Venture Capital Survey: How do they make decisions, what’s important: Summary

A fairly extensive survey of venture capitalists was published this week from 4 professors at Booth School, Chicago; Stanford; Harvard; and Univ of British Columbia.

How do VC's decide to invest in a startup
How do VC’s decide to invest in a startup

It is a long 80 page read, but worth it.

Here are the highlights that I thought were worth reiterating. Nothing in this report would surprise an insider, but for new entrepreneurs seeking investment, it answers questions about the 8 areas:

  1. deal sourcing (where do they get startups to invest in);
  2. investment decisions (which ones they invest in);
  3. valuation;
  4. deal structure (what are the key terms and conditions);
  5. post-investment value-added;
  6. exits;
  7. internal organization of firms; and
  8. relationships with limited partners. In selecting investments

They surveyed over 889 VC’s 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
  • Public companies that previously received VC backing account for one-fifth of the market capitalization and 44% of the research and development spending of U.S. public companies.
  • The ability to generate a pipeline of high-quality investment opportunities or proprietary deal flow is considered an important determinant of success in the VC industry.
  • Over 30% of investments are generated through professional networks. Another 20% are referred by other investors and 8% from a portfolio company. Almost 30% are proactively self-generated. Only 10% come inbound from company management.
  • Few VC investments (<10%) come from entrepreneurs who beat a path to the VC’s door without any connection

  • The median firm closes about 4 deals per year. For each deal in which a VC firm eventually invests or closes, the firm considers roughly 151+ potential opportunities
  • VCs focus on the quality of the management team, the market or industry, the competition, the product or technology and the business model in their investment decisions.
  • VCs ranked the management team (or jockey) as the most important factor.

  • California VC firms are more likely to say passion is important and experience is less important.
  • The average deal takes 83 days to close; the average firm spends 118 hours on due diligence over that period and the average firm calls 10 references.

  • The average required IRR is 31%. Late-stage and larger VCs require lower IRRs of 28% to 29% while smaller and early-stage VCs have higher IRR requirements. The same pattern holds in cash-on-cash multiples, with an average multiple of 5.5 and a median of 5 required on average, with higher multiples for early-stage and small funds
  • VCs report that fewer than 30% of the companies meet projections.

  • Interestingly, 91% of our sample believe that unicorns are overvalued—either slightly or significantly
  • 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
  • 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 gives investors a seniority position in an exit.
  • An option pool is a set of shares set aside to compensate and incentivize employees, vesting refers to a partial forfeiture of shares by the founders or employees who leave the company, and control rights include features such as board seats, veto rights on important decisions, and protective provisions. VC’s were most comfortable negotiating these rights
  • The average VC firm syndicates an average 65% of its deals.
  • Over 25% interact multiple times per week and an additional 30% interact once a week, indicting that 60% of VCs report interacting at least once per week with their portfolio companies. Fewer than, one-eighth report interacting once per month or less. The high level of involvement is consistent with previous work and anecdotal evidence.
  • 87% of VCs are involved in strategic guidance of their portfolio companies.
  • 72% of VC firms help their companies connect with investors in future rounds.
  • 69% of the VCs say they help their companies connect to customers.
  • 65% of VC firms say they provide operational guidance.
  • Overall, the average VC firm reports that 15% of its exits are through IPOs, 53% are through M&A, and 32% are failures.
  • Deal selection emerges as the most important  with 49% of VCs ranking it most important. Value-add follows with 27% and deal flow lags with 23%.
  • The average VC firm in our survey employs 14 people, 5 of whom are senior partners in decision-making positions.
  • VC’s report working an average of 55 hours per week.

  • VC firms spend the single largest amount of time working with their portfolio companies, 18 hours a week.
  • Consistent with the importance of sourcing and selecting potential deals, sourcing is the second most important activity, at 15 hours per week.
  • Networking is the fourth most important at 7 hours per week

How to leverage Moving Averages to confirm a SaaS company’s traction?

On Tuesday I had a chance to talk to 23 entrepreneurs who were selected to participate in the Microsoft Accelerator Jury selection for cohort 4 at the Seattle Accelerator.

The companies were all advanced stage (ready for a post seed or Series A round) with an average of $1.5 Million ARR (Annual Recurring Revenue).

Moving Average
Moving Average

One of the things that got hard this time was to evaluate a company’s traction, given that all of them said their “market was very large”. The teams mostly looked strong, so there was little a Jury member could do in 15 min of presentation + 15 min of Q&A, so we had to look at momentum in the short term. Which in itself is bizarre, given that these were long term bets, but humor me for a while.

So, I asked a few of the companies to outline their 3 month moving average of traction. Most did not know what that meant.

Moving averages (MAs) are one of the most popular and widely used technical indicators. Moving averages smooth the traction data to form a trend following indicator (# of customer signups, monthly recurring revenue, etc.)

A Simple Moving Average (SMA) is figured using the monthly ARR for a specified period, such as 6 months.

If prices are closing lower, the SMA points down. If prices are closing higher, the SMA points up.The average “moves” because every day the oldest day is dropped off as the current day’s information is added.

A criticism to the SMA concept is that each day’s action carries equal weight.

Exponential moving averages (EMAs) are similar to SMAs except that more weight is given to the latest data.

What are physical and synthetic ETFs?

