The anatomy of a deal: VC decision making, the inside story

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Investment decisions in the venture capital industry inevitably take place behind closed doors, and despite limited research their mechanics remain a mystery. But now, with unprecedented access to real time deal information, Jeffrey S. Petty and Marc Gruber are able to provide new insights into the venture capital decision making process.

4 min read

In doing so they identify important lessons for both the entrepreneurs and the VCs who invest in them.

PettyJeffrey S. Petty is a professor of Entrepreneurship. His research interests include entrepreneurial finance and the new venture funding process.

Venture capitalists play a vital role in economic life, and in particular in high tech new business creation. By providing capital and access to a powerful resource network they enable thousands of entrepreneurs to realize their dreams of creating and growing new ventures. Understandably the deal making activities of venture capitalists have received considerable attention. With VCs receiving thousands of business proposals every year, yet investing in just a few businesses, much of the focus has been on VC decision making processes.

Existing research in this area has its limitations, however. Methods such as relying on VC’s recollections of deals after the event, or using experiments to artificially imitate deal evaluation, have significant drawbacks. They can introduce bias, fail to account for the VC’s limited understanding of the decision making process, and fall someway short of replicating the environment and context in which deal evaluation decisions are made in real life.

What decision making criteria are most important for venture capitalists?

Consequently detailed knowledge of many aspects of the VC deal evaluation process remain elusive. What decision making criteria are most important? Do the decision making criteria change at different stages of the VC evaluation process, and if so how?

Jeffrey S. Petty and co-author Marc Gruber set out to remedy these knowledge gaps, through an innovative investigation of VC investment decision making, studying the actual decisions of VCs operating within their normal context.

The academics analyzed 11 years of contemporaneous deal related data from a European VC firm that focuses on investing in companies within a specific high-tech, high growth industry. Over the time period the firm received 3631 proposals and made 35 portfolio investments across two funds (that overlapped slightly in time) at an average acceptance rate of one per cent, which is standard acceptance rate among venture capitalists.

Data was sourced from emails and memos, electronic and written, from archived deal files plus entries in the firm’s deal flow database used to record the fundamental information relevant to each deal. Deals were marked as open (under review), invest, or dead.

Leaving the door open

The analysis reveals some interesting insights. For a start, “no” was not necessarily a definitive rejection. With 146 rejections the door was left open for resubmissions. These rejections were usually accompanied by an indication that the VC might reconsider the deal in the future, together with reasons for rejection, feedback about the firm’s interest, when the company should resubmit, and any milestones required for re-evaluation purposes. Despite the VC’s encouraging feedback only 22 of these proposals were resubmitted.

In total, 438 proposals were submitted more than once. Yet despite the initial rejection and, in most cases, no encouraging feedback, the acceptance rate for resubmissions was approximately the same for original submissions.

A surprisingly high ten per cent of the 3631 deals were classified “dead” because the VC firm did not have the opportunity to pursue them. About half failed to respond to the VC’s requests for more information. The rest of the companies appeared to have changed their mind about VC funding in general or the VC firm in particular.

Previous research consistently identified product/service characteristics, target market characteristics, financial potential, and management team as criteria used in VC decision making. The research confirmed the importance of the first three, particularly product/service characteristics — a primary reason for rejection. The characteristics of the management team appeared much less significant when rejecting a deal, however. This may be because, as one VC noted: “We have a list of experienced managers and you can always bring in a management team”.

The most important decision criteria overall with respect to deal rejection were VC fund-related reasons.

However, the most important decision criteria overall with respect to deal rejection were VC fund-related reasons — a set of VC decision-making criteria largely neglected in previous research. This included, for example, deals rejected due to constraints or conflicts imposed by the character of the existing portfolio. There were also over fifty cases where potentially viable proposals were rejected because of the VCs perception that evaluating, monitoring or managing the deal would take too much time.

Interestingly, the relative of importance of selected criteria used by the VCs differed across the two funds, with fund related considerations becoming increasingly important towards the latter years of the second fund. While market and finance considerations grew less significant. VCs also became more efficient, taking less time to make rejections and identify proposals that merited further investigation.

Entrepreneurs should maintain communications with the VC where the VC expresses an interest, even if rejected initially.

The authors conclude with some recommendations for entrepreneurs and VCs. For example, entrepreneurs should maintain communications with the VC where the VC expresses an interest, even if rejected initially. It also pays for the entrepreneur to do due diligence on the VC firm, so they can tailor a proposal to the firm’s portfolio strategy at that point in time. Two firms with similar investment strategies may view the same proposal differently because they are focused on different criteria based upon the lifecycle phase of each firm’s fund.

As for VCs, Petty and his co-author suggest that VCs evaluate their management capacity, developing strategies to cope with evaluating submissions, at particularly busy times. Being unable to pursue deals that are interesting to due to management time pressures could prove very costly in terms of missed opportunity. After all one of those rejected proposals just might turn out to be the next big thing.


Read the original research paper: “In pursuit of the real deal” A longitudinal study of VC decision making. Jeffrey S. Petty, Faculty of Business and Economics of the University of Lausanne (HEC Lausanne) and Marc Gruber, Ecole Polytechnique Fédérale de Lausanne (EPFL), College of Management of Technology. In the Journal of Business Venturing 26 (2011) 172–188.


Featured image by Erik Ludwig / Flickr CC