My friend Chicago Booth Professor Steve Kaplan just published some research on why VC’s invest. He and his collaborators surveyed 885 institutional venture capitalists. They found the quality of the management team is the reason they invested. Venture capitalists also say that deal selection is the most important factor in making winning investments. The next factor, their gut feel.
None of those metrics are data driven metrics which is why venture capital investing is so squishy.
What metrics do they look at? When it comes to the deal, they look at the potential cash on cash return or IRR. For obvious reasons, they don’t look at discounted cash flow analysis. Hard to project cash flows for venture. It is possible to project out your own assumptions given what you think about the business. Good VCs will form models to help guide decision making. But, I have never ever seen those numbers go as planned.
You might even take those numbers and run them through a NPV calculation to see what the terminal value of the business is versus the real value. It can be instructive, but again because the numbers are all made up it’s hardly set in stone.
VCs look at 101 deals and offer term sheets to 1.7. Those are long odds for entrepreneurs. Every time an entrepreneur pitches, they only have a 1.7% chance of getting a term sheet? Better than the lottery but still. Most of the deals, 31%, come from the VCs professional network. 28% are proactively self-generated.
This is also why it’s so hard to raise a first-time fund. Investors don’t have a sense of anything. What’s the network, what’s the gut like? The only thing they can go on is returns and if you don’t have any they are taking a leap of faith. That’s not any different than a VC writing a seed check. Most of the funds you see raised that are first-time funds are spin-outs of other funds.
For what it’s worth, the statistics Professor Kaplan cites apply to my investing over the years. I have learned a tremendous amount. Deals that I did ten years ago are deals I’d never write a check for today. Deals come from a network that I have personally built, or by my networking for them. I don’t invest in that many. When I do, the management team is the tipping point. The other thing I really hone in on is risk versus reward. As an old trader, you have a great gut feel about these sorts of things. Understanding how much capital to invest, and how much return you think you will get, combined with how long it will take to get there is intuitive and built up over years and years of trading.
Another thing old traders have is a really good “bullshit meter”. It’s more highly tuned than most, and it works faster than most. People don’t really understand the skills we acquired on the trading floor. They saw us as lucky, colorful gamblers. To be fair, from the outside looking in it’s really hard to know how the business worked. Even if a person only visited a trading floor one time and saw it, they wouldn’t understand.
I tend to be able to analyze things very quickly. I cut to the chase, and we can be very, very abrupt about it. Feelings be damned. That doesn’t sit well with people but it was necessary on a trading floor. I have tried to temper the abruptness and frankness of my bullshit meter. I am a very tolerant person. But, there comes a point where you know you just can’t do business and the old trader takes over. In venture, it pays to take a lot more time to come to an opinion. It is better to try and soften the words. Of course, just like trading, opinions are strong but loosely held. You didn’t survive in trading if you couldn’t recognize and adapt to change. You also knew when you had a competitive advantage and when you were behind the 8 ball.
When you know you have an advantage, you exploit it and press with all your might.