What Venture Capitalists Look For

The venture capital industry spends a great deal of time screening business ventures for appropriate opportunities as many as a hundred may be reviewed before one is selected for investment. During this process of elimination implicit models of what makes a good opportunity have been evolved.

Entrepreneurs need to recognise and understand these models as part of their search for funding. Even though venture capital in Europe and the US represents only a small percentage of total capital invested in entrepreneurial business these investors have had a significant impact on the evaluation models of other classes of risk-capital investors. They provide guidance on the factors to consider when evaluating an opportunity.

 

This is a complex area. So, the investor is likely to have to weigh up the relative importance of, for example, market potential, forecast financial performance and management skills.

Curious as to whether there was a generalised decision model used in the industry, we asked 70 venture capitalists about the factors they considered and the trade-offs they made in their investment decisions.

While reviewing these factors it is important to keep the phrase all else being equal in mind since we assume there is data available to support each of the criteria listed. A lack of information on any may arouse suspicions and propel it to number one for evaluation purposes.

The criteria used fall under seven headings:

Product-market: involving aspects of the nature of the product and the market, such as projected market size, growth and seasonality.

Strategic-competitive: related to the classic notions of strategy and competitive dynamics and including the nature and degree of competition, strength of suppliers and distributors, and the ability to create post-entry barriers (the ability to block others from coming into a market).

Management team: involving the leadership capabilities and track-record of the lead entrepreneur and management team.

Management competence: including organisational and administrative abilities, marketing, sales and production capabilities.

Financial: including, for example, time to break-even and the projected rate of return.

Funding: reflecting the relationship of the opportunity to the nature and location of the fund. Venture capitalists must be mindful of their portfolio and the commitments they have made to their investors regarding the type of investments they will consider (for example, early-stage start-ups, management buy-outs and so on).

The deal: relating to the specific nature of the investment, the stage of the businesss development, and the ability to syndicate the deal and to invest in later rounds

(that is, at later stages in the growth of the investment).

Is there a common view and, if so, what is the relative importance of each of these factors when venture capitalists are asked to trade one off against another?

The answer to the first is Yes. European venture capitalists generally have the same model for evaluating potential investment, whatever the stage of development of the business and these are the same as those used by their colleagues around the world. Figure 1 lists the overall rankings and shows:

Venture capitalists are primarily interested in whether the lead entrepreneur and the team have the required leadership and managerial capacity to be able to deliver the opportunity. The logic is clear. If these are absent, everything else is problematic.

Financial projections receive some weight but are overwhelmed by considerations of the team and the market opportunity. Again, this makes sense. Financial projections are only realised when a good business proposition becomes a reality, not when it is forecast.

The nature and degree of competition in the market is less important than the teams apparent ability to sustain and protect market share.

The implications for entrepreneurs when seeking external finance are clear. Who does what is most important. How and where they will do it is secondary.

Entrepreneurs need to worry about themselves, their skills and the fit of the management team in relation to their proposed venture. They must make sure they can convincingly demonstrate leadership ability and the appropriate competencies to potential investors.

They should also focus on presenting a clear product-market strategy, incorporating a unique product or service that can create post-entry barriers.

In addition they must make sure they have credible financials that are clear about the time to operating break-even (which for venture capitalists should be relatively short) and show a way for investors to get their money out (the all-important exit route).

The entrepreneur should not become obsessive about presenting copious, well-packaged financial information: real risk capital investors know these are all fantasy if the rest of the opportunity is not in line.

In fact, these guidelines are relevant whatever the situation whether you are seeking funding from a bank, from a private risk capital investor or venture angel, from your family and friends, or whether you are simply trying to convince yourself of your proposals viability. After all, you have almost certainly invested time and, probably, money already and it makes sense to see if it is worth continuing! n

(For a full report of the study see Muzyka, Birley and Leleux, 1996 Tradeoffs in the Investment Decisions of European Venture Capitalists, Journal of Business Venturing Vol 11, July 4, 273-288.)