Dec 2, 2022 | Financial Acceleration

What are venture capitalists looking for in a startup team?

Q. Dear Zenagos,
I’ve heard that VCs care about the team. What are they looking for?
–Leslie

Every investor is unique, but research has shown that the management team is consistently among the most important factors when venture capitalists (“VCs”) make an investment decision. Gompers et al wrote, “In selecting investments, VCs see the management team as more important than business related characteristics such as product or technology. They also attribute more of the likelihood of ultimate investment success or failure to the team than to the business” (2020, P. 169). It is a common belief among investors that a good team can problem-solve and pivot in response to challenges, improving the overall probability of the venture’s success.

What do VCs look for in a management team?
Venture capitalists tend to make large investments in companies at a very early stage in their development. These investments are high-risk, and they are predicated on the idea that one or two investments inside a portfolio of bets will have a huge return in a short period of time (at least 30% in 3-5 years). Understanding that every venture capital group has its own personalities and its own theories of success, we have seen the following factors come up repeatedly across a wide range of venture capital firms:

1. Experience working together as a team
When a management team has a track record of working together on a series of successful projects, this sends a positive signal to investors. An experienced, cohesive team will be a preferred team.
2. Commitment to the idea
There are many ways to demonstrate commitment. Some teams will take a small salary during the initial phase of the business (far lower than their market rates) in order to show commitment. Other teams will work long hours. Still others will make large investments of their own money. Investors will look for these positive signs that the team is “all in.”
3. Industry expertise

It is important that the members of the team have experience in the industry in which the company will operate. Investors will accept a team that has one team member who has exceptional knowledge of the industry (instead of a team in which every team member has experience), but they are unlikely to invest in a team that lacks experience in the industry.

4. Demonstrated history of execution

While it is not possible to have a history of execution for a radical idea or a brand new technology, venture capitalists will preferentially choose a team with a history of success over a new team. Research shows that the entrepreneur’s track record is a critical factor in the investment decision (Gompers et al., 2010). This is especially true if that track record includes a successful exit for previous investors, such as a merger, sale, or Initial Public Offering.

5. Critical thinkers and problem-solvers

No matter how great the idea is or how convincing the plan is, venture capitalists always assume that something big will go wrong. When things don’t go according to plan, the team needs to adapt and possibly “pivot” (making a dramatic change in the company’s direction). With this eventuality in mind, venture capitalists will evaluate the problem-solving ability of the team, and this will factor into their decision.

These factors all relate to the team’s ability to make wise decisions under pressure and with limited information, skills that are critical for entrepreneurs.

What other factors matter?
There are a number of other factors that can influence a venture capitalist’s decision.

Sourcing
VCs have tons of deal flow and very little time. What they need most is high-quality deal flow, so they can increase their probability of success within their limited time. One of the ways that they gauge deal quality is by considering the source of the potential deal. As Kaplan and Strebulaev (2021) noted, “Few deals are produced by founders who beat a path to a VC’s door without any connection” (p. 14). Indeed, most VC’s find their deals through either networking or self-sourcing. Gompers et al (2020) found that only 10% of VC deals come inbound from company management.” If you want a VC to take you seriously, try to network in through an investor or other professional whom they trust.

“Gray Hair”
It is an ageist concept, but VCs believe that having a CEO with strong contacts and considerable industry experience (signified by “gray hair” or having reached an age of at least 45) is predictive of success (Zook, 2003). If your team is all 20-somethings, you would be wise to bring on a team member who has a convincing track record in your industry.

Methodology
Each investment shop has its own approach (or “methodology”) to finding investments. For example, some investors choose an industry and/or a trend and make their own idea for a company and then search for the CEO. As you spend time around VCs, you may run into former CEOs holding the title “Entrepreneur in Residence.” These are typically entrepreneurs who provided a successful exit for the VC group in the past, and they are now waiting to take on the next great idea. As you develop relationships with VCs, it helps to ask about their methodology, so you can find an appropriate fit.

Venture capitalists are not the only kind of investor, and they might not be the right kind of investor for your business idea, particularly if it is unlikely to grow very large in a short period of time. As you learn more about VCs, make sure that you are learning about other types of investors, as well, and having as many conversations as possible.

 

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References

Gompers, P. A., Gornall, W., Kaplan, S. N., & Strebulaev, I. A. (2020). How do venture capitalists make decisions? Journal of Financial Economics, 135(1), 169-190. Retrieved on December 1, 2022, from https://www.nber.org/system/files/working_papers/w22587/w22587.pdf
Gompers, P., Kovner, A., Lerner, J. and Scharfstein, D. (2010), Performance persistence in entrepreneurship. Journal of Financial Economics 96(1), 18–32.
Kaplan, S. N. and Strebulaev, I.A. (2021, March-April). How venture capitalists make decisions. Harvard Business Review, 99, 14. Retrieved on December 1, 2022, from https://hbr.org/2021/03/how-venture-capitalists-make-decisions
Zook, M.A.. (2003, June 12-14). The knowledge brokers: Venture capitalists, tacit knowledge and regional development [Paper presentation]. DRUID Summer Conference 2003 on Creating, Sharing, and Transferring Knowledge. Copenhagen, Denmark. Retrieved on December 1, 2022, from https://www.researchgate.net/profile/Matthew-Zook/publication/4734242_The_knowledge_brokers_Venture_capitalists_tacit_knowledge_and_regional_development/links/5d3f5a72299bf1995b56013f/The-knowledge-brokers-Venture-capitalists-tacit-knowledge-and-regional-development.pdf

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