
How Do Venture Capitalists Make Decisions? - Gimpei
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801385
======
hoodoof
If it's already a success in a global market, with a complete team, a fully
complete product, clearly making plenty of money with tens of thousands of
paying customers (we'd really prefer to see millions) and all risk removed
then WE INVEST!

~~~
hoodoof
AND we want a board seat, 45% of the company and a bit of damn gratitude.

And a new CEO, the founders, well......who are these inexperienced bozos?

------
hodder
Given the dismal returns on the median venture capital firm, perhaps the
criteria identified in the paper should be a guide to how NOT to make
investment decisions.

~~~
gohrt
median is wrong metric for an asymmetric distribution.

~~~
dlkfjasdflkj
Excuse my limited knowledge of statistics, but I thought the mean is
considered an improper metric for the "average" value of asymmetric
distributions.

If not mean, nor median, what metric would you suggest to approximate a
typical value?

~~~
lpolovets
Let's say that for a basket of 100 VC funds:

* 30 return 0.5X (i.e. half of the initial investment)

* 30 return 1X

* 25 return 3X

* 10 return 6X

* 4 return 10X

* 1 returns 20X

The fund class overall returns 2.4X, but the median fund is very underwhelming
(investors just get their money back). The "average" fund return (2.4x) is
also kind of underwhelming because that's so much worse than the top funds.
However, if an investor either a) has broad exposure to multiple VC funds or
b) has some insight that helps them pick out the top 20% or 40% of fund
managers, then the asset class is a pretty good investment. I think a good
evaluation metric for VC as an asset class would a combination of expected
returns and variance, and how those two quantities compare to other assets
like public stocks or bonds.

~~~
qwrusz
b) You can't generalize having magical abilities to pick top quartile managers
ex ante.

a) Some bigger LPs diversify across multiple VC firms and smaller LPs may
access fund of funds (though very expensive). Either way broad diversification
across VC funds is not significant in the industry. One reason is because VC
fund returns and broad exposure to multiple VCs is not really the main point
here - it is the startups behind the VC layer that generate returns to LPs.
Thus VC firms themselves are the conduit by which LPs get diversified exposure
to the growth/returns of multiple startups, which is the goal for this asset
class. Diversifying on top of your diversification gets expensive and
impractical.

I agree with you risk adjusting returns is important. Sharpe ratios would use
standard deviation and historical returns. Of course caveat emptor "past
performance does not necessarily predict future results."
[https://en.wikipedia.org/wiki/Sharpe_ratio](https://en.wikipedia.org/wiki/Sharpe_ratio)

There is no official must do approach to looking at VC performance. In
practice median and mean are both used, along with some other measures that
look at consistency and write off ratios etc...

For those interested one can google search for a professional VC analysis to
see what they do. [https://www.preqin.com](https://www.preqin.com) might have
something not behind a paywall.

~~~
lpolovets
b) Probably true, but in VC some of the top managers seem to be fairly
consistent. I think that's one reason that LPs invest in emerging funds: if
they hit the next Benchmark or Lowercase, that fund will soon be closed to new
investors, so the only way to have an allocation is to be an early backer.

a) I generally agree. I was just trying to illustrate why mean and median
aren't great for analyzing asymmetric distributions.

~~~
qwrusz
Well ya, if some VCs aren't open to new investors then LPs must invest with
emerging managers. The extent to which top managers will revert to the mean is
anyone's guess and years away from an answer.

Why not just call it like it is...VC is really just a people business, there's
money involved, but trying to quantify the process at all can be misleading. A
VC firm is a small group of people (partners) using their best judgement and
experience to find another group of people (founders) worth investing in.
That's it, there's a ton of key man risk and there's no secret sauce.

Lowercase and Matt Mazzeo are a great example: VCs are basically just like
Hollywood talent agents who get to find the next movie stars and help them
along a bit - but in VC they are finding the next big tech founders instead of
actors. These are people businesses, numbers can't really capture it but they
can distract.

I didn't mean to get into a statistics debate on here. The great thing about
VC and startups is everyone gets to be right until they're not :)

Sidenote: I hear you guys are running one the best shops in the space.
Congrats on the recent close. Best of luck to you and your portfolio co's.

------
lowglow
Surveying might yield skewed results. Perception is reality to outside players
in venture capital. I actually wrote an article about what I (a Hacker)
observed sitting on the other side of the table during my time working at a
Venture Capital firm.

Check it (forgive the slightly tongue-in-cheek writing):
[http://www.techendo.com/posts/what-venture-capital-
companies...](http://www.techendo.com/posts/what-venture-capital-companies-
look-for-in-a-startup)

------
hammerzeit
This is a really interesting question to ask, but survey-based responses only
tells us how venture capitalists _think_ they make decisions. Obviously this
is a secretive industry but I think the far more interesting question to
answer is around revealed preferences rather than self-assessment.

------
known
Hope someone explains in Feynman Technique [http://qz.com/849256/how-to-
master-a-new-subject/](http://qz.com/849256/how-to-master-a-new-subject/)

------
hugs

      function decide(marketSize) {
        if (Math.random() < .01) {
          return "term sheet"
        } else {
          return undefined
        }
      }

