Venture capitalists use a multi-step decision process to evaluate potential investments. They screen hundreds of opportunities to select a few to evaluate more thoroughly. Key factors in selection include the founding team, business model, product, industry, and market potential. Venture capitalists analyze market size, growth, competition, profitability, and target consumers to assess opportunities. They build decision trees to quantify risks and probabilities at different stages from early to mass market. This helps visualize outcomes and estimate chances of success, failure, or achieving different levels in the market.

1. Delhi Technological University
(Delhi School of Management)
Decision Making Process of Venture Capitalists (VCs)
MGF- 04 Financial Markets and Institutions
Prepared by: Yhtiyar Achilov
Submitted to: Dr. Sonal Thukral
2020

2. Contents
1. Introduction
2. Literature Review
3. Selection of Ventures
4. Perspective in the Market
5. Decision Process
6. Decision Analysis
7. Conclusion
8. References

3. Introduction
Economy of a country mostly depends on small and medium sized firms, thus, Venture
capitalist firms or individuals play crucial roles in making these ventures real. Moreover,
Venture Capitalists (VCs) play the most significant role in identifying and financing the new and
highly innovative firms. Criterias VCs used to make decisions of credibility or economic value
of companies have a lot of difficulties, and it has been the most complex task of a decision
making process of investment.
Venture capital (VC) - is a ​capital or fund invested in a business venture or project in
which there is a substantial element of risk, its usually new or expanding business. In other
words, it is a collection of funds that are usually invested in new and high potential ventures, and
have a high rate of risk. Venture capitalist (VCs)- is a firm or individual who invests in those
young high potential firms or projects. Due to high default risk in investment it has difficulties in
foreseeing a potential and making the right decision.
The first steps towards development of a professionally managed VC industry was the
encouragement of the Small Business Investment Act of 1958. The Act officially let the U.S.
Small Business Administration to give licence private "Small Business Investment Companies"
(SBICs) to financing and management of the small entrepreneurial businesses in the United
States. The Small Business Investment Act of 1958 provided tax breaks that helped contribute to
the rise of private equity firms. Since then venture capitalists focused their investment activities
primarily on young businesses, startups, and mostly in IT, healthcare, and similar high potential
companies.

4. Literature Review
A large number of academicians and researchers have studied the VCs ability to identify
the potential in companies in order to invest. (Tyebjee and Bruno 1984; Wells 1974; MacMillan
et al. 1987; Schweiger, and Hofer 1988; Khan 1987; Robinson 1987; Timmons et al. 1987;
Sandberg, Hall and Hofer 1993; Poindexter 1976; Zacharakis and Meyer 1995; Zacharakis 1995;
Zacharakis and Mayer 1998, Zacharakis and Shepherd 2007). Study of the decision making
process of VCs became increasingly important because statistically, the companies backed up by
VCs have more success rate than backed by non- VC companies. Tyebjee and Bruno (1984)
were the first who introduced five stages of decision making process model of VCs. They are:
● (1) deal origination - screening potential firm;
● (2) deal screening - reviewing proposals particularly in technology, product and scope of
market;
● (3) deal evaluation – assessment of a business plan (risk and return);
● (4) deal structuring – negotiating and mutually establishing VC agreement and
● (5) post-investment activities – providing value-added activities.
VCs spend most of their valuable time making the best investment decision. Gorman and
Sahlman (1989) mentioned that VCs spend 110 hours to assist one company. VCs performance
can improve with the better understanding of an investment process, and it leads to improved
time efficiency and overall returns (Zacharakis and Meyer, 2000).
Venture capitalists also take time to analyse and take into consideration a large amount of
subjective and intangible information about early stage startups (Armandi, 2015; Gompers et al.,
2016; Sharma, 2015; Wright & Robbie, 1998). For obvious reasons, financial information about

5. the new venture is greatly lacking. The high degree of uncertainty often leads to a wide
discrepancy between entrepreneurs' own financial projections, VC projections and subsequent
actual performance. Forecasting then discounting cash flows is extremely difficult when a
venture has not yet generated profits or revenues, and would lead to inaccurate estimates of a
startup true value (Gompers et al., 2016). Nonetheless, if available, financial information help
VCs greatly when making evaluations of a potential investment (kohn, 2018). Venture capitalists
prefer to base their projections on actual revenues and cash flows rather than depend on the
projections supplied by entrepreneurs that are not based on actual data. “Logistic regression
analysis reveals that venture capitalists prefer to invest in startups with mature products and
actual financial performance.”(Elsayeda A. Ismail, Mona I. Medhat 2019)
Selection of Ventures
In screening of ventures as it is one of the first steps of the VCs investment process.
Venture Capitalists in average screen between 200-250 firms in a year and make investment
decisions only for 4-6 of them (​Will Gornall 2019) . Most of the applications to VCs’ desks
come from professional networks around 30%, about 20% comes from other investors'
recommendations or networks. Only 8% referred by existing portfolio firms. These kinds of
indicators show us active deal generation.
Although, screening process is one of the first steps, selection of the ventures and
application is more important. According to findings of some of the researches the most
importance of the selection process is paid attention to the founding or management team of a
funds requesting company. The importance of the founding or management team was mentioned
by 95% of the VCs during the survey, while 47% of VCs have mentioned it as the main factor in

