How VCs Make Investment Decisions?

In a previous article, I have spoken about what defines and distinguishes a venture capitalist from an angel investor. In the forthcoming articles, I will be talking about each in great detail. In this article and the ones that will follow, my focus is going to be venture capital and being one myself, I can provide great amounts of information about how we pursue deals, evaluate and sift opportunities, add value to portfolio companies, and structure agreements with founders etc.

For decades now, venture capitalists have played a crucial role in the economy by financing high-growth start-ups. Amazon, Apple, Facebook, Gilead Sciences, Google, Intel, Microsoft, Whole Foods, and countless other innovative companies owe their early success in part to the capital and coaching provided by VCs. Venture capital has become an essential driver of economic value.

During the first quarter of 22, the diversity of jurisdictions attracting large funding rounds highlighted the growing breadth of VC markets - companies from 11 different countries raised $500 million+ funding rounds during the quarter, including the US with Altos Labs, Flexport, Ramp, Fireblocks, Eikon Therapeutics, India with Byju’s and Swiggy and China with JD Property, Changan New Energy amongst several others.

The diversity of the largest funding rounds seen in Q1’22 extended beyond geography, reflecting a range of sectors from health-tech and energy to fintech, e-commerce, and cybersecurity.

There’s a lot of positivity right now in the global VC space and, assuming there’s not some major setback due to the new covid variant, this positivity is likely going to carry well into 2022. Over the next few years, we’re also anticipating to start seeing VC investments pick up in less developed regions of the world, including Africa, the Middle East, and South America.

Let’s take a look at some key considerations for a VC when evaluating a potential investment:

??Management

Management is by far the most important factor that investors take into consideration. VCs invest in a management team and its ability to execute on the business plan, first and foremost. We are looking ideally for executives who have successfully built businesses that have generated high returns for the investors.

Businesses looking for venture capital investment should be able to provide a list of experienced, qualified people who will play central roles in the company's development. There is an old saying that holds true for many VCs—they would prefer to invest in a bad idea led by accomplished management rather than a great business plan supported by a team of inexperienced managers.

Emily Weiss, the founder of Glossier, worked in fashion before launching the DTC beauty company. Airbnb’s founders understood the culture of a generation willing to share homes and experiences. Konstantin Guericke, the co-founder of LinkedIn, studied software engineering at Stanford before arriving at the idea that professional networking could be done online.

A group of early PayPal employees went on to start a number of highly successful startups, including Yelp, Palantir, LinkedIn and Tesla. Other such startup founders— made up of early employees-turned-founders — continue to branch off from mature startups like Uber and Airbnb, in turn attracting additional VC attention and funding.

??Market Size

Demonstrating that the business will target a large, addressable market opportunity is important for grabbing VC investors' attention. In order to receive the large returns that they expect from investments, VCs generally want to ensure that their portfolio companies have a chance of growing sales worth hundreds of millions of dollars. The bigger the market size, the greater the likelihood of a trade sale, making the business even more exciting for VCs looking for potential ways to exit their investment. Venture capitalists expect business plans to include detailed market size analysis.

??Great Product With a Competitive Edge

Investors want to invest in great products and services with a competitive edge that is long lasting. They look for a solution to a real, burning problem that hasn't been solved before by other companies in the marketplace. They look for products and services that customers can't do without—because it's so much better or because it's so much cheaper than anything else in the market.

VCs look for a competitive advantage in the market. They want their portfolio companies to be able to generate sales and profits before competitors enter the market and reduce profitability. The fewer direct competitors operating in the space, the better.

But VCs don’t just want to invest in companies situated within large addressable markets from the get-go. They also want to bet on companies that grow their addressable markets over time.

Uber’s TAM grew 70x over 10 years, from a $4B black-car market to a near $300B cab and car ownership market. As the product matured, it’s cheaper, more convenient service converted customers, starting a network effect in which costs decreased as ride availability increased.

Another example is Airbnb, which started in 2009 as a couch-surfing website for college students. At the time, its own pitch deck told investors that there were only 630,000 global listings on couchsurfing.com. By 2017, Airbnb had 4M listings — more rooms than the 5 biggest hotel groups combined. Its TAM had grown with it.

Today, AirBnB has 7 million listings across 100,000 cities with 14,000 new hosts?joining the platform each month in 2022.

??Assessment Of Risks

A VC's job is to take on risk. So, naturally, they want to know what they are getting into when they take a stake in an early-stage company. As they speak to the business's founders or read the business plan, VCs will want to be absolutely clear about what the business has accomplished and what still needs to be accomplished.

The ways that VCs measure, evaluate and try to minimize risk can vary depending on the type of fund and the individuals who are making the investment decisions. But at the end of the day, VCs are trying to mitigate risk while producing big returns from their investments.

??Exit

During an IPO, a company that’s been funded by private investors sells public shares for the first time. IPOs are often thought of as the ideal exit scenario, because founders keep control of the company while shareholders enjoy high payoffs.

An alternative exit strategy is a merger or acquisition. Acquisitions can also be highly profitable, but founders often have to give up control. For instance, Instagram was acquired by Facebook for $1B in 2012, but its co-founders left the company in 2018 when they couldn’t see eye-to-eye with Mark Zuckerberg.

Facebook turned down many acquisitions offers throughout the years, including a $1B offer from Yahoo! in 2006.

By 2012, Facebook had more than 500 round-lot stockholders, subjecting it to SEC disclosure rules despite its status as a private company. Facebook took steps toward an IPO by buying up smaller companies to enhance its offerings and solidify its foothold in the consumer internet space.

In May 2012, Facebook raised $16B in its IPO, putting the company’s valuation at $104B and producing net profits in billions for early investors like Thiel, Accel Partners and Breyer Capital.

Facebook’s continued success, however, would go on to make its IPO look like a bargain. As its revenue continued to grow — from around $5B in 2012 to over $70B in 2019 — its stock price also climbed, trading at over 6 times its IPO price as of May 2022.

I will talk about the VC investment cycle in much more detail in another article.

The Bottom Line

The rewards of a spectacularly successful, high-return investment can be spoiled by money-losing investments. So, before putting money into an opportunity, we spend a lot of time vetting them and looking for key ingredients to success. We want to know whether management is up to the task, the size of the market opportunity and whether the product has what it takes to make money. Moreover, we want to reduce the risks that come along with this opportunity.

In the next article, I will throw light on how we evaluate and sift opportunities, add value to portfolio companies and structure agreements with founders. Stay tuned! ?