~~~
danieltillett
Almost right :)

    
    
      function decide(connected) {
        if (connected || Math.random() < .01) {
          return "term sheet"
        } else {
          return "keep us updated on your progress"
        }
      }

~~~
fatdog
decision :: ([slides], hope, naivety, GSachsClient) -> greaterFool

naivety = foldl hope slides

map naivety GSachsClient

ah who am I kidding, I could never get the hang of monads anyway.

------
mathattack
This is very interesting research. I'm interested in anything that goes beyond
Survey data to what actually happened. (VCs may say founding teams matter
most, but I also say that I eat less than 2000 calories a day - memory is
suspect) I'm also interested in how this would look weighted on firm size or
returns. There are lots of small VCs out there who don't make money. How do
the VCs who funded Google/Facebook/Apple/Oracle invest?

There's a ton of academic research on public equity investment decision
theory. It's great to see private market investment get some focus.

------
graycat
On page 2, the paper has

> In fact, Kaplan and Stromberg (2001) and Gompers and Lerner (2001) argue
> that VCs are particularly successful at solving an important problem in
> market economies|connecting entrepreneurs with good ideas (but no money)
> with investors who have money (but no ideas).

IMHO, for information technology (IT) venture capitalists (VCs), this
statement about "ideas" is mostly wrong. One reason the statement is wrong is
that VCs will rarely even look in any detail at an _idea_.

In contrast the US NSF and DoD will look very carefully at ideas, e.g., GPS,
stealth, measuring the 3 K background radiation. So, will Ph.D. dissertation
committees, reviewers at peer reviewed journals of original research, and
more. IT VCs won't do such things.

IMHO what IT VCs look at is current _traction_ , that is, users or revenue,
and want that traction to be significant and growing rapidly. Then if nothing
else is wrong -- team, competition, scalability, etc. -- an IT VC can get very
interested.

So, the VCs want the _idea_ already implemented in hard/software (usually
software) and in the market and in front of users/customers.

In the world of VCs, the _idea_ is not something from research, that could be
in a peer-reviewed papers, etc. but is just a short description of what the
business looks like externally to a casual observer, the _common man in the
street_. That there could be anything from a research _idea_ as the crucial
core of the business, crucial for getting the traction, being defensible and
scalable, etc., is just ignored.

So, suppose some IT founding team has the coveted _traction_. If they have
lots of users, then the team should be able to run ads and get significant
revenue. If they have lots of customers, then they should also have
significant revenue.

With that revenue, there will be some serious question if the team should
accept equity funding, that is, accept the terms, a Delaware C-corporation,
the BoD, reporting to the BoD that can fire team members, etc. A C-corp and a
BoD bring a lot of overhead.

Really, the example of the romantic match making service Plenty of Fish (PoF)
starts to look more important as a example for IT startups in the future. PoF
was long just one guy, two old Dell servers, revenue just from ads and the ads
just from Google, and $10 million a year in revenue. As in

[http://techcrunch.com/2015/07/14/match-group-buys-
plentyoffi...](http://techcrunch.com/2015/07/14/match-group-buys-plentyoffish-
for-575m-to-bag-more-singles/)

on about July 14, 2015, the solo founder Markus Frind sold out for $575
million.

If a solo founder has a good _idea_ that needs mostly only software, then
there is a good chance they can just write the software, bring it to market,
get _traction,_ and have revenue enough for rapid _organic_ (that is, funded
by earnings from revenue) growth.

That is, a solo founder who invented the idea can keep costs, time on
communications, etc. low, write the software, go to market, and get the
traction. That day is the first a VC wants to hear from that founder, and it
is likely the last day the founder would be willing to accept a check, term
sheet, etc. from a VC.

Net, with the VC rules, by the time the VC is willing to invest, the solo
founder is beyond willing to accept the check.

Of course, if there are several founders, some high _burn rate_ , maxed out
credit cards, each of the founder with a pregnant wife, etc., then the VC's
check might be more welcome.

But we need to understand: All across the US, entrepreneurs start and grow
businesses -- pizza shops, auto body repair, dentist's office, etc. -- without
VC investing. Then, the big difference for an IT startup is that some software
and current computing, the Internet, etc. can let an entrepreneur make money
much faster than a pizza shop. E.g., suppose the founder's business is a new
Web site, and a lot of people like to connect. Suppose the site sends 10 Web
pages a second with each page with five ads. Suppose get paid (from a report
from Mary Meeker at VC firm KPCB) $2 per 1000 ads displayed. Then the monthly
revenue would be

    
    
         10 * 5 * 2 * 3600 * 24 * 30 / 1000 =   
         259,200
    

dollars. Heck, sending even just 1 page per second would yield $25,920 a
month. Then one founder with $25,920 a month in revenue growing rapidly is
just the _traction_ VCs want, but, with that _traction_ , why should the
founder want to accept the VC's check?

