/statements/observations extracted from the results of the survey and added some charts and graphs of my own. It’s a long read but, you can use this as a fact set whenever you need to refresh your memory.
I think it’s worth reading for these people:
- For VCs: to compare their practices to industry as a whole and benchmark their own funds against industry average as well as successful VCs. I bet you can learn something that you didn’t know here.
- For entrepreneurs: 1) to understand VC investment process and selection criteria, which will increase your odds of being invested and 2) to understand VCs’ financial expectations and how VCs value add, which helps you decide if venture funding is for you. Look out for ii). investment selection and v). post-investment value-added.
- For people interested in VC: to gain a quick world view of venture capital. VCs invest in 0.25% of companies but these companies have a disproportionately large contribution to the economy (e.g. public companies that received VC funding account for 20% of the total market capitalization). It’s good to know how they operate.
Caveat: The survey sample is skewed towards U.S. VCs so it may not represent VC in other parts of the world well. Secondly, due to the backgrounds of the researchers, a disproportionate part of the sample comes from Kauffman Fellows and the graduates of top MBA programs. The respondents are likely to be more successful than average VCs, so the average reflected here may be higher or lower than the actual average depending on the metric.
i). Deal Sourcing
1. Deal sourcing and selection are more important drivers of returns than VC value-add (60–40 split).
2. High performing VC firms are more likely to invest in successful serial entrepreneurs who have higher investment success rates.
3. VC deal flow breakdown:
4. Few VC investments come from entrepreneurs who beat a path to the VC’s door without any connection.
5. Where the deal comes from could be less important than expected as there is little difference between the pipeline sources of VCs with a high number of IPOs versus those with a low number of IPOs.
6. The critical differentiating factor for VCs with a high number of IPOs is the quality of their referral network.
7. The deal funnel & Conversion rate at each step:
8. The median VC closes about 4 deals per year.
9. For each deal in which a VC firm eventually invests, the VC considers roughly 100 potential opportunities. (~1% close rate)
10. Early-stage opportunities require greater understanding of the technology and development timelines while late-stage opportunities have longer track records and are easier to evaluate.
11. The more successful VCs and also larger VCs have more meetings with management and initiate due diligence on more firms per closed investment.
12. An IT VC firm considers 151 deals for each investment made and a healthcare VC firm considers only 78 — because 1). larger fixed costs of evaluating healthcare investments and 2). the smaller universe of potential healthcare entrepreneurs.
ii). Investment Selection
13. VCs focus on the quality of the management team, the market or industry, the competition, the product or technology and the business model in their investment decisions.
14. Investment memo is not ranked as an important criterion.
15. VCs do not select the same (“the jockey and the horse” analogy) — some focus more heavily on the management (the jockey) while others focus more on the business: the product, technology and business model (the horse).
16. The IPO prospectuses of successful VC-backed companies reveal that the “horse” (product, technology or business model) is more stable in these companies than the “jockey” (the management team).
17. Most important factors that drive the VC selection decision:
18. The team is more likely to be the most important factor for early-stage investors and IT investors than for late-stage and healthcare investors.
19. Business related factors are more likely to be most important for late-stage and healthcare investors.
20. Valuation and business model are more important for late-stage investors, similar to private equity funds.
21. Larger VC funds and more successful VCs care more about valuation and product and less about fit or ability to add value.
22. High quality VCs are able to win deals despite submitting term sheets at a lower valuation.
23. The qualities that are important in a management team.
24. California VC firms are more likely to say passion is important and less likely to say experience is important.
25. For Healthcare VCs, industry experience is by far the most important quality.
26. VCs devote substantial resources to conducting due diligence on their investments — the average deal takes 83 days to close; the average firm spends 118 hours on due diligence over that period and the average firm calls 10 references.
iii). Valuation
27. U.S. VC firms typically invest using convertible preferred equity, which entitles them to cash flow rights and an ownership stake in the company.
28. The most important point of negotiation is the size of the ownership stake or, equivalently, the implied valuation the financing terms create.
29. Factors in deciding on the valuation:
30. There is more competition in VCs that invest in IT, so founders of IT firms have better bargaining power.
31. Late-stage VC firms found exit considerations to be more important while early-stage VCs care more about desired ownership.
