By Sergei Mosunov
Oct 12, 2022
How Venture Capitalists Make Investment Decisions
Innovative ideas can be brought to life in a variety of ways for a foundation for a startup. There’s no single universal truth about how it should be approached to guarantee success. That’s why entrepreneurs take risks when they start a company. They have to navigate an environment where customers’ preferences constantly change, market niches are highly specific and competition is always intense. Eventually, many startups end their life in the so-called "valley of death."
In the language of investors and entrepreneurs, the valley of death refers to that critical period when a startup has begun to operate but has not yet produced revenue. It’s never easy to make it out of the valley, so to help solve this problem, many founders look for venture capitalists (VCs) who can fuel the scaling of their startup and provide it with higher viability and resilience.
Facing the necessity to find investors, entrepreneurs often try to guess how VCs make decisions to back a startup. Often newcomer founders think of this process of decision-making as something either mysterious or random, but in fact, I believe it can be deconstructed and systemized.
Logic and Experience-Based
The famous Swiss psychoanalyst Carl Jung had a theory that people can be categorized according to their general attitudes. For instance, based on them being introverted or extraverted, preferring to make decisions through logic or feelings, etc. This theory led Jung to create a model with eight types of personalities, which later was developed into a 16-personality type model by Katherine Briggs.
Today’s scientists may be skeptical about the possibility of arranging humanity into just 16 categories, but I think there is some truth in that model. For instance, people indeed tend to base their decision either on logic or on intuition rooted in their past experiences. And as for VCs, in many ways, they are just like the rest of us.
A VC usually has a variety of mental models which they use in the decision-making process, choosing the apt ones depending on the situation. These mental models largely come from the investor’s previous experience with other deals and entrepreneurs. Meeting new startups, a VC compares them to those past experiences to find relevant past models. Basically, an investor has a number of templates that they apply to the investment selection process.
To appropriately evaluate fintech startups, it’s important to have experience in the field and be acquainted with successful cases in the industry. It helps in understanding whether a startup’s business model is sustainable. On the whole, VCs make decisions differently depending on the length and intensiveness of their experience. An investor who has worked with 1,000 startups thinks differently in comparison to an investor who has encountered only 100 companies during their career.
However, VCs often have to deal with companies coming from sectors they have no experience in. Facing an unfamiliar situation, investors can’t use any templates from the past and prefer to turn to logical interpretation. They may be assessing the same factors but use more universal patterns. A VC well acquainted with the industry and a VC who’s new to it are going to assess a startup differently and come to different conclusions.
What Drives A VC’s Decision To Invest
No matter what kind of approach a VC is using, there is a set of characteristics that each investor assesses in order to make a decision:
  • Team. VCs always want to know who stands behind a company and what background its founders have. A research project by the National Bureau of Economic Research showed that 95% of VC firms agree that the management team of a startup is an important factor in making decisions about investment opportunities.
It’s best for founders to have relevant experience and come from the industry if they want their chances to be backed by VCs to be good. Investors want to make sure that the team is qualified to lead the startup to success.
  • Business-related factors. This category includes the business model, the product or service and its market fit. Founders should be able to explain to investors how their venture is going to create revenue. VCs are risking their money by chasing startup opportunities and they want to be assured that the company is going to be marketable and profitable. The key is to be exceedingly precise, clear and transparent about your startup’s strategy and current indicators when presenting it to an investor.
  • Internal rate of return. The IRR is a metric that helps to estimate the profitability of a potential investment. As an alternative, VCs often turn to the metric known as cash-on-cash return to calculate possible returns from an investment. After all, investors expect to profit from the deal.
When embarking on an entrepreneurial career, it’s necessary to crack the code of venture capitalists’ decision-making processes. Using the various methods that VCs tend to assess, founders should work out their own efficient templates for communicating with investors.
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