10 ms·

How Do Venture Capitalists Make Decisions?

87 points by Gimpei 10y ago

CalChris 10y ago
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 10y ago
  Thanks, we've updated the link from http://www.nber.org/papers/w22587 http://www.nber.org/papers/w22587.
hodder 10y ago
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.
- djyaz1200 10y ago
  Agree! I'm far more interested in how they con LPs into paying them to lose money. Why should entrepreneurs do all the work to build companies, create jobs and solve problems for customers when we could just get paid to lose money for pension funds?!
- gohrt 10y ago
  median is wrong metric for an asymmetric distribution.
  - dlkfjasdflkj 10y ago
    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 10y ago
      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 10y ago
        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 10y ago
        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.
  - Retric 10y ago
    That's reasonable at a fund level, but when 50% of the firms have negative returns why do people use them?
    - pradeep_m 10y ago
      Well, more than 50% of the companies have negative returns in the public market. So why do people invest in the public markets? For LPs, investing in VC firms is just to way to diversify and invest in private markets.
      - Retric 10y ago
        Far from it the median company on the stock-market has positive returns just about every way you slice it. That's not beating the market, but the median VC firm does not just fail to keep up with the stock market, they also flat out lose money.
      - bduerst 10y ago
        Are you sure? Net market growth is positive since 2009, so that would mean that the growth would have to be limited to an increasingly smaller number of companies.
    - lappa 10y ago
      If you have 5 firms with ROIs of -10%, -5%, -3%, 1%, 14% and 31%, then 50% of the firms have negative growth rates and the median firm loses money. However you can observe that if you invested $100 ($600 total) into each firm, you would end up with $636. Median return isn't a very useful measure of the health of a sector. It is a predictor for risk, but not a very good one.
      - Retric 10y ago
        Except the worst returns are closer to -100%, the median is closer to -30% and only a small fraction are positive. Also, your example was 7 firms with the median being 1% and a positive return.
hugs 10y ago
function decide(marketSize) { if (Math.random() < .01) { return "term sheet" } else { return undefined } }
- danieltillett 10y ago
  Almost right :) function decide(connected) { if (connected || Math.random() < .01) { return "term sheet" } else { return "keep us updated on your progress" } }
  - lonefermion 10y ago
    This is hilarious. I approve.
  - fatdog 10y ago
    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.
hoodoof 10y ago
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 10y ago
  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?
- hugs 10y ago
  Lots of entrepreneurs would save so much time and headaches if they realized how right you are.
- ulfw 10y ago
  Yep exactly. Great to invest when there is really no need for it at all.
hammerzeit 10y ago
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.
lowglow 10y ago
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-look-for-in-a-startup http://www.techendo.com/posts/what-venture-capital-companies...
deleted 10y ago
[deleted]
graycat 10y ago
On page 2, the paper has > In fact, Kaplan and Stromberg (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-plentyoffish-for-575m-to-bag-more-singles/ http://techcrunch.com/2015/07/14/match-group-buys-plentyoffi... 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?
myf01d 10y ago
Like any other kind of thieves, I guess.
ubernostrum 10y ago
Decision-making and business politics are... political topics. Get it off HN.
known 10y ago
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/
dpandey 10y ago
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?
kriro 10y ago
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.
dilemma 10y ago
feels
mathattack 10y ago
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.
bayesian_horse 10y ago
Optimistically, of course.

87 points by Gimpei 10y ago

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 10y ago
Thanks, we've updated the link from http://www.nber.org/papers/w22587 http://www.nber.org/papers/w22587.

hodder 10y ago

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.

djyaz1200 10y ago
Agree! I'm far more interested in how they con LPs into paying them to lose money. Why should entrepreneurs do all the work to build companies, create jobs and solve problems for customers when we could just get paid to lose money for pension funds?!
gohrt 10y ago
median is wrong metric for an asymmetric distribution.
- dlkfjasdflkj 10y ago
  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 10y ago
    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 10y ago
      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 10y ago
        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.
- Retric 10y ago
  That's reasonable at a fund level, but when 50% of the firms have negative returns why do people use them?
  - pradeep_m 10y ago
    Well, more than 50% of the companies have negative returns in the public market. So why do people invest in the public markets? For LPs, investing in VC firms is just to way to diversify and invest in private markets.
    - Retric 10y ago
      Far from it the median company on the stock-market has positive returns just about every way you slice it. That's not beating the market, but the median VC firm does not just fail to keep up with the stock market, they also flat out lose money.
    - bduerst 10y ago
      Are you sure? Net market growth is positive since 2009, so that would mean that the growth would have to be limited to an increasingly smaller number of companies.
  - lappa 10y ago
    If you have 5 firms with ROIs of -10%, -5%, -3%, 1%, 14% and 31%, then 50% of the firms have negative growth rates and the median firm loses money. However you can observe that if you invested $100 ($600 total) into each firm, you would end up with $636. Median return isn't a very useful measure of the health of a sector. It is a predictor for risk, but not a very good one.
    - Retric 10y ago
      Except the worst returns are closer to -100%, the median is closer to -30% and only a small fraction are positive. Also, your example was 7 firms with the median being 1% and a positive return.

hugs 10y ago

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

danieltillett 10y ago
Almost right :) function decide(connected) { if (connected || Math.random() < .01) { return "term sheet" } else { return "keep us updated on your progress" } }
- lonefermion 10y ago
  This is hilarious. I approve.
- fatdog 10y ago
  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.

hoodoof 10y ago

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 10y ago
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?
hugs 10y ago
Lots of entrepreneurs would save so much time and headaches if they realized how right you are.
ulfw 10y ago
Yep exactly. Great to invest when there is really no need for it at all.

hammerzeit 10y ago

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.

lowglow 10y ago

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-look-for-in-a-startup http://www.techendo.com/posts/what-venture-capital-companies...

deleted 10y ago

[deleted]

graycat 10y ago

On page 2, the paper has > In fact, Kaplan and Stromberg (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-plentyoffish-for-575m-to-bag-more-singles/ http://techcrunch.com/2015/07/14/match-group-buys-plentyoffi... 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?

myf01d 10y ago

Like any other kind of thieves, I guess.

ubernostrum 10y ago

Decision-making and business politics are... political topics. Get it off HN.

known 10y ago

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/

dpandey 10y ago

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?

kriro 10y ago

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.

dilemma 10y ago

feels

mathattack 10y ago

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.

bayesian_horse 10y ago

Optimistically, of course.