Deal or No Deal – Assessing the factors that shape the choices of a VC

Ideas are never in short supply, but the funding to make them fly is often harder to come by. Venture Capitalists (VCs) have been a huge source of financing for early-stage businesses, and the impact they bring to their portfolio companies makes founders covet them. In this article, Keisi Mancellari and Muideen Abubakar evaluate the critical factors that run through the mind of a VC before making an investment, a valuation and even hiring choices. This report is based on a recent IFT seminar on “Key Drivers in Early Stage Venture Capitalism” with David Grimm, Albion VC and UCL Technology Fund.

Just as every other category of investors, VCs are seeking alpha. This means they are far from a jack-of-all-trades and will not necessarily throw money at start-ups in every industry, in their quest for superior returns. This takes us to the first question that comes to the mind of a VC approaching a founder.

What’s your playing field?

VCs tend to have industry preferences as to where they deploy capital. That way, they can demonstrate their specialised knowledge of an industry, the dynamics, and the potentials. Knowing what kind of companies are being funded by a VC should give direction to founders on which VC they should court as they jostle for cash. As David Grimm highlighted during his seminar at the UCL Institute of Finance and Technology, his VC focuses on enterprise software, deeptech, data analytics and digital healthcare. It is common for VCs to build a specialist fund for every industry that they have an interest in. For instance, Albion VC being a tech-oriented investor manages the specialist UCL Technology Fund in collaboration with UCL Business.

When a VC funds a venture, the deal doesn’t end with the handshake. They assume the role of an adviser to the management. This is another reason why they focus on a niche, as they must be able to deploy their specialist knowledge to provide critical guidance to founders, bear the torch for them on the customer acquisition path and perhaps refer them to other investors of interest.

As David also alluded to, valuation plays a key part in why a VC may ignore a pitch if the proposal doesn’t fall within their industry remit. A VC’s knowledge of an industry enables them to put an appropriate price on the table when they are approached and, most importantly, to forecast the viable exit opportunities and magnitude of multiples. After all, the end should justify the wait and the risk.

What differentiates you?

You can be sure that a VC knows your competitors – direct or indirect. So, what new thing are you bringing to the table? The answer a VC will want to hear is not simply the novelty of a business idea but extends to the unique strength of the team, Go-To-Market, customer acquisition and monetisation strategy. When David and his team are considering a potential investee, they ask the founders about the competitive advantage they bring to the market, hoping also to discover that the founders’ ambition aligns with their own. Moreover, tech-focused VCs like Albion seek a well-differentiated technology product with a plan of likely updates that may follow, and at what pace..

A key determinant of company value leads us to the next question.

What’s the potential market share?

As a VC contemplates whether to sign the cheque, it is also assessing if the Total Addressable Market (TAM), down to the Serviceable Obtainable Market (SOM) compensates for the deal ticket size. This means that a team who understands its key market metrics and can convincingly articulate its approach to scaling, while acknowledging the strategy of its competitors, would be taken more seriously than one with ambitious but empty promises on its pitch decks.

As Sebastian Mallaby writes in his book The Power Law, “That extreme ratio of success and failure is the power law that drives venture capital, Silicon Valley, the tech sector, and, by extension, the world”. David strongly confirms the play out of this power law (a similitude of the Pareto principle) in the world of VC investing where 20% of portfolio companies drive 80% of returns. Hence, it is intuitive that VCs would want to concentrate their exposure to that 20% of companies. Funds like David’s seek to invest in the next unicorn. Accordingly, start-ups must demonstrate how much of the market they can amass to translate to such a record valuation.

Are you building a responsible venture?

VC funding has undergone a marked transformation in the last several decades and in 2022, it looks very different. ESG considerations are gathering momentum towards a crucial role in the change. Admittedly, there’s still huge headroom concerning how many funders demonstrate commitment to sustainable practices or look out for the same in potential investees. Regardless, those that do (like Albion VC) have added ESG evaluation to their due diligence checklist. In other words, founders must double down on their efforts to integrate key ESG considerations in their operations. VC funds may just be the new ESG sheriffs in town.

Valuation choices

When asked how they approach the valuation of start-ups, it comes as no surprise that the conventional valuation techniques taught in MBAs and finance classes fail to make the list. Rather, David confirmed that every VC has its preferred and usually ‘artistic’ approach, rather than a scientific one. For Albion, a reverse-engineering approach is adopted at the pre-seed stage, whereby they consider how much the start-up is requesting and how much dilution it translates to, versus how much dilution they will seek in such companies.

Meanwhile, in an era where start-ups are enjoying some negotiating power due to the vast amount of available funding, VCs might look to their competitor VCs to establish a baseline. The amount they would look to offer for a particular stake could offer relative guidance to valuation. However, by the time the company attains post-product-market-fit, the multiples valuation technique becomes a favoured approach. At the point where they feel that the market has saturated or the chances of a portfolio company’s success have dissipated, then it’s time to pull the plug.

Hiring choices

Finally, David gave some nuggets to potential VC recruits among the audience. Most important of all is to take risks and not to favour the easy way out. After all, VC investing is an inherently risky business. Candidates should be willing to demonstrate that they have the guts to take risks and manage successes as well as crises with gravitas.

One of David’s key interview questions is to ask which technology company they would invest in and why. He expects to see that an aspiring VC investor can have an opinion and make a judgement call on the viability of a company.

Ultimately, the VC business is like a marriage– you’ll be “wedded” to a company for a long while and need to understand how to manage relationships, for better or for worse. An aspiring VC candidate should be personable, be able to manage difficult conversations, and be in it for the long haul.

The authors Keisi Mancellari and Muideen Abubakar are MSc Banking and Digital Finance students (2021/22).