How Venture Capitalists Make Decisions: Increase Your Chances of Landing a Deal
By Space Coast Daily // August 5, 2022
Venture capitalists are the proverbial spearheads of innovation. They are the Genie to every Prince Ali, the Watson to every Holmes. Venture capital firms have funded & helped companies like Amazon, Facebook, and Google become what they are today – revolutionizing the way we live by simply supporting a good idea.
So, what goes on behind the scenes at VC firms, and how do the people behind the curtains make decisions? We spoke with veteran investors like Dale W. Wood of Dale Ventures and other fund managers to find out what they look for in an investment, which fundraising strategies they recommend, and how to clinch the perfect deal.
Any entrepreneur’s first order of business is to understand the existing portfolio maintained by any venture capital fund they are interested in working with.
Consider that a significant chunk – about 90% – of the ‘deal-flow,’ or potential investments of a firm, comes from their existing network and only 10% directly from founders and company management. A drill-down of the existing investments will give business owners a sense of the direction their networking efforts need to take.
And network you must.
“The right connections can translate into meaningful introductions,” Dale W. Wood said.
Venture capitalists proactively seeking investment opportunities account for about 30% of deal flow, meaning the money is always there and looking for the next big deal.
Brownie points aside, networking & personal introductions help to map out internal dynamics of a particular fund. How many investment partners are there? How do they work? Do they hand you off to others after closing the deal, or do they invest their time and skills in you personally? Who among the partners can influence decisions? How has the firm dealt with success and unsuccessful ventures?
Intensive research and thoughtful questions will provide insight into how each firm operates and who calls the shots.
Once entrepreneurs understand the basics of a particular fund, it’s time to map out how decisions are made within each unique firm.
On average, of 100 deals a firm considers, 28 make it into a meeting with the venture capitalist themselves, 10 are invited to a review at a partner meeting and less than five move forward to the due diligence phase. Less than two per 100 business owners will negotiate the term sheet, and only one will secure the funding.
Understanding how the venture capitalist of your dreams makes decisions may be the difference between a deal or a pat on the back on your way out.
According to experts, these are the crucial factors that play into investment decisions:
■ Connection with the management or founding team
■ A strong business models
■ A top-tier product
■ Market interest
■ Industry potential
■ Company valuation
The principal element that influences a venture capitalist in selecting a company for funding is the management or founding team. Anecdotal evidence suggests that almost half of investors consider a good working relationship to be the most significant element in deciding whether or not to work with a fledgling business.
Factors relating to the business – like the market dynamics, the product itself, and the proposed business model – are next on the list of priorities, and company valuation is considered the final factor in deciding whether or not to sign a deal from the late-stage investment phase.
Tools & Metrics
Compared with traditional investors, venture capitalists use different metrics to measure the value of an organization.
The uncertainty associated with early-stage start-up companies makes the use of non-standard metrics necessary, and many venture capitalists use qualitative measures to evaluate investment value rather than relying solely on numbers to make a decision. As many as 20% of venture capitalists don’t even forecast cash flows when deciding whether or not to invest.
VC’s generally avoid using discounted cash flow – or net present value (NPV) – to determine interest in a company. Instead, the metrics they pay attention to are MOIC (or Cash on Cash Return) and IRR (Internal Rate of Return).
1. MOIC / Cash on Cash Return
MOIC and Cash on Cash Return both signify the cash value of a VC’s initial investment.
The formula for MOIC is:
MOIC=Net Asset Value Realized Value + Unrealized ValueTotal Invested Capital
And the formula for Cash-on-Cash Return is:
Cash on Cash Return=Total Yearly Cashflow pretaxTotal Invested Capital
While the formula is slightly different, both calculations reflect the value of the holding, regardless of the length of investment.
2. Internal Rate of Return (IRR)
IRR measures the value of the total return as a function of the time it took for them to generate. IRR is a tool used in conjunction with MOIC to give the investor a holistic picture of a company’s performance.
The formula for IRR is:
t=1TCt1+IRRt- C0 = 0
■ Ct = Net cash inflow, this number can be positive or negative
■ C0 = Total initial investment, which is always negative
■ IRR = Internal Rate of Return
■ (t, T) = Time period
Note: For the curious among us, the zero on the right-hand side of the equation stands for the company’s Net Present Value (NPV), which, in nominal terms, is always zero.
How To Know if You Have the Right Partner
Venture capital funds usually consist of senior investment partners – the decision makers – as well as non-partner support staff. When communicating with a firm, it is important to know the role of the person you’re communicating with and how they contribute to the team as a whole.
Although non-partner staff at VC firms execute essential functions like sourcing and screening deals, carrying out due diligence, and more, they often lack the decision-making pull that investment partners bring. Knowing whether you’re talking with an investment partner or a support staff member can give entrepreneurs the edge.
If you play your cards right, you might be one among the lucky 1% to make it to a review by the partners. That’s the job half done!
The Deal is in the Details
Venture capital firms aren’t known for having their soft spots. Making sure you get the sweetest deal possible is your moral prerogative.
By design, the venture capitalist’s contract will reward the founders for impressive performance, or give the investors greater control in case of non-performance.
As a rule of thumb, you can expect the VC firm to be flexible with some monetary details, including employee stock option pool, redemption rights, initial investment, dividends and participation rights in later stages.
Conversely, you can also expect resistance in aspects of maintaining control over the investment, including liquidation preferences over other investors, length of vesting period, company valuation, control of the board and anti-dilution rights.
Grab That Cash
Firms vary in the way they generate and approach prospective investments. The fund managers at Dale Ventures, a firm formed by Dale W. Wood, says there is no silver bullet to securing funding, but this article has covered the basics of the general decision-making processes. It’s an excellent place to start your research and move one step closer to securing the perfect deal.