50 Questions: How do VCs make investment decisions?

By December 14, 2011Uncategorized

Fortieth in a series of weekly posts by myself and Nicholas Lovell of Gamesbrief which answer the fifty questions you should ask before raising venture capital.  We expect the series to run for a year after which we will collate the posts into a book.  You can find the rationale behind the series here, and the list of questions here.  We welcome your comments on any and every aspect of what we are doing.

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Most VCs are secretive about the detail of their decision making processes.  Some have spent a lot of time thinking about it and regard their processes as a core part of their IP whilst others are reluctant to share because they haven’t thought about it and don’t have too much to say.  For these reasons it is hard to get a complete picture of how decisions are taken in the industry as a whole, and this post is based on what I’ve observed across the two partnerships I’ve worked in, one we acquired, what I’ve seen at DFJ in the Valley, what my friends at other funds have told me, and the small amounts I’ve read on the web.

Caveat made, I think for most funds, from a practical perspective postive investment decisions go through the following steps:

  1. A partner (or maybe two) falls in love with a deal
  2. They socialise it with other partners, typically at the weekly partners meeting
  3. If there is a positive reception the proposing partner does more due diligence and works to build an investment case, whilst the other partners think about the deal and maybe socialise it with some of their contacts
  4. The proposer makes a formal request of her investment committee to offer a termsheet to the company, at which point if there is a consensus in favour of making the investment an in principle decision to do the deal will be made, and a termsheet will be offered
  5. If the legals go smoothly and any remaining due diligence goes without a hitch the investment is made – often there is a second formal investment committee review prior to completion, but unless something unexpected crops up this is a meeting to check that due process has been followed rather make a decision on the investment

The time from steps two to four can vary hugely, depending on how hot the deal is, and how ready the partnership is to make the investment.  The benefit of getting to know a VC before starting a fund raising process is that they will already have socialised your company with their partners before a deal is in discussion, which makes it easier and quicker to build consensus and offer a termsheet.

The level of consensus required before a positive decision can be made varies hugely, but the general model is that all the partners agree to make the investment.  That is in contrast to the way traditional funds like 3i used to operate where investment managers would find a company they liked, work it up into a deal, and then pitch it to an investment committee that was largely unfamiliar with the deal which would then hand out a ‘yes’ or a ‘no’.  These days the investment committee is either made up of the investing partners in the fund or it is a committee that largely exists to rubber stamp the decisions that the investing partners suggest that it make.

The required level of consensus varies both between funds and also within funds over time.  Smaller and newer funds typically require the greatest levels of consensus, and in a young fund with only two or three partners it is common that a deal will only get done if there is a very high level of buy in from all the partners.  However, the level of consensus necesarily drops when the number of partners increases, when thre is a need to increase the rate of investment, or when portfolio management begins taking up more of the partners’ time.  Different funds approach this in different ways.  Some evolve detailed processes (often based on voting) by which deals get done with only tacit support from some partners.  Others operate less formulaic processes for getting deals done without every partner needing to really love a deal – a common model is for a dominant partner to run the investment committee meetings and drive the group to a decision when there is an appropriate level of buy in across the group.

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