How VC’s evaluate startups and entrepreneurs

What you should be aware of before you ask money from a VC.

This article provides a breakdown of the academic research on venture capital and more specifically on the investment decision. We follow the theory of two systems from Kahneman[1] and his famous book “Thinking, Fast and Slow” by splitting the investment decision into two stages. Initially, we see the quick dismissal or advance (“System 1”) in the early filtering stage and after we present the slow and logical (“System 2”) investment decision in the deal evaluation stage.

Early filtering — Deal screening

On this stage, the focus of the venture capitalists is to filter out a large number of companies and ideas (for more see “The venture capital funnel”). Two main points are seen in academic research; first, on intuition, investor preferences and experiences[2][3] and second, on quick facts and estimations such as industry, stage, location, and capital required[4]. To cope with the volume and to save time, energy and resources, VC’s use many heuristics or “rule of thumbs”, but more commonly they use “satisficing[5]” heuristics[6] , which means that they are looking to dismiss an idea quickly and move to the next one. Experienced investors would use a combination of experience and intuition coupled with quick facts and estimations. Once a “pitch” fulfils these criteria, it advances to the next stage for further evaluation.

Aspiring entrepreneurs should take advantage of the “System 1” which is faster, emotional and stereotypic. Some examples are to look at what the VC has invested in recently, what are his interests and his background and maybe what else he might be doing routinely. For example, if someone wanted to solve a problem in the fitness category, his chances would be better to make an impression on a VC who often exercises. Furthermore, presenting quick facts should also be added to the pitch. For example, the fitness industry covers people that do bodybuilding as a lifestyle, but a bodybuilder might have a different set of problems than someone runs in the park daily. The pitch should have facts about “How many the bodybuilders are in X city?”, “How many times they train?”, “How much money they spend on X?”, “Do they find it difficult to do X?”. Presenting the problem precisely is important, but doing the initial segmentation and assigning estimations and quick facts about cost and profits should be highlighted on the pitch-deck.

Due-diligence — Deal Evaluation

On this stage, the stakes are higher, and the evaluation criteria are stricter and more detailed. The decision is slow, effortful and logical and it involves research and further due-diligence. The table below summarises the finding of four studies on early-stage startup evaluation criteria.

Startup Evaluation CriteriaThere are three main similarities in these reports. The investors want clear answers about who (“team”), where (“market”) and what (“product”). First, we see the management team competence. In other words, the VC wants to know if the company can be managed well and if there is any track record. Second, market considerations such as attractiveness, rivalry, lead-time, stability or familiarity answer questions about where the company competes and what is the advantage in this market. Third, we see product considerations such as uniqueness, differentiation, and protection that present the problem that needs to be solved.

On this phase, the aspiring entrepreneurs have to have good knowledge of these three key points. They have to know:

a) what is their idea (“product”) and why is it important to build it,

b) what is their industry (“market”) and how they can compete with an advantage and finally,

c) how they can assemble and manage a great team.

These questions have to be answered by the entrepreneurs and the better the answer the more it signals that this is a good investment. If the entrepreneurs do not have the right experience yet, it is fine but hey should look to find the right people and add it to their team. A great example is from the Google founders, Larry Page and Sergey Brin, who hired Eric Schmidt to be the CEO of their company.

Conclusions

The entrepreneurs should know the investor’s decision-making process and what they are looking for, to prepare their “pitch”. Doing some early due diligence and answering questions about team and management, market and industry, and product and solution accordingly is critical to the success of the investment decision. Moreover, presenting to the right investors and making it through the filtering process should be seen as a first marketing test of their startup. Getting the attention of someone that “searches for new ideas” for a living seems easier than real customers.

Note: This article has been appeared first in www.whydotheyfail.com and is based on the research for the project and dissertation named “Venture Capital failures. Why VC backed start-ups fail and how can we improve the failure rate” that was submitted to Warwick Business School on 05/03/2018 by Kostakis Bouzoukas.

[1] Kahneman, D., 2011. Thinking, fast and slow. Macmillan.

[2] Hisrich, R.D. and Jankowicz, A.D., 1990. Intuition in venture capital decisions: An exploratory study using a new technique. Journal of business venturing, 5(1), pp.49–62.

[3] Tyebjee, Tyzoon T., and Albert V. Bruno. 1984. “A model of venture capitalist investment activity.” Management Science 30(9): 1051–1066. doi:10.1287/mnsc.30.9.1051

[4] Shepherd, D.A., 1999. Venture capitalists’ assessment of new venture survival. Management science, 45(5), pp.621–632.

[5] https://www.investopedia.com/terms/s/satisficing.asp

[6] Zacharakis, A.L. and Meyer, G.D., 2000. The potential of actuarial decision models: can they improve the venture capital investment decision?. Journal of Business Venturing, 15(4), pp.323–346.

[7] Bruno, A.V. and Tyebjee, T.T., 1985. The entrepreneur’s search for capital. Journal of Business Venturing, 1(1), pp.61–74.

[8] MacMillan, Ian C., Robin Siegel, and P.N. Subba Narasimha. 1985. “Criteria used by venture capitalists to evaluate new venture proposals.” Journal of Business Venturing 1(1): 119–128. doi:10.1016/0883–9026(85)90011–4

Originally published at www.whydotheyfail.com on March 14, 2018.

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