32. ~50% of VCs set valuations using investment amount and target ownership.
33. Early-stage VCs are more likely to set the valuation using investment amount and target ownership, because early-stage companies have little information and high uncertainty, so VCs have to simplify their valuation analysis.
34. 75% of CFOs always or almost always use discounted cash flow (DCF) or net present value (NPV) analysis with a cost of capital based on the systemic risk, as often as they do for internal rates of return.
35. Private equity investors rely primarily on internal rates of return and multiples to evaluate investments.
36. Financial metrics used by VCs to analyze investments:
37. 22% of the VCs use NPV methods, which is higher than popular belief.
38. 9% of all VCs do not use any financial metrics, and for early-stage VCs, 17% of them do not use any financial metrics.
39. Almost half of the VCs, particular the early-stage, IT and smaller VCs, admit to often making investment decisions based on gut feel.
40. Only one out of ten VCs quantitatively analyze their past investment decisions and performance.
41. The average required IRR is 31%, which higher than the 20–25% IRR reported by private equity investors.
42. Late-stage and larger VCs require lower IRRs of 28–29% while smaller and early-stage VCs have higher IRR requirements.
43. The same is true for cash-on-cash multiples; the average multiple is 5.5x and the median is 5x, with higher multiples for early-stage and smaller funds.
44. Early-stage funds may demand higher IRR due to higher risk of failure, i.e. they may calculate IRRs from “if successful” scenarios.
45. Small funds potentially demand higher IRRs due to capital constraints or the fact that they invest in, on average, earlier-stage deals.
46. 64% of VC firms adjust their target IRRs or CoC multiples for risk.
47. The Late-stage VC, Large funds and Healthcare VCs are likely to adjust for risk — as they use more technical methods in investment analysis.
48. Roughly 50% of the VCs adjust for time to liquidity in making a decision.
49. Adjustment for time to liquidity is needed because 1) longer-term investments require a larger multiple because of the greater elapsed time at a given return. 2). VC funds have a limited lifetime (typically 10+3).
50. 23% of VCs do not make any adjustments for risk, time to liquidity or industry conditions.
51. VC firms as a class appear to make decisions in a way that is inconsistent with predictions and recommendation of finance theory — not only do they adjust for idiosyncratic risk (14% of VCs), and neglect market risk (only 5% of VCs discount for market risk), 23% of them use the same metric for all investments, even though it seems likely that different investments face different risks.
52. Overall, 20% of VCs do not forecast company cash flows — 31% of early-stage VCs do not forecast while 7% of late-stage VCs do not forecast.
53. For VC funds that do forecast, the median forecast period is 3 to 4 years — a shorter period than the 5-year forecast period used by virtually all private equity firms.
54. Late-stage VCs forecast cash flows for longer periods — as uncertainty declines, VCs behave more like PEs.
55. Fewer than 30% of the companies meet projections, with early-stage companies less likely to meet projections (26%) than do late-stage companies (33%) — another reason why early-stage VCs require higher IRR to offset greater (total) risk.
56. 91% of VCs believe that unicorns are overvalued, even those that have invested in unicorns.
57. 40% of VCs claim to have invested in a unicorn.
iv). Deal Structure
58. Aside from valuation, the other important part of negotiation is the sophisticated contract terms — cash flow, control, liquidation rights.
59. Average frequency with which VCs use each of contract terms:
60. The terms in the IT sector are more founder-friendly than in the healthcare sector.
61. The IT VC firms are less likely to use participation rights and less likely to use 2x or higher liquidation preferences.
62. California VCs firms also use more founder-friendly terms; they are less likely to use participation rights, redemption rights or cumulative dividends than the VC firms elsewhere in the U.S. — this may reflect a more competitive VC industry in CA or just a difference in approaches.
63. What VCs and entrepreneurs negotiate on:
64. VCs are somewhat less flexible on terms that manage internal risk i.e. liquidation preference, anti-dilution protection, board control.
65. Healthcare VC firms are substantially less flexible on many features (e.g. control, valuation, ownership stake, dividends) than the IT VC firms.
66. Syndication is common in VC investments — the average VC firm syndicates on 65% of its investments; early-stage and healthcare VCs are more likely to syndicate their deals.
