Research Paper on "Venture Capital Decision-Making"

Research Paper 6 pages (1647 words) Sources: 7 Style: APA

[EXCERPT] . . . .

Capital Decision-Making

It presently little understood as to precisely what factors determine the final funding decisions of Venture Capitalists (VCs) and this has become the focus of much study because of the necessity to understand what factors enable and empower the funding of entrepreneurs and business ventures. Venture Capital decision-making is stated in the work of Vouros and Panayiotopoulos to represent "...a complex, ill-structured, decision-making task." (2004) the following study explores decision-making among Venture Capitalists (VCs) which is an area characterized by complexity and confounding findings in previous studies. For instance, the work of Robert D. Hisrich entitled: "Toward a Model of Venture Capital Investment Decision Making" relates that the venture capital market's role in providing capital to a wide variety of enterprises is significant in nature and that decisions to invest are difficult ones "with serious adverse selection risk." (1994) This is held to be true because once the decision to invest has been made "...the investment is illiquid, and its success is highly dependent on a small group of managers..." (Hisrich, 1994)

Hisrich reports having gathered data from eighteen venture capitalists in three U.S. regions and conducting personal interviews concerning the process of investment each of these used in decision relating to most recent investments. Hisrich states that it is "...gradually becoming clear that human decision making cannot be understood by simply studying final decisions. The perceptual, emotional and cognitive processes which ultimately lead to the choice of a decision alternative must also be studied if we want to gain an adequate understanding of human decision making.." (1994) the investment decision making processes of the Venture Capitalist is one with a design specifically focused on the mitigation of adverse selection risk. The suppliers of capital are served by the Venture Capitalists (VCs) in two areas and specifically in the production of information and in making decisions. The Venture Capitalist (VC) also benefit through equity provision by those using the capital provided by the VC and as well benefits from advice in business. The VC provides equity to firms that are yet too small "to access the public equity market efficiently..." And does so through reduction of both information and contracting costs. (Hisrich, 1994, paraphrased)

The following factors are identified in the work of Hisrich as being common to investments by the VCs in the decision-making process: (1) There must be significant potential for earnings growth; (2) the investment must involve a business idea that works already or can be brought to market within two to three years; (3) the concept must officer a substantial 'competitive advantage' or be in a relatively non-competitive industry; and (4) the concept must have reasonable overall capital requirements. (1994)

Attributes that the VC investor most desire in managers of the business venture include the following attributes: (1) Personal integrity; (2) a good record of accomplishment; (3) Realistic and able to identify and mitigate risks; (4) Hard-working and flexible with a thorough understanding of the business; (5) Flexibility; (6) leadership abilities. (Hisrich, 1994) Hisrich states that there are stated to be three components to returns: (1) There must be an exit opportunity present; (2) the investment must offer the potential for a high rate-of-return; (3) the venture must offer the potential for a high absolute return. (Hisrich, 1994) Hisrich additionally relates that the decision-making process contains six specific stages with the first being 'Origination'. The second stage is the 'VC Firm-Specific Screen' with the third stage being the 'Generic Screen'. The fourth stage is the 'First-Phase Evaluation' in which the VC begins gathering information concerning the proposal. The next stage is 'Second-Phase Evaluation', which involves the determination of "obstacles to the investment...and how they can be overcome." (Hisrich, 1994) the next stage is the 'Closing' stage and in this stage, "the proposal enters the closing stage, where the details of the structure are finalized and legal documents negotiated." (Hisrich, 1994) it is reported by Hisrich (1994) that approximately twenty-percent of deals are not funded at this stage due to: (1) Proposals with serious problems; and (2) Requests by the VC for significant changes to the proposal. The following list shows the activities of VCs and how often these activities are performed in decision-making concerning funding of deals.

Figure 1: VC Activities and How Often These Activities Take Place

ACTIVITY

HOW OFTEN (%)

Interview all members of management team

Tour facilities

Contact entrepreneur's former business associates

Contact existing outside investors

Contact current customers

Contact potential customers

Investigate market value of comparable companies

Have informal discussions with experts about the product

Conduct in-depth review of pro forma financials prepared by company

Contact competitors

Contact banker

Solicit the opinion of managers of some of your other portfolio companies

Contact suppliers

Solicit the opinion of other venture capital firms

Contact accountant

Contact attorney

Conduct in-depth library research

Secure formal technical study of product

Secure formal research study

Source: Hisrich (1994)

The work of Patel, and D'Souza (2008) entitled: "Uncovering Knowledge Structures of Venture Capital Investment Decision Making" states that entrepreneurs are in constant search of capital for "new and existing ventures although they face considerable constraints in obtaining financing." Patel and D'Souza state a belief that "venture capitalists may be willing to fund a marginal team with better venture potential than a good venture team with limited venture potential." (2008) Patel and D'Souza relate that the decisions made by VCs are under "conditions of uncertainty, vagueness, and subjectivity of starting a new venture." (2008) it is suggested in the literature that expert knowledge is comprised by:

1) concepts;

2) relations;

3) features;

4) chunks

5) plans;

6) heuristics;

7) theories; and 8) mental models. (Patel & D'Souza, 2008)

Findings in the study conducted by Patel and D'Souza relate that in contrast to previous studies on VC investment funding decisions which had as their main focus "espoused criteria, this study focuses on funding criteria, trying to replicate latent investment preferences of VCs and provides a more contingent view to the VC investment decision process. The findings explain the prior research in terms of the importance of a team and go further by explaining that VCs use the competitive environment more intensely, while the venture team, though important, is of limited help beyond a certain extent. This suggests that team composition is a major factor in explaining why a business plan gets rejected, but is not significant in explaining why a business plan gets funded." (2008) Patel and D'Souza state that the study results "...suggest that market factors are most important in determining whether a business does receive VC funding, and the quality of the management team is most important in determining whether a business does not receive funding. More important, compared with previous research it provides a more contingent view to the VC investment decision process. Even though the venture team ability is a minimum requirement and a venture may not be funded if the team is not qualified, this qualification is a prerequisite for considering venture potential. VCs are willing to accept a marginal team if the venture potential is high, but the prime reason for not funding is the lack of an appropriate team." (2008)

The work of Kinnunen (2004) entitled: "Institutional Investor's Decision-Making Criteria for Investing in Venture Capital Funds" explores the reasons that institutional investors invest in Venture Capital funds and how the investors made choices between various Venture Capital Funds and states that diversification "is very important when an investor is dealing with large portfolios." (Kinnunen, 2004) This area was researched and reported by Cochrane (2001) who placed emphasis on the "individual venture capital investment perspective." (Kinnunen, 2004) However, diversification I stated by Kinnunen to be only one aspect as in his own study respondents placed emphasis on the "high expected rate of returns as one incentive to insist in venture capital… READ MORE

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