How Venture Capital Investors Asses Companies Today

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Relative to liquid investments such as stocks or bonds, venture capital offers higher potential returns in exchange for increased investment risk and longer lockups of capital. Venture investments are typically illiquid for the 10-year average duration life of a fund. With regards to funding innovation, some venture investors may see partial return of capital during the life of the fund, but the average fund investment takes 6-10 years to return capital depending on the stage of investment and the exit opportunities provided by the capital markets (through M&A or IPOs). Venture firms pool the risk of multiple investments and venture fund economics is based on one or a few investments generating outsize returns relative to others.

In other words, for a venture firm that makes 10 investments, perhaps only one winning investment “returns the fund”—meaning it generates enough return to pay back the entire fund’s invested capital. And, this winning investment may generate a much higher return—20 to 40 times (or more) the original investment. For example, venture investor Peter Thiel made a 2200 times return on his $500,000 early investment in Facebook yielding $1.1 billion. Typically, a few of the ten companies in a sample portfolio may generate a good return of 1-3 times capital invested but most of the companies fail and return nothing. These economics have been termed the “power law” because one outsized capital return ensures the fund returns a multiple of capital to its investors regardless of the performance of most of its investments.

To secure future funds and sustain the brand, a venture firm must maximize returns on each fund. This is crucial for maintaining long-term relationships with institutional investors, who prefer to invest in a series of successive funds, ensuring ongoing participation and trust in the firm’s franchise.

Software Is Eating The World

Several business model characteristics contribute to higher returns and favor software relative to hardware: low capital intensity, low startup costs and faster exits. Capital intensity is the capital required for product development, equipment for production and inventories to support revenue growth. Startup costs are the costs to initiate and develop the business which have dramatically shrunk for software in the past decade given widespread access to high-performance computing and networking through cloud services (instead of buying and managing dedicated compute resources in a data center), open-source code components to build software (lego blocks of software functions sourced from open-source libraries instead of custom code) and remote-work contributions from lower-cost engineering locations due to global connectivity.

Additionally, software firms also tend to have faster time to liquidity (through M&A or IPOs) which also generates better returns. Since software can also be developed more rapidly than hardware, software firms can demonstrate product-market fit sooner and scale faster. Finally, software has the potential to generate outsized returns by becoming a platform—such as a widely-used productivity tool like Zoom or a social network like Facebook—where network effects lead to increasing returns with more user adoption.

Although there are exceptions, hardware businesses are less likely to become a platform, represent more technical risk, require more time to develop, and require more capital for manufacturing equipment and inventories. From an industrial policy perspective, venture capitalists need no incentives to invest in software where the U.S. enjoys a global comparative advantage. However, for hardware-based or capital-intensive industries, the private sector does not have sufficient incentives to invest in these riskier businesses. In sum, absent a market intervention, venture capital investors will continue to invest much more in software, including ad targeting and dating apps, rather than in technologies important for national security like new battery chemistries or hypersonic aircraft.

The implications for industrial strategy are clear: venture capital firms invest for outsize returns (not average returns) and absent economic incentives will not support national policy objectives such as supply chain resilience. Because venture capitalists already sufficiently fund software businesses, to motivate venture investment in hardware-based businesses, government incentives must increase the likelihood of an outsize return or reduce the technical risk sufficiently to enable an outsize return.

How VCs Evaluate Deals: Team, TAM, Tech

There are three basic factors that venture capitalists consider when making an investment to determine the likelihood of outsize returns: the founding team, the market size and technology maturity. This first factor is the capability, experience and success characteristics of the founding team. A team is more likely to be successful than a solo founder and the team needs to have experience in the key functions required to build a business in addition to developing the core technology. Included in these would be a sound go-to-market strategy, curiosity about customer feedback and the open-mindedness to shift the business idea to better achieve product-market fit.

Additionally, the team needs the perseverance and team cohesiveness to overcome many obstacles in building a business. While unknowable at the time of an investment, patterns of behavior and previous business experiences are important determinants of successful behaviors.

Second, the total addressable market of the business idea will be a critical determinant of an outsize return. If the market is too small or uncertain to build a large enough business valued at $1 billion or more, then the business idea will not be appropriate for a venture investment. The U.S. government’s role in building a large market can be essential for dual-use markets, especially where the military can be a large customer. Good business ideas attract competition so the market must be sufficiently large that—with multiple competitors—each competitor can grow to a size that yields a venture return of 10 times or more of invested capital. Ideas which address an existing market are generally less risky than developing a new market or changing customer behavior.

Third, the technology must be developed beyond the basic research stage so that a resulting product or solution can be delivered in a timeframe consistent with the venture investment horizon of 10 years or less. Venture capitalists avoid immature ideas which are not yet at a sufficient development level to yield a solution that customers can try within a few years. If there are still years more of research or large capital investments to prove the feasibility of an idea, this is a large obstacle to achieving outsize returns. Venture capital generally invests in proven technologies where the founding team can package and test the technology relatively rapidly in a customer-ready solution to test the product-market fit.

It remains to be seen how the U.S. government is employing these incentives of ensuring there is a capable team, technology maturity and a visible addressable market.