67. Most important factors in consideration when VC syndicate investments: capital constraints, complementary expertise, risk sharing, future deals.
68. Early-stage VCs care more about risk sharing, possibly because of the greater uncertainty at the early-stage, and also care more about the ability to participate in future deals.
69. Smaller VC firms syndicate due to more on capital constraints and participation in future deals.
70. Most important factors in consideration when choosing a syndicate partner: past shared success, expertise, reputation, track record, capital, social connections, geography.
v). Post-investment Value-added
71. VCs are actively involved in managing their portfolio companies, frequently meeting with their portfolio companies’ management and playing an important role in critical hiring and strategic decisions.
72. Across stage, sector, and fund size, VCs are actively involved in their portfolio companies.
73. What type of value-add VCs provide:
74. California VCs are also more involved in helping companies find customers, potentially because they work in a cluster-like environment that makes them better connected along the whole of the supply chain of their ecosystem.
75. Other value-adding activities not being mentioned — liquidity events (introducing a company to acquirers or connecting with investment banks, helping with M&A), mentoring, fundraising, product development (including help with global expansion, technical advice, operating procedures) and various board service activities (such as board governance).
vi). Exits
76. Achieving a successful IPO exit is useful for VC firms to establish a reputation and raise new capital.
77. The average VC firm reports that 15% of its exits are through IPOs, 53% are through M&A, and 32% are failures.
78. Some M&A events are disguised failures in the VC industry, so statistics on M&A may not be a valid measure of success.
79. Cash-on-cash exit multiples on past investments reported by VCs:
80. There is a wide dispersion of financial outcomes for VC investments; the dispersion is even wider for IT, Large and CA VCs.
81. Deal sourcing, deal selection, and VC value-add are all important for value creation, but deal selection is the most important value driver.
82. For VCs with high number of IPOs, selection is more important than any other sub-group of VCs.
83. Deal flow is relatively more important for IT, Large and less successful (low IPOs) investors while value-add is relatively more important for Small, Healthcare and Foreign investors.
84. Team is by far the most important factor that contributes to the success of a startup.
85. The factors that make a startup succeed are also the factors (or the lack thereof) that make a startup fail.
vii.) Internal Firm Organization
86. The average VC firm employs 14 people, 5 of whom are senior partners in decision-making positions.
87. VC firms have relatively few junior deal-making personnel (about one for every two partners) and an average of 1.3 venture partners.
88. Others working at VCs would include entrepreneurs in residence, analysts (likely at larger firms), back-end office personnel, and logistics personnel.
89. Early-stage VC firms are smaller and, in particular, have fewer junior deal-making personnel than late-stage VC firms.
90. Late-stage firms deal with companies that require more due diligence and have more information available for analysis; the presence of associates and similar personnel makes sense.
91. 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 medical school faculty) can provide.
92. The reported working hours for VCs is an average of 55 hours per week; VCs spend the single largest amount of time working with their portfolio companies, 18 hours a week; sourcing is the second most important activity, at 15 hours per week; network at 7 hour per week; 8 hours per week on managing their firm; 3 hours per week managing LP relationships and fundraising.
93. 74% of VC firms compensate their partners based on individual success; 44% of VC firms partners receive an equal share of the carry, particularly partners in early-stage funds; 49% of VC firms have partners invest an equal share of fund capital.
94. How funds make investment decisions:
viii). Relationship with limited partners.
95. VCs believe that cash-on-cash multiples and net IRR are the most important benchmark metrics for most LPs.
96. VCs strongly believe that LPs are primarily motivated by absolute rather than relative performance; this is inconsistent with finance theory where LPs should allocate their money to funds according to their relative performance expectations; it’s also inconsistent with the common practice in the mutual fund industry, in which relative performance is paramount.
97. Consistently, the mean net IRR is about 24% with a median of 20% across all subsamples of VCs.
98. This IRR is similar to the IRR private equity investors market to their LPs — this is not consistent with VC investments being riskier than PE investments.
99. VCs also market on average a 3.5x cash-on-cash multiple to their LPs, with early-stage VCs marketing more at 3.8x and late-stage VCs marketing less at 2.8x.
100. The vast majority (93%) of VCs expect to beat the public markets; 71% of VCs are optimistic about the VC industry as a whole.
