Entrepreneurs try to convince venture capitalists that their business idea is a winner in pursuit of start-up capital potentially in the millions. But how do venture capitalists decide which businesses are worth investing in? Olaf Jacobi, a partner at Munich-based VC Target Partners, outlines the steps by which venture capital investors arrive at their decisions, from the day they receive a new business plan through to completion of the funding round.
When deciding whether to invest in a company with a new business idea, VC investors have a methodical and structured approach that minimises risk and ensures that funding goes to those businesses with the best chance of success. This begins with a thorough evaluation of the business plan. If it passes muster, a Term Sheet is drawn up with the entrepreneur. Finally, following a systematic and detailed analysis of the business and due diligence procedures, investment contracts are prepared.
Analysing the startup’s business plan
A venture capital investor typically receives between 40 and 100 business plans a month. The business plans are entered into a deal-database to analyse them all in a structured way and identify those with investment potential.
A VC looks for possible synergies
Once familiar with the contents of the business plan, investment managers begin to evaluate the business case for each idea and the level of investment each would require. Key points of consideration are whether the entrepreneur plans to launch a business in a sector where the VC firm is already active, which might, for example, offer opportunities for synergies or leverage of existing expertise. The investor also considers what stage of financing the company is at. Does it only require, for example, seed funding to prove a business idea and get the ball rolling, or is it at a later stage that will require a more substantial investment?
The VC’s scope of investment
A business plan will be dropped at this stage if it does not fit in to the VC firm’s scope of investment. Firms will typically categorise business ideas while making this initial assessment; the structure of categories varies within firms. Target Partners, for example, uses a simple 1 to 3 scale to rate the investment potential of each idea. Only those ideas with a rating of 1 or 2 will be evaluated further.
Deeper analysis of the startup
The venture capital investor then examines each business case in more depth, looking at a range of different factors to determine which idea to invest in.
Evaluating the startup’s market
Analysis of the market is a crucial factor in any evaluation. How high is demand for the service or product of the firm in the target market? How big is the existing market? How many potential customers can we expect, and how high therefore is the likely recoverable revenue?
The product itself – and any associated technology – is another key area for evaluation. The investment manager has to know whether the product is already functional, whether it can be put into service in its existing form or if it will require further development. What about potential customers? Investors want to know if a customer base already exists and, if so, from which target groups it is composed.
Naturally, VC investors are also keenly interested in competitors to any proposed new business. If competition exists, it must be clear which advantages differentiate the company from its competitors. The investment manager must also consider how unique or sustainable those advantages are, if at all.
How does the startup propose to operate?
Next, the investor scrutinises the proposed company set up, including the management structure and the status of shareholders. The strength of the start-up team is evaluated to determine whether key management positions will be filled and, if not, which candidates exist to fill the required roles. In addition, the investor will consider any patents or copyrights belonging to the company.
Investors will also pore over the financial planning for the business,looking particularly at how realistic the financial planning is (entrepreneurs may often underestimate the amount of money they need) and how much capital the company actually requires to meet its goals.
Finally, the investor considers possible exit strategies. If an IPO is envisaged, who are the likely buyers and how probable is it that a proposed exit is achievable?
Due diligence precedes any VC investment decision
At this point, the VC investor has not yet done a rigorous and systematic analysis of the company or the business plan – this follows in due diligence, which always precedes any investment decision. It enables the investor to double check all information provided in the business plan and arrive at an accurate risk profile of the opportunity before committing funds.
In my next column, I’ll be looking at the drawing up of so-called term sheets, which summarise the terms & conditions of the investor’s participation.