6 simple questions a venture capitalist should ask before making an investment decision

After 20 years in venture capital, I have had plenty of chances to question myself on the underlying reasons why I like certain deals better than others. With the benefit of hindsight, I have looked in detail at whether my decisions where sound or not, and what facts and beliefs I based the decisions on at the time.

Unsurprisingly, it really boils down to whether you know your stuff as a VC or not, and being honest about it. But it is impossible to know everything from material science chemistry to e-commerce KPIs and the thousands of different kinds of key business details in between, that land on a typical VC’s desk. The solution is obviously to focus — but this isn’t easy in a fast moving environment with millions of new trends and ideas popping up everywhere from San Francisco to Stockholm.

When introspecting over my own successes and failures, I tried to find the underlying drivers that explained the actual outcomes, as well as the hypothetical outcomes if my decision at the time of investment would have been different. To some surprise, the set of factors that had the best correlation to the investment outcome was responding to six simple questions on specific experience with a “YES” or “NO” answer. So here are the questions:

1. Have I invested before in a company addressing this specific customer category? Consumer to Consumer, B2C, Prosumers, SMEs, Large Corporates, Government, Defense and similar.

2. Have I invested before in a company addressing the same industry vertical? Online Media, Adtech, Consumer Fintech, E-commerce, Security Software are examples of industry verticals that are specific enough.

3. Have I invested before in a company at this stage of development? Seed, A-round, B-round, C-round, bootstrapped mature company taking its first external capital.

4. Have I invested before in this specific geography? Stockholm, Berlin, New York, rather than Nordics, Germany, East Coast.

5. Have I invested in this Founder team or members of this Founder team before?

6. Have I co-invested before with the other VCs in the deal?

As long as I responded YES to 4 or 5 of the question above, the actual outcomes several years later proved that I should indeed have made the investment. Had I responded YES to less than four of the questions I should not have done it. Even more notable; if I would have invested only when responding YES to all six questions, it wouldn’t have improved my investment outcome, but rather dulled it to just below what I would have generated without considering the questions at all. But let’s come back to that. I also looked at other questions that turned out to have no correlation to outcome such as “Have I invested in this business model before?” or “Is this my typical round size?”.

So how much would it have improved my investment returns if I had followed this rule from the start? A staggering 50% improvement from an already decent performance base! And in addition, I would had freed up capacity both in terms of capital and time to do more good investments instead of suffering through the failures, which would have further increased the 50%.

Some of these factors are probably much more important than others, and I’ll have to owe you that analysis for a future article. Also, my sample size is just over 30 companies so I cannot claim this evidence as more than anecdotal. But really successful investments in my portfolio like Spotify, Avito, iZettle, Widespace and Pricerunner all fit this model nicely.

So how would I explain this?

Firstly, when investing venture capital, you need to know the difference between what you know, known unknowns and unknown unknowns. This is a concept most VCs have heard a million times. The more you follow the above yes-no rule, the more likely you are not to expose yourself to the undefined risks of the various unknowns. Following this rule means that you probably have access to a highly relevant network that helps you make the right decision.

Secondly, if you only invest exactly as you have done before, you may run the risk of wrongly settling for a lower expected maximum outcome since the perceived risk is lower. Also, I sincerely believe that deal flow quality is inherently weaker the more it is focused to specific sets of criteria. And if you are always inside the box, how could you then realistically think outside of it?

And lastly, if you want to take a very high strategic and calculated risk in one dimension — like building your success on a new emerging model or distribution platform (think Google Adsense in 2003, Facebook in 2005 or Appstore in 2008) — then you may want to minimize risks in other dimensions. Outsize returns often come as a result of capturing such seismic shifts at the right time.

What about “Pattern Recognition” as a key determinant of making an investment? I struggled to find general common denominators of success other than entrepreneurial team quality and true grit. All other factors are, in my experience, deal specific — but if you add the introspective elements as manifested in the above 6 questions, then a pattern that you could actually act on should begin to show.

It’s easy to see how a newcomer to the VC industry sneers at this unadulterated praise to experience — but if your firm has strong team processes, you should be able to leverage the collective strength and experience from your peers and mentors to answer these questions. You may have noted that I consistently wrote “I” and not “we” which indicates that this rule explains my performance really well but is not as clear an indicator for my Northzone colleagues. It would be interesting to hear my industry peers’ views on this and I invite your comments!

What does this mean for entrepreneurs?

So how could an entrepreneur raising capital relate to this? Well, a good idea could be to test the questions on your prospective VC when doing your investor diligence. It helps you to determine how receptive a good investor will be to hearing your pitch before you even start. If he or she scores less than 4 YES’s, you may just have found a greater fool, which could be good for the entrepreneur in desperate need of closing an investment round, but mostly bad if real investor value-add is what you need for the coming 6–8 years.