The Venture Capital Investment Process

The development of new entrepreneurial ventures plays a key role in shaping any national economy. Entrepreneurial firms are a source of growth and innovation in the industry for owners and provide jobs for the local population. They are also believed to offset economic declines and help to restructure existing industry. A healthy entrepreneurial sector is critical to any national economy and imperative to economic growth for several reasons. First, it is estimated that six out of every ten jobs are created by entrepreneurial firms. Second, young firms are spearheading the industrial transformation from traditional industries into high technology sectors. Third, entrepreneurial firms are at the forefront of developing innovations with a clear competitive advantage; they are known to commit more capital and resources to research and development when compared with more established corporate entities. Last, entrepreneurial firms are making significant inroads in developing global markets.

The completion of a successful venture capital deal requires the deal to progress through a multistage process. This process is no easy task, as venture capitalists face a number of unique challenges along the way. First, it is up to venture capitalists to educate the young entrepreneurs who often confuse venture capital with other types of financing. The initial interactions between the two sides are difficult, as venture capitalists must fill the dual role of educator and negotiator. Second, entrepreneurs are often not prepared to receive venture capital. They may not have any formal documentation describing their business, and may not have prepared business plans or financial forecasts—the cornerstones of venture capital evaluation. Third, the process of structuring and negotiating venture capital deals is inherently difficult—a fact that is especially true for first-time venture capital recipients.

Deal generation is a fundamental concept in venture capital financing. Some venture capitalists argue that it represents the most important function in the venture capital investment process . A strong pipeline of high quality deals almost always converts into superior returns for the venture capital firm. Deal generation, commonly called deal flow, is understood as the venture capital firm’s ability to generate a stream of investment opportunities.

The process used by venture capitalists to make investment decisions lies at the heart of venture capital investing. Practitioners of venture capital regard the venture capital process as a combination of art and science. The science relates to the application of specific and concrete decision criteria to a detailed and technical investigation of the market or industry, competition, technical issues, the investee firm’s financial performance, and its valuation. By relying on internal and external resources, venture capitalists are able to arrive at concrete, technical conclusions about a firm’s future prospects and its past operational performance. There are, however, other aspects of the assessment that are more difficult to ascertain. The “art” of venturing relates to the “soft,” unquantifiable, less tangible, non-concrete, and subtle evaluations embodied in the assessment of people, deal terms, negotiating tactics, and the “investment story.” Sometimes referred to as “venture capitalist intuition,” this assessment can be more appropriately categorized as an experience-based judgment call. Some academic researchers argue that the traditional approaches based on the concrete assessment of tangible criteria may be less reliable and relevant to venture capital decision-making today.

The investment committee, the internal decision-making body operating in the venture capital firm, initially provides venture capitalists with preliminary feedback on potential investee firms. Once the members of the investment committee have been satisfied with the preliminary analysis performed by venture capitalists, venture capitalists commence a more intensive round of interactions with the management and entrepreneurs of potential investee firms. These interactions relate to two basic areas: financial forecasting and business valuation.

Having understood the issues related to financial forecasting and business valuation, venture capitalists proceed to conclude one of the most important steps in the early stage of the investment process—negotiation and finalization of the terms of the deal with entrepreneurs. Negotiations of the major terms of the deal are to have been completed and the term sheet is to have been signed before the deal is presented to the investment committee for formal approval. The term sheet allows venture capitalists to show to the investment committee that the deal, in principle, is signed and that the major areas of commercial investigation have been checked off. This is a critical step to complete prior to obtaining any internal approvals and is the focal point of this chapter.

If venture capitalists are successful in negotiating the basic parameters of the transaction and the investment committee is enthusiastic toward the deal, the next step in the investment process is the involvement of external advisors. This is an expensive but necessary process during which the activities of venture capitalists are limited to providing appropriate briefs to external consultants in order to facilitate smooth communication between consultants and the potential investee firm. External advisors are involved in the investment process for between four and six weeks and their involvement normally ceases upon the submission of their final report to the venture capital firm. This report creates the basis for further interaction between venture capitalists, the investment committee, and the business founders.

Deal completion refers to a conclusion of the negotiation of detailed legal documents in a transaction between venture capitalists and entrepreneurs. Anxiety is felt by both sides at this point in the venture capital investment process. Unanticipated issues can often arise when the general terms of the deal (captured in the term sheet) are converted into detailed legal documents. Signing multiple copies of legal documents formally commences cooperation between venture capitalists and entrepreneurs.

Once the investee firm has been funded, venture capitalists focus on the following key considerations: maintaining the operational efficiency of the business, developing the business according to the pre-agreed upon business plan, achieving operational and financial milestones, and performing operational reviews and audits. The achievement of operating efficiencies anticipated in the business plan is reflected in the strength of operating margins (at EBITDA and EBIT levels) and cash flows. Monitoring these financial parameters ensures that the business is unlikely to experience any financial surprises that may require the business to restructure, make changes to the management team, or inject additional capital. The agreed upon business plan effectively forms an “operational bible” for key stakeholders in the business, including entrepreneurs, venture capitalists, and management. The business plan outlines key operational milestones that need to be met at every facet of business development if the business is to achieve its long-term goals.

The initial years of cooperation with an investee firm focus on increasing efficiencies, reaching operational milestones, and meeting financial forecasts. At some point in the deal (normally between years two-four), venture capitalists begin to shift their discussions with management and other shareholders away from issues related to the business and toward those related to the exit and its timing. Other shareholders generally place less importance on this issue than venture capitalists, in spite of the fact that many entrepreneurs actually see themselves going public. If an investee firm has been performing well according to its business plan, achieved considerable market share and brand awareness, developed a strong customer base, and maintained a strong future outlook, venture capitalists will focus their attention on the most profitable mode of exit for the business. In these circumstances, the investee firm is likely to have already lured interested buyers or been approached by investment bankers promising a successful initial public offering (IPO). If the firm’s development has not proceeded according to plan, the spectrum of profitable exit choices diminishes significantly. In the most critical situations, the firm may be liquidated and venture capitalists may face the prospect of writing-off their investment to zero.

With over $2.2 trillion raised and nearly $1.5 trillion invested over the period between 1998 and 2007, the venture capital and private equity industry continues to be an important asset class. The industry is a strong contributor toward supporting firms deploying new technologies, increasing sales growth for expanding firms, developing export markets, increasing employment, and reducing rates of failure. For limited partners, the venture capital and private equity industry provides access to private firms that would otherwise not be possible.