6. the selection process. If we move to business related factors, 83% of participants mentioned that
business model is important, product at 74%, industry at 31% and market at 68% have relative
importance in selection decisions. However, factors above or business related factors considered
important by 37% of VCs.
Perspectives in the Market
Venture capitalists are entrepreneurs who are able to foresee the potential in the market
and take risk to invest into. There are few fundamental techniques to identify the potential in the
market or in the business environment. We can think of 5 elements which are most significant in
analyzing potential in businesses or in knowing a market.
Illustration 1. Source: Author’s work
As Illustrated above we see 5 important elements to study, calculate, and analyze to better
understand the market and foresee the potential in the businesses.
Market Size - in order to know the market size we Venture Capitalists look at the first of all
direct and indirect competitors of the potential companies they would like to invest. Market size

7. study has to be done by companies which are seeking for funds, and VCs have good analytical
skills to know the quality of study and identify the potential in the market.
Market Growth - ​The ongoing trend in the market is crucial as the future of a startup and a new
venture forcased according to the growth of the market. The market growth rate can be
determined by checking authorized sources, web pages and facts of the last 5 years in the
industry. VCs fulfill these gaps by networking with their connections, companies and etc to get a
better picture about market growth.
Competition - As a new startup we need to know and understand the competition in an industry
we are going to operate and identify the potential to do business, If the industry is highly
competitive as a new venture we will need to require competitive advantages, and require more
funds to pass high entry barriers. When competition is low we might have more chances to
succeed as well as capture the market faster than competitors.
Profitability - in order to determine the profitability of the business we need to understand the
market potential. In case, if the business is focusing on providing services, or to produce
products with low profitability, then the volume of production should be high, and if profitability
of a company is high, then we will need to focus on high volumes to increase profitability.
Product type and Consumers - ​as a new venture it is significant to understand the customers
and of course our products that need to be produced. Venture Capitalists will most likely pay
attention to the indicators that show the consumers size, as well as the products success rate in
the industry.
After analyzing, calculating, benchmarking all the above mentioned elements VCs will proceed
with the final decision making process which will be including screening, reviewing, assessing,
taking decisions and investing.

8. Decision Process
Venture Capitalist firms carefully select their potential companies to invest. Along with
the complex process of investment of VCs, we should know that they take a huge risk and they
expect high return on investment (ROI) in exchange. Therefore, VCs take a long time to screen,
select, review and make the decision. As we already mentioned VCs invest only 4-6 new
companies from 200-300s, it indicates that they conduct much deeper research of companies and
industries.
According to surveys by Venture Capital investors are like Private Equity investors
surveyed by Gompers, Kaplan, and Mukharlyamov (2016) having similar characteristics, mostly
care about cash returns and net internal rate of return, rather than relative performance measures
such as how a stock is performing relative to a specific market or index. That is why VCs are
confident in connecting with their investors and carefully make their decisions.
After selecting their potential companies VCs will proceed to study the market, and
understand the industry and profitability of a company. As we also mentioned above, they take
detailed attention to the business factors as well, such as business model, production, industry,
market and many more. Furthermore, VCs after combining all factors they make final decisions
and invest in companies with higher possible opportunity and growth rate.
Decision analysis
Decision analysis is a set of tools for making quality decisions that links the art and science of
decision-making through a continuous process. Decision analysis was created at the Stanford
School of Engineering and the Harvard Business School. Due to the scholastic direction and
memorable spotlight on quantitative examination, clients of decision analysis have commonly

9. been driving organizations in huge enterprises, for example, drug, oil and gas, utilities, car, and
(less significantly) budgetary administrations. These associations have commonly utilized choice
investigation to settle on asset distribution choices, capital choices, portfolio choices—any
choice that could be numerically demonstrated from a quantifiable arrangement of values.
This tool doesn't disregard intuition, design coordinating, or judgment: these are the
establishments whereupon venture decisions are made. Decision analysis can and does, in any
case, give a structure that directs our investment intuition, much as route instrumentation in a
plane assists pilots with finding an air terminal in dimness or awful climate.
In order to get a better picture of the decision analysis, we will assume a company and a product
and assign probable success rates in the early stages of a venture.
Illustration 2. Source: (Goofrey Moore 1991)
According to the decision model of (Goofrey Moore 1991), illustration 2 shows us different
stages of the business process and we can use it as for risk assessment in decision making.

