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Venture Capitalists' Investment Criteria
Many years ago I attended a talk given by a venture capitalist.
He was introduced, and stood up to speak.
“Let’s play a game,” he announced. “Let’s play Hangman,” he said, referring to the strangely named guessing game. He stepped to the white board and drew the scaffold.
“Can anyone tell me what the most important thing is to a venture capitalist when deciding whether or not to make an investment?” he asked. “If anyone guesses correctly, you all collectively win. Each time there’s a wrong answer, I’ll draw part of the man. If I get all the way to drawing the hung man, I’ll win,” he explained.
A few people in the audience raised their hands.
He indicated to one person. “Having a strong patent” was volunteered.
“That’s very important” the venture capitalist replied, “but that is not the most important” he continued. He walked back to the whiteboard and drew a head.
He nodded to another member of the audience. “A large market,” was said.
“That’s really important as well, but it’s not the most important,” he repeated. Again, he headed to the whiteboard and drew another body part on the emerging stickman.
He repeated his question, “what is the most important thing is to a venture capitalist when making an investment decision?” This time he emphasised “most”.
“A quick pathway to market” one person responded.
“A realisable exit” another responded.
“Reliable financial forecasts” was volunteered.
With each suggestion he shook his head, and drew another body part on the almost completed stickman.
He smiled. “One more incorrect response and I win” he said gleefully.
There was hesitation. No one wanted to be the one to give the last incorrect answer that would give the game to the venture capitalist.
A hand arose.
The venture capitalist looked over and acknowledged the hand’s owner.
“A good CEO,” was volunteered.
“No,” the venture capitalist said, as he triumphantly stepped back to the whiteboard to draw the stickman’s last body part.
“Hung. I win,” he announced.
Turning to his listeners, “the most important thing to a venture capitalist when deciding whether or not to make an investment is 'People' he said.
A protest ensued. “The last response was 'a good CEO'. That qualifies, surely.”
The venture capitalist shook his head.
The audience clearly felt that the answer qualified. The controversy was left unresolved.
Whether it should have qualified or not, the venture capitalist had made his important point.
Amongst the many factors that a venture capitalist considers when deciding whether or not to invest in a start-up company, the most important is the people behind the start-up company.
There is an old anecdote that supports that assertion: “A venture capitalist would rather invest in a second (or even third) ranking opportunity backed by a good team, than invest in a first ranking opportunity backed by a doubtful team.”
In fact, so important is this single factor that the second-most important factor influencing the venture capitalist’s decision is not in proximity, but instead ranks in a distant second place.
Having a strong intellectual property position almost goes without saying. A venture capitalist needs to be confident that the start-up company’s business, in which the speculative investment will be made, can be protected with a robust intellectual property position. This deters infringers, and provides confidence that an infringer can be stopped.
A large market may or may not be important. A start-up company with a small but niche and profitable market can be very attractive.
A quick pathway to market, may or may not be important. For a biotech start-up company, there is no such thing as a quick pathway to market. It is most often a case of developing the intellectual property to a point where a trade sale would be attractive. For an IT start-up, a quick pathway to market will rank with importance.
The importance of a realisable exit cannot be understated. A venture capitalist is not a long term investor. Having an achievable exit opportunity (by which the venture capitalist gets its return on its investment) is of critical importance.
Financial forecasts for a start-up company that is still to complete the “D” phase of its R&D, a venture capitalist knows, can be wishful and fanciful, and therefore of little persuasive value.
So, what does it mean when a venture capitalist says that the single most important consideration in its decision to invest in a start-up is the start-up’s people?
What attributes in the people behind the start-up company is the venture capitalist seeking?
There are many.
Expertise. Is the team expert in the start-up’s technology? (Vital) Does the team have experience in business? (Desirable)
Trustworthiness. Can the founders be trusted to accept corporate decision-making? (That is, will the founders accept and carry out the decisions of the start-up company’s board, instead of doing what they please?). Can the founders be trusted to share information? (That is, share all information with the Board, the good, and the not-so-good?). Do the founders keep promises? (From something as simple as calling back when they say they will, to furnishing a report when its due?). Are the founders willing to be influenced? (That is, are they willing to listen to and take into consideration the experience and suggestions of others – like the Board?). Are the founders fair?
Motivation and commitment. Are the founders ready to work 10 – 12 – 14 hours a day if necessary, 7 days a week if necessary, to make the start-up company a success?
Connection. Do the venture capitalist and the founders like one another? They will work together, intimately, for a long time, so they need to like each other.
All of these “people” considerations dwarf all other considerations.
They boil down to the question “Will this team make this start-up company a success?” If that question, with all its components, cannot be confidently answered in the positive, all the other considerations do not matter.