Stanford GSB on Venture Capital Secrets

The world of venture capital was mostly overlooked till recently.

Now the Stanford Venture Capital Initiative at the business school is building a database on the industry.

The VC world is interesting because the truth is that it’s very small in terms of available funding. One large pension fund or sovereign fund is bigger than the whole VC industry, but its relative impact, of course, is huge. Even though it is such a small industry, of the 1,300 or so companies that became public in the U.S. over the past four decades, 40% were backed by venture capital and they accounted for 82% of the research and development expenditures by all those 1,300 firms. Of the 10 that went on to become the biggest, as measured by market capitalization, eight began with VC funding.

And yet we know very little about how VCs make decisions, or how the economics of their funds really works. What are the best contracts to incentivize entrepreneurs? What’s the best way to add value to these fledgling firms? We have a huge list of unanswered questions.

Inside the Secret World of Venture Capital

What do venture capitalists do?

VCs use a multi-stage selection process to sort through investment opportunities. Most potential deals pass through each stage of this so-called deal funnel before being funded by the firm. When a member of the VC firm generates a potential deal, the opportunity is first considered by the individual originator (who could be a senior partner, a junior partner, an associate, or an affiliated member such as a venture partner). If the investment shows potential from this initial evaluation, a VC firm member will meet the management of the potential portfolio company at least once. If the VC firm member continues to be impressed with the potential investment, he or she will bring the company to other members of the VC firm for the review. Potential investments will then be scrutinized and evaluated by the other partners at the VC firm, a process that can itself take many forms. After this approval, the other partners at the VC firm will start a more formal process of due diligence (e.g., calling more references, conducting industry analysis and peer comparison). If the company passes the due diligence process, the VC firm will present a term sheet that summarizes the VC’s conditions for a financing. Finally, if the company agrees to the term sheet, legal documents are drafted, a letter of commitment is signed, and the deal closes.

How Do Venture Capitalists Make Decisions?

The skylight inside the Cantor Arts Center at Stanford.
Photo by Caitlyn Chau on Unsplash

Post by Marcelino Pantoja