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Return on VC Investments

The VC Investment Process

The VC investment process typically unfolds in three main stages:

  1. Pre-Evaluation: This is a continuous process where VCs actively seek out promising companies.

    • Deal Sourcing: VCs are constantly looking for investment opportunities and aim to avoid missing out on potential successes. They employ analysts to proactively identify startups, work with incubators and accelerators as funnels for deals, receive referrals from other VCs, and handle numerous inbound requests from companies seeking funding.
    • Screening: An initial screening evaluates a company's sector, progress, and alignment with the VC's investment interests. This helps filter out companies that are not yet "VC-ready."

  2. Deal Evaluation: This stage involves in-depth assessment and negotiation.

    • Engagement: Selected startups are invited for engagement, marking the beginning of a multi-round process of conversations and negotiations.
    • Due Diligence: VCs conduct extensive due diligence on both the venture and its founders. This includes examining the founders' background, reputation, and the company's accounting practices. A "crowded cap table" (too many early investors, particularly angels) can be a red flag for VCs as it might complicate future decision-making.
    • Valuation and Deal Structuring: This is a critical and often contentious phase. VCs ascribe a value to the company (valuation), which then determines the equity stake they receive for their investment. For example, if a company is valued at $50 million and the VC invests $5 million, they would take a 10% stake. Valuation is subjective and lacks objective, formulaic methods, making it a primary point of negotiation. Deal structuring involves determining how funds will be disbursed (e.g., upfront or staggered), and the rights and control VCs gain (e.g., board seats, ability to fire a CEO if performance falters, involvement in strategic decisions).
    • Contracting (Term Sheet): Once a consensus is reached on valuation and deal structure, a formal, legally binding contract, often called a "term sheet," is drafted. Entrepreneurs may receive term sheets from multiple VCs. Legal counsel is essential for founders during this phase.

  3. Post-Financing: This phase focuses on governance, support, and eventual exit.

    • Board Representation: A VC partner typically takes a seat on the startup's board of directors.
    • Hands-off Approach: VCs generally prefer entrepreneurs to run the day-to-day operations, as founders are closer to the business.
    • Strategic Involvement: VCs primarily get involved in strategic decisions, such as major acquisitions, diversification into new products/services, and ensuring the company stays on its promised trajectory. They typically meet quarterly to review progress.
    • Exit: The ultimate goal for VCs is to exit their investment and realize returns. Common exit mechanisms include:
      • IPO (Initial Public Offering): The company lists on a public stock exchange, allowing VCs to sell their shares to retail investors.
      • Acquisition: A larger company buys the startup, providing liquidity to investors.
      • Secondary Sale: Early-stage VCs may exit by selling their stake to a later-stage VC during subsequent funding rounds (e.g., a Series A investor selling to a Series C investor).

Convergence and Barriers to Agreement between VCs and Entrepreneurs

While both VCs and entrepreneurs are motivated by building successful ventures, aligning their interests isn't always straightforward.

Points of Convergence:

  • Building a Successful Venture: Both parties are fundamentally aligned in their desire to see the venture succeed and grow.
  • Reputation Building: Entrepreneurs want to be seen as bankable and capable of delivering returns, while VCs aim to build a reputation as supportive investors who add value.
  • Financial Returns: Both seek substantial financial returns. For entrepreneurs, it's a key motivation to pursue entrepreneurship over traditional employment. For VCs, it's their primary objective as financial investors.

Barriers to Agreement:

  • Differences in Expectations/Perspectives:
    • Optimism vs. Caution: Entrepreneurs are inherently optimistic and passionate about their ventures, often seeing immediate signals of success. VCs, having witnessed numerous successes and failures across a broader portfolio, tend to be more cautious, bringing a moderating perspective based on wider business and macroeconomic insights.
  • Subjectivity of Valuation: Valuation for privately held companies lacks objective, standardized methods. It's highly negotiable, making it a frequent source of contention.
  • Distributive Issues: Many issues are zero-sum in nature. If VCs take a larger equity stake or more control, it often comes at the expense of the founders, who must relinquish a greater share of ownership or decision-making power. These distributive conflicts can create significant barriers to reaching an agreement.
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