~~~
taneq
> Net, with the VC rules, by the time the VC is willing to invest, the solo
> founder is beyond willing to accept the check.

This is what I don't understand. So often someone is in this position, dips
their toe in the VC pool, and a VC says "here, have two million dollars but
give me control." Then suddenly their formerly highly-profitable startup has
to have 50 staff, a big office building with board rooms and lots of shiny
glass, and before they know it they're living off successive rounds of funding
then filing for bankruptcy, because a $1mil/quarter 1-man company can't
magically produce $50mil/quarter from the same banner ads just by hiring 49
more people.

Why would you not just tell the VC "no thanks, I'm doing fine without
interference"? Your company is real at that stage. The dollar signs being
waved in your eyes by the VC are not.

~~~
lmeyerov
Both of you seem to conflate seed stage and growth stage, where the latter is
generally series A and beyond.

The below reflects enterprise, and probably in some form, consumer:

1\. Seed stage is likely before growable revenue. This may still be an idea.
If technology advances are involved, not just a CMS to power PoF (think
university startups vs. most Y Combinators), there may be real capital costs
(time, equipment, enterprise POC cycles, ...) before there's something
growable. This is also known as turning a technical _invention_ into an
adopted _innovation_. A $500K-$2M seed grant for an AI/infrastructure/etc.
company would often need that. Without it, they could only really innovate on
stapling together other people's technology.

2\. In growth stage, there's a link between money spent on sales + marketing +
field engineers and generated revenue, and likely, adding bells & whistles to
grow into nearby markets. At this point, first mover advantage gets pretty
real. Even cooler, revenue _should_ be predictable within some range, so as
soon as sales KPIs aren't being hit, hiring etc. can be scaled back to reflect
reality. Or, just keep growing because the market is worth it.

In both cases, the goal is to go big fast, e.g., world leader in 3-7 years,
vs. the 5-10 year plan. This isn't necessarily about greed: dealing with
competitive industry, the desire to work on big things, the desire to work on
many things, hiring certain folks, etc.

Of course, if you can do all of the above with a PoF idea, great. However, if
you're that good, maybe just pick the right numbers for lottery tickets and
use the proceeds to start a research lab? :)

~~~
graycat
> 1\. Seed stage is likely before growable revenue.

In which case from all I can tell, essentially no VC in the country will pay
any attention at all. That is, the startup didn't have traction significant
and growing rapidly.

For university startups, okay, but have to look in detail at the project
plans. As I mentioned, that's possible: E.g., the first version of GPS was a
back of the envelope thing by some guys at the Johns Hopkins Applied Physics
Lab. That envelope was converted to a project plan; the plan was executed and
successful. Lesson: If look carefully, should be able to evaluate the project
technology just on paper long before soft/hardware or traction. If the
technology really is overwhelmingly powerful for some commercial need, then,
sure, should have a successful company. But IT VCs won't look at the details
and, instead, just want to look at traction.

For funding of on-going companies, sure, there is a big industry for that from
later stage VCs, private equity, M&A, IPOs, etc. There to evaluate a company,
make heavy use of accountants and lawyers.

------
kriro
It's interesting sure but I feel like a different method is needed. I think
qualitative research would be more valuable at this stage. A large field study
would be ideal. Embed researchers with VCs possibly also with startups who try
to raise for an interesting overall picture. Obviously not the easiest thing
to pull off.

------
dpandey
This paper is simply a comprehensive survey of VC opinion broken down
statistically, rather than a genuine study into how VCs work.

In other words, the singular focus on survey data without a sharp focus on
correct interpretation has killed the spirit of digging deep and understanding
the VC setup, with the result that it's not very actionable or insightful.

If the findings were perhaps informed by cross referencing with a survey of
others in the ecosystem who aren't VCs, the authors would probably have been
more skeptical and possibly better educated on reality. It'd have been
extremely valuable to go to entrepreneurs and ask.

Reading one of PG's essays provides a far more useful perspective.

The challenge with a generic survey such as this is that while it gives an
(really long) introduction into how VC works, it misses all the subtleties. A
better researcher would have looked into that, and turned this into a
legendary paper. Why is that important? Because as a VC, decisions are the
most important thing you make, and subtleties play a huge role in that. If you
don't dig deep, then you're just documenting interviews rather than
understanding and interpreting reality correctly.

What the authors should actually have focussed on is:

How do VCs _really_ make decisions?

------
myf01d
Like any other kind of thieves, I guess.

------
bayesian_horse
Optimistically, of course.

------
dilemma
feels

------
CalChris
It's behind a paywall. Publicly accessible version:

[https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801385](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2801385)

Actually, it's a pretty good read if long (89 pages). Kinda lite on angels but
it covers syndication.

~~~
sctb
Thanks, we've updated the link from
[http://www.nber.org/papers/w22587](http://www.nber.org/papers/w22587).

