More people involved in the process often decide the final funding decisions in VC. However, when we talk about venture capital, we often only think of the two players; entrepreneur and VC. Although this sounds simple enough, there is more to it.
Typically, whoever is on the board committee, will take part in making decisions. Limited partners and lawyers are also critical players in venture capital.
So, to cover the basics, we described the role of each party in VC.
Venture Capitalist (VC) manages the day-to-day activities of the venture capital firm. They are responsible for identifying and executing potential investment deals. Among hundreds of business pitches they receive, they decide to invest in those who stand out the most.
General Partners (GPs) are at the top of command. They are responsible for raising financing for the fund and managing it, including making final investment decisions, hiring and firing staff, managing expenses, and more. In addition, a general partner has the authority to act on behalf of the business. A partnership also offers a pool of investment for building and maintaining a business on a scale that might be beyond the resources of a single individual.
While on the other hand, in Limited Partners (LPs), only one of the partners will become the general partner, while the others will have limited liability. Where general partners invest in startups, limited partners invest in venture capital funds.
Second in the venture capital chain of command is usually the principal, who is often on the partner track. Principals are the middlemen between associates/analysts and the partners.
The Entrepreneur’s Role in Funding Decisions in VC
The entrepreneur is the most important player in venture capital. Without Facebook’s Mark Zuckerberg, Google’s Sergei Brin and Larry Page, Microsoft’s Bill Gates, and Apple’s Steve Jobs, these companies would not exist. VCs want to look for companies with a global vision and opportunities to scale up.
Venture capital will likely allow the entrepreneur to scale faster and make necessary hires to grow the business. Another positiveness about venture capital funding is that it opens up resources for an entrepreneur. If you are an entrepreneur who has launched a promising start-up but needs funding to reach the next level, you should consider venture capital. We talked about other options in our previous blog post, How to Raise Money for your Startup.
Moving forward, entrepreneurs play a key role in funding decisions in VC. Your company vision and your team should lead the way in convincing the board committee and VCs that you are the next Mark Zuckerberg.
Finally, entrepreneurs also need help from lawyers. They help entrepreneurs incorporate their businesses, patent their IP, and with any other legalities involved in starting a company. More and more law firms are beginning to catch on to helping startups at their earliest stages. The second way lawyers play a role in venture capital is by representing entrepreneurs in negotiations with VCs. They can also play essential functions in helping VCs raise money.
How Do Venture Capitalists Make Decisions?
To summarise the VCs’ decision-making process, here we explain each stage.
Deal Sourcing
Deal sourcing refers to how VCs attract entrepreneurs and sort through those opportunities to make an investment decision. So, how do they find a potential startup? There are multiple sources. If the potential startup can be generated through a professional network, referred by other investors, inbound from company management, referred from the portfolio company, quantitative sourcing or proactively self-generated.
Once a company is considered at the top of the funnel, the selection process usually consists of: a consideration deal, meeting management, reviewing the proposal with partners, due diligence, term sheet, and finally, closing the deal.
Investment Selection
When considering a deal, VCs will look at the attractiveness of the market, strategy, technology, product/service, customer adoption, competition, deal terms and the quality and experience of the management team. Since venture capitalists invest at high risk, VCs tend to be very selective about placing their money. But, regardless of high risk, VCs give out thousands and millions of dollars to small, untested ventures with the hope that they may eventually evolve into something big. We covered this in more detail in our article What Venture Capitalists Look for in an Investment Opportunity.
Deal Structure and Valuation Tools
Most VCs use financial techniques such as DCFs or NPV to evaluate their investments. However, according to Antoine Buteau’s article on How Do Venture Capitalists Make Decisions?, common metrics used are cash-on-cash return, multiple of invested capital and net IRR.
He also explains how VCs take leverage if entrepreneurs don’t perform, through cash flow rights, control rights, liquidation rights and employment terms. However, VCs are more flexible on option pool, participation rights, investment amount, redemption rights and cumulative dividends provision.
VCs are critical in the professionalization of startups: they will improve governance through strategic guidance, by structuring the boards of directors and by helping in hiring outside managers and directors.
Exit strategy
Each venture capitalist will have an exit strategy in place for their portfolio companies. As CFI explains, exit strategies are plans executed by business owners, investors, traders, or venture capitalists to liquidate their position in a financial asset upon meeting certain criteria. An exit plan is how an investor plans to get out of an investment.
Common types of exit strategies for startups are Initial public offering (IPO), Strategic acquisitions and Management buyouts. The exit plan chosen by the entrepreneur depends on the role they want in the future of the company. For example, a strategic acquisition will relieve the entrepreneur of all roles and responsibilities in his or her founding company as they give up control of it.
To sum up, entrepreneurs and VCs are the key players in funding decisions in VC. However, the decision-making process also goes through the VC committee board, and multiple parties are involved. These include; VCs, GPs, LPs, lawyers, principals and analysts, who also take a role in this process. How VCs make final decisions is a tad bit more complicated to explain. However, from what we covered, VCs devote a great time to this process and resources. A deal source in an activity that helps VCs predict the value of the company. When going through deal selection, VCs focus on team management and business factors, market size, ability to scale up etc. Venture Capitalists help companies succeed through new hires, financing, and connecting with potential customers.
