Investment Selection

When considering a deal, VCs will look at the attractiveness of the market, strategy, technology, product/service, customer adoption, competition, deal terms and the quality and experience of the management team.

Table 2: Important Factors for Investment Selection

Late stage funds are more similar to private equity funds because they think valuation and business models are highly important. Given that early stage invests in companies that might not have monetized their offerings yet, it is not surprising to see that they rank the team and the product/technology as the most important factors. When looking at a team, VCs think that the most important qualities are, in order: ability, industry experience, passion, entrepreneurial experience, and teamwork.

Given the rise of competition in VCs it is surprising to see valuation ranking so low, as something overpriced will most likely reduce cash-on-cash multiples. One interesting finding is that larger funds and more successful firms care more about valuation and product than their counterparts. This is consistent with the ability of high quality firms to win deals despite lower valuation term sheets.

Finally, it is interesting to see how investment selection factors compare to successful investment factors. For early stage investments, the team has the most impact on success whereas the product/technology has less importance than when investors select the company. Interestingly, timing, luck and industry have a rather large impact on the success of investments.

Table 3: Important Factors for Investment Success

Valuation Tools

Give the uncertainty of most of their investments, it is not surprising that most VCs don’t really use financial techniques such as DCFs or NPV to evaluate their investments. Most commonly metrics used are cash-on-cash return, multiple of invested capital and net IRR. An other interesting finding is that fewer than 30% of companies meet projections. The survey found that 20% of VCs, 7% of late stage VCs and 31% of early stage VCs do not forecast cash flows when they make an investment. When they do they usually forecast on a 3 to 4 year period. Early stage VCs are more likely to set the valuation using investment amount and target ownership whereas late stage VCs can use more sophisticated methods to get to the company valuation.

Deal Structure

The intended goals of VCs contracts are to make sure that the entrepreneur does well if he/she performs well while providing VCs with leverage if the entrepreneur does not perform. VCs achieve these objectives through cash flow rights, control rights, liquidation rights and employment terms. Although California VC firms use more founder friendly terms, overall VCs are not very flexible on terms, particularly on control rights and liquidation rights (pro-rata rights, liquidation preference, anti-dilution protection, valuation, board control, and vesting). However, VCs are more flexible on option pool, participation rights, investment amount, redemption rights and cumulative dividends provision.

Table 4: Frequency of Contractual Features

An other important feature of VCs deal structure is syndication. VCs syndicate around 65% of their investments in an attempt to share risks, build reputation, reduce capital constraints and gain complimentary expertise. VCs will choose along those factors when partnering with other VCs in deals.

Table 5: Important Factors when Choosing Syndicate Partners

Post-Investment Value Add

VCs are active investors and strive to add value to their companies after they invest. VCs are critical in the professionalization of startups: they will improve governance through strategic guidance, by structuring the boards of directors and by helping in hiring outside managers and directors.

Table 6: Activities in Portfolio Companies

Unsurprisingly, given the “Series A Crunch” (see graph below from Mattermark), connecting to investors is more important for early stage than late stage investors. One interesting finding is that California VCs are more involved in helping companies find customers, which is critical for B2B companies, most likely because Silicon Valley work in a cluster environment that makes easier to connect people together.

Exits

According to the survey, VC returns are driven by 60% deal sourcing/selection and 40% by value-added activities. The table below show the frequency of exits for VCs. It is important to note that most of the M&A events are disguised failures in the VC industry.

Table 7: Frequency of IPO, M&A, and Failure

In terms of reported multiple for these exits, the mean reported multiple is 4.2 for early stage VCs and 3.5 for late stage VCs.

Table 8: Exit Multiple Frequency

Surprisingly, VCs report that the most important contributor to value creation is deal selection in front of deal flow and value add, although many VCs will market their proprietary deal flow and value add/founder friendly infrastructure.

Table 9: Important Factors to Value Creation

Internal Organizations of the Firms

The average firm from the sample is small, with 14 employees and 5 senior investment professionals. VCs typically spend their time on the following activities.

Table 10: Time Use in Vc Firms

Furthermore, in 60% of the funds, partners specialized in different tasks such as fund raising, deal making, sourcing deals and networking. 74% of VC firms compensate partners based on individual success. More successful and larger firms are less likely to allocate compensation based on success which highlight that VC is a team sport more than anything. In terms of decision making for investments, firms use the rules highlighted in the table below.

Table 11: Fund-Level Decision Making Process

Relationships with LPs

Data from Cambridge Associates show that over the long term, the private indexes continue to outperform public markets. While there are still opportunities in the asset class, Cambridge Associates expect the relative outperformance to deteriorate because of the increase competition and the lack of liquidity market. What is surprising is that, given this deterioration and that fund performance tend to be persistent for the best funds, 93% of VCs still expected to beat the public markets on a relative basis. LPs need to be wary of this overconfidence in generating above market returns and most likely need to lower VC firms marketed multiples (early stage: 24% net IRR/ 3.8 cash-on-cash, late stage: 21% net IRR/2.8 cash-on-cash).

Table 12: U.S. Private Equity and Venture Capital Index Returns (Net IRR in %) — Periods Ended September 30, 2016

Final Words

As we saw in this post, although the VC world seems mysterious, it is not that special when we analyze it. With this post, VCs can benchmark their activities against other VCs and founders can try to understand better where they are at in the deal pipeline and what they can fix to increase their chance of going through the pipeline. Here are some key points of the research.