ETF Structures
ETF Structures

Physical ETFs attempt to track their target indexes by holding all, or a representative sample, of the underlying securities that make up the index. For example, if you invest in an S&P 500 ETF, you own each of the 500 securities represented in the S&P 500 Index, or some subset of them. Physical replication is reasonably straightforward and transparent. Nearly all ETF products in the United States are physical ETFs.

Instead of physically holding each of the securities in its index, a synthetic ETF relies on derivatives such as swaps to execute its investment strategy.

Because they don’t physically hold the securities in which they invest, synthetic ETFs can provide a competitive offering for investors seeking to invest in harder-to-access markets, less liquid benchmarks, or other difficult-to-implement strategies that would otherwise be very costly and difficult for physical ETFs to track.

How to invest in Alternatives ETFs?

Alternative ETF
Alternative ETF

Roughly 40 funds occupy the alternative ETF space, and they provide two broad categories of product: absolute return funds and tactical funds giving access to unique patterns of returns, such as volatility-focused products.

Alternatives are used for two primary objectives. First, they can be used to reduce volatility and manage risk in investment portfolios. They can provide diversification to reduce overall portfolio risk or to help hedge against declines in equities or bonds. Second, they can enhance returns by investing in unique asset classes.

How to invest in Commodities using ETF?

ETFs have made investing in commodities cheap and easy for investors of every size and level of sophistication. Before ETFs, if investors wanted to invest in commodities, they had to open up a futures account, get approval from a broker, and maintain margin to cover any movements in the commodities contracts they were holding.

Investors interested in exposure to commodities, with 112 funds available, have a number of options to choose from. They range from physically backed single-commodity funds, such as the SPDR Gold Shares (GLD), to futures-based commodity baskets.

Commodity ETF
Commodity ETF

The two major types of commodity ETFs are (1) those that physically hold a given commodity and (2) those that use futures contracts to gain exposure to a commodity.
Physical commodity ETFs are simple: They store the commodity in a
vault somewhere, and each share represents a certain percentage of the stored commodity. Physical commodity ETFs are currently available only for the precious metals—gold, silver, platinum, and palladium—and baskets of them.

Futures-based commodity ETFs are both more prevalent than physical commodity ETFs (by number, if not by assets) and more complicated. These ETFs hold futures contracts linked to the targeted commodity. Futures contracts are agreements to buy the commodity in question at a future date.

Unlike equities, for which a number of standard benchmark indexes exist that everyone agrees generally represent the market as a whole, there is no consensus on what constitutes a commodity market portfolio.

How to choose the right set of ETF for your portfolio?

Asset Allocation
Asset Allocation

More than a quarter of all ETFs are US equity based. They range from broad-based, total market index offerings to ETFs narrowly focused on, for example, only companies involved in supplying wind power.

Generally three factors play a role in the selection methodology: size of companies (large, small, etc.), style of investment (growth, value, dividend paying, etc.), and sector of the companies (financial companies, transportation companies, etc.).

The primary mechanism through which most equity ETFs are differentiated is by company coverage in terms of size, style, or sector, but within those categories, further distinctions—and performance differences—arise from differences in weighting schemes.

Broadly, the three basic weighting schemes are cap weighting, equal weighting, and “other.”

International equities, with 434 US-listed funds and almost a quarter of the total assets under management, are the most popular type of ETF.

Fixed-income ETFs allow investors to access institutional-level bond portfolios at a scale and cost that were unimaginable at the turn of the 21st century.

Above and beyond these ETF construction issues, the most critical thing to understand about bond ETFs is that, like bond mutual funds,  their behavior differs greatly from that of single bonds.

Because portfolios never mature, the only way to value them is by using the market price for each of the bonds held. Thus, bond funds do not offer principal protection in the way that single bonds can: We are not guaranteed to get our money back at a fixed point in the future.

How to evaluate an ETF to trade

Choosing an ETF
Choosing an ETF

ETFs, like stocks, are accessed on exchanges, through a brokerage account— that is, via financial advisers or institutional sales teams of registered broker/dealers or through on-line transaction services. Trading is one of the largest differences between ETFs and open-end mutual funds, which are purchased and sold once a day at the closing net asset value of the fund holdings.

An ETF has the advantage that it can be purchased whenever  exchanges are open—as well as at closing NAV when a transaction is large enough to qualify for a creation or redemption.

As with all exchange-traded products, ETF investors usually need to pay a commission, however, and incur a trading cost related to the liquidity factors associated with the ETF.

Since 2007 in the United States, ETFs have consistently represented between 15% and 25% of the total dollar value traded when aggregated with equity trading activity.

The 10 largest ETF in volume and AUM are:

  1. SPY – SPDR S&P 500 (US stocks)
  2. IVV Ishares Core S&P 500 (US stocks)
  3. EFA iShares MSCI EAFE (Europe Australasia and Far East)
  4. QQQ Powershares QQQ (Nasdaq 100 trading index)
  5. VWO Vanguard FTSE emerging markets (Emerging markets)
  6. VTI Vanguard Total Stock Market (US Total stock market)
  7. GLD SPDR Gold (Gold bullion)
  8. EEM IShares MCSI Emerging markets (Emerging Markets)
  9. IWM iShares Russell 2000 (Small cap & Mid Cap US Stocks)
  10. IWF iShares Russell 1000 Growth (US Stocks, mid/small cap)

 

The personal blog of Mukund Mohan

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