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VCs Investment Decision Factors & Criteria

This article summarizes my PhD dissertation’s (article #1V1) investigation and critique of the scholarly literature about the factors & criteria venture capitalists’ use (or say they use) when making decisions to invest in growth-oriented entrepreneurial ventures (‘GOEVs’). It should be read in conjunction with the companion article “A Comprehensive Model of Venture Capitalists’ Investing Process” (article #1V7). The most important feature of this article is its description and evaluative factors for each of the three Primary Investment Decision Constructs used by VCs: Management Capabilities, the Technology/Product/Market Opportunity, and Financial Factors. The relative importance of each to a specific investment decision depends on each VCs' investment preferences and whether it is screening the proposal or evaluating it in depth. Secondary Investment Decision Constructs (Alliances, Strategic-Competitive) are briefly discussed also.

Primary Investment Decision Constructs:
Using my financial management lens perspective, I organize VCs’ primary investment decision constructs into three (most extant literature identifies four or more – particularly separating the market and the product/service which I combine). The three are the Technology/Product/Market (‘TPM’) Opportunity (i.e. the entrepreneurial business opportunity), Management Capabilities (the people/talent for pursuing & realizing the opportunity), and Financial Factors (the sufficiency of the reward/risk relationship). Most extant literature suggest VCs give primacy to the Management factor. But, the findings of my dissertation (and some extant research) is that VCs do not always act the way they say they do and I have found that if a VC-firm has a significant interest in early-stage of very-early-stage investments, they tend to focus on the TPM Opportunity as there is often not much of a management team, per se, in place and VCs typically think they can add one if the TPM Opportunity exists and appears financially lucrative for the risk involved.

The TPM Opportunity describes various market factors (need/want, awareness, size, growth potential) to answer the question: “Is there a significant problem?”. The technology/product/service factors describe whether the enterprise has an innovative, unique, technologically feasible, and ideally patentable solution to the problem, or can likely develop one. If both of these are favourable, the rest, as they say, is management. VCs ideally prefer to deal in a TPM space in which they already have expertise and networks/connections because having those can accelerate development and/or commercialization. Other factors considered as part of sizing up the business opportunity are industry structure (e.g. supply chains and distribution systems) and the nature of competition. But, this is not an exhaustive list.

Financial Factors are used by VCs to assess the prospects for generating significant returns on their total investment (typically made in stages over several years). It has been typical that VCs evaluate an investment opportunity on the basis of the possibility, or probability, of generating a 10x return. This can only occur if the enterprise increases in valuation 10-fold and that will be determined by performance relative to the other constructs. But venture investing is characterized by many challenges including high uncertainty and high risk. This is evidenced by recent US VC industry performance indicating these lofty returns are only achieved on 3-5% of deals while more than half lose money. According to my estimates (Table 3), the VC industry has not performed as well as some broader market benchmark indexes – so, this suggests VCs could benefit from some research-based guidance in their decision-making and post-investment activities.

Of course, Management is the key to turning an opportunity into a thriving, growing, cash-generating business. And, there are some problems in how VCs evaluate an enterprise’s Management Capabilities. The first is, that based on extant research and my own, many VCs don’t assess management effectively. Often this is because they don’t know how to. Sometimes, the exercise might be a checklist-type of activity seeking confirmation that the team is complete and functionally-balanced. VCs with years of experience (14 is apparently optimum) have developed intuitive judgment to assess whether an enterprise’s management team actually functions ‘like a team’. VCs will also assess management’s social capital (networks), education/general intelligence, and the quality of the entrepreneur-leader whom they look to as the ‘visionary-driver’. But, a second problem is that “it is difficult to clap with one hand”. By this, I mean entrepreneurship is more successful when driven by teams than solo-preneurs and yet many VCs focus almost entirely on the entrepreneur-leader when assessing management. In particular, they often defer adding professionally-qualified financial management – sometimes as late as some months prior to their exit event (e.g. IPO). This results in several problems including turnover cost & lost investment as a result of under-hiring in the first place, losing the opportunity to transfer executive workload from the entrepreneur-leader to a CFO, and possibly extending the investment holding period. The article describes other management evaluation factors.

Secondary Investment Decision Constructs:
Two other factors VCs sometimes consider are Alliances/Networks and the particular Strategy the management team has developed to realizing the opportunity. I rate these as secondary b/c the VC can often influence these as part of their post-investment activities.

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