How Do Venture Capitalists Make Decisions?

Author: Paul Gompers, William Gornall, Steven N. Kaplan, Ilya A. Strebulaev — NBER Working Paper 22587 (September 2016) URL: nber.org/papers/w22587 · local archive: source.pdf One-line: A survey of 885 institutional VCs at 681 firms on how they actually source, select, structure, and add value to deals — and how often that diverges from textbook finance. Investing

Got the summary of this VC paper from Ece Edgragoz, who read it at Stanford GSB. Original source was a Google Drive PDF; archived locally above.

Key findings (from the survey)

• We surveyed 885 institutional VCs at 681 firms.
• Roughly one-half of all true IPOs are VC-backed even though fewer than one quarter of 1% of companies receive venture financing.
• Are VC returns driven by deal sourcing and investment selection versus VC value-added? He concludes that both matter, with roughly a 60/40 split in importance.
• Only about one-third of VC-backed companies still have a founder as CEO at the time of IPO.
• 20% of all VCs and 31% of early-stage VCs reported that they do not forecast cash flows when they make an investment.
• Respondents report working an average of 55 hours per week. VCs spend the single largest amount of time working with their portfolio companies, 18 hours a week.
• 74% of VC firms compensate their partners based on individual success. Interestingly, more successful and larger VC firms are less likely to allocate compensation based on success.
• Roughly half the funds—particularly smaller funds, healthcare funds and non-California funds—require a unanimous vote of the partners. An additional 7% of funds require a unanimous vote less one.
• In 60% of the funds, partners specialize in different tasks; this degree of specialization is relatively uniform across subsamples.
• VC firms on average offer 1.7 term sheets for each deal that they close, a close rate of roughly 60%, suggests that a meaningful number of opportunities that ultimately receive funding are not proprietary.
• Pro-rata rights, which give investors the right to participate in the next round of funding, are used in 81% of investments. Participation rights that allow VC investors to combine upside and downside protection (so that VC investors first receive their downside protection and then share in the upside) are used on average 53% of the time. Redemption rights give the investor the right to redeem their securities, or demand from the company the repayment of the original amount. These rights are granted 45% of the time.
• Other investor-friendly terms are less common. Cumulative dividends accumulate over time and effectively increase the investor’s return (and sometimes ownership stake) upon eventual liquidation. Our VC firms use this provision 27% of the time. Full-ratchet anti-dilution protection gives the VC more shares (compared to the more standard choice of weighted-average dilution protection) if the company raises a future round at a lower price; this investor protection is used 27% of the time. Liquidation preference is used 19% of the time.

Notable quotes

VC firms as a class appear to make decisions in a way that is inconsistent with predictions and recommendations of finance theory.

How it connects

• Investing — Kyle filed this under #Investing in the daily log.
• Venture Capital — empirics on how the asset class actually operates (sourcing, selection, deal terms, value-add).
• Stanford GSB / Ece Edgragoz — provenance of the recommendation.