10. Evaluation of risk in early stages of a company
We will start by assessing risks associated with market, product, team, and financial risks for
each company. This is a standard procedure for venture capitalists, and we will go further by
assigning probabilities to each of the elements to make our model work and quantifiable.
Illustration 3.
Source: ​https://www.kauffmanfellows.org/journal_posts/applying-decision-analysis-to-venture-investing/
Market risk: ​Market risk in the (Illustration 3) we have assigned approximately according to the
experience and intuition of the venture investor probabilities 80% chance that it will get market
success, get customers.
Product risk: ​Depending on the product’s nature, and past performance of the company we
should evaluate and give probability of success rate in the product section. As an example we
will take 80% chance to to this section as well

11. Team risk: ​Here we will consider the factors related to experience of a team or founder of a
company, also, we will consider the expertise of the founder and give success rate accordingly.
As an example we will assume that our founder is experienced and give a 95% success rate.
Financial risks:​ In the last section of the evaluation of risks we will consider financial and
business related risks in order to get a better picture of the complete model, here we will give
95% as an example by assuming that our business or product is unique in nature.
Overall Early stage risks assessment: ​In order to succeed, the company should overcome all
four stages. Failure in any one of them will negatively affect the company’s success. In order to
measure the success rate of early stage of a company 80%*80%*95%*95% = 58%, and get a
58% success rate of our hypothetical company in the early stages of investment.
The early stage of evaluation is a first step in building a successful business and according to
Goofrey Moore there is the chasm between the first and second stages of a business process.
For our hypothetical company “cross the chasm” will be when the visionary customers converted
to pragmatic customers. Hence, we will develop another analysis for crossing the chasm strategy.

12. Illustration 4. Source: https://www.kauffmanfellows.org/journal_posts/applying-decision-analysis-to-venture-investing
As we see in Illustration 4, we have market, product, team, anf financial risks, however, this time
we calculate how a company successfully passes the chasm between early stage and early
majority which is also known as market success stage. Taking all four of the risk factors with
probabilities we can calculate the market success of 24% chance that a company crosses the
chasm. This figure will seem very low and not attractive for investors but, as we all know the
longer period we are predicting the more uncertainty we are facing. Although, as higher risk
investors will see in the company’s future more return they expect.
After calculation of the cross the chasm period of a company, we can move to calculation of the
risks that company needs to overcome in order to mass market production. We can assess 60%
probability of overcoming market risks, product, team, and financial challenges as we can see on
the illustration 5.

13. Illustration 5. Source: ​https://www.kauffmanfellows.org/journal_posts/applying-decision-analysis-to-venture-investing
Scaling production, scaling a sales organization, establishing appropriate revenue sharing
relationships—but we assumed all manageable. Taken together, we see these combined risks
translating into a 37 percent chance our company would be able to overcome the hurdles and
achieve success in the broader market.
Furthermore, we can use the same technique to calculate the chance of becoming market leader
in the market, and for our example we will consider it as 25% chance that the company will be
market leader with the unique product and 50% chance to be challenger in the market, and
another 25% chance that the company will be the also run player in the market.
Representing risks
All of these risk assessments from the early stage of our hypothetical company through
mass-market share can be summarized in a decision tree below on illustration 6. Each branch of

14. the tree represents the success as well as failure rates of the stages. In the first branch the success
rate of the Early stage a company 58% and 42% rate of failure and so on. The numbers on the
right side of the branches show the ultimate number of probabilities for each of the scenarios.
For instance: by multiplying all the success rates of the each of the stages to know the probability
of the company’s market leader rate we can see that 1% chance that the company becomes the
market leader, 3% chance that it will become challenger in the market, and another 1% that it
will be an also ran in the market. By going on with the same principle we can estimate that 9%
chance that our company will get a niche only, and an 86% chance that the venture investors will
not get anything in return for their investments, which means the failure rate. Of course this rate
is terribly high and risky for investors to put money in the company, however, if the company
passes successfully all the two stages, the return will be tremendous and investors will get decent
returns.
Illustration 6. Source:https://www.kauffmanfellows.org/journal_posts/applying-decision-analysis-to-venture-investing

15. The technique is an additional tool that venture investors use in order to check and visualize their
intuition based decision making analysis. As per survey conducted by Gompers, Kaplan, and
Mukharlyamov (2016), the VCs also apply the Discounted Cash Flow (DCF) technique andNet
Present Value (NPV) in addition to get better quantitative estimations from the analysis in
making such risky decisions.
Conclusion
Venture Capital firms are above industry return seeking firms that are vigilantes for new
companies which require funds to grow. In other hands, VCs are entrepreneurs that need to take
critical decisions in order to minimize the risks of investment failure. For that reason they take
help of connections, experience, risk taking nature, research abilities, analytical skills to make
successful decisions. More importantly they pay attention to the management team/founders of a
company, then, as the second most important aspect they pay attention is business related factors
including business model, connections, product/service, profitability, industry, market growth,
competition, and customers. They use techniques such as DCF, NPV, Decision science
techniques, Decision analysis and their experience along with market expertise in order to get a
better picture of the market behavior and possibilities of an investment seeking company’s future
opportunities. Business ventures that seek to consider venture capital as a source of funds need to
consider all those factors and conduct enough studies on the related elements and also time needs
to be taken into consideration due to the limited number of funds available.

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