Master Thesis - Danièle Müllender

8/10/2019 Master Thesis - Danile Mllender

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THE SELECTION CRITERIA USED BY

VENTURE CAPITALISTS TO EVALUATENEW VENTURE INVESTMENT PROPOSALS.

A COMPARATIVE STUDY OF PUBLIC ANDPRIVATE PLAYERS IN BELGIUM.

Jury: Dissertation by

Promoter: Danile MLLENDER

Maurice OLIVIER For a Masters Degree in Management

Reader(s): Sciences

Georges HBNER Academic year 2010/2011

Constanze CHWALLEK


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Acknowledgements

I would like to acknowledge the following people for their encouragement, support and

assistance with this master thesis.

First of all, I would like to express my deepest gratitude to my promoter, Maurice Olivier,

who guided and supported me from the initial idea to the completion of this master thesis,

provided me with highly relevant information, documents and contact details and advised me

whenever I encountered impasse situations.

At HEC-ULg, I would like to thank Georges Hbner for his assistance and advice as well as

Bernard Caeymaex for the organization of this master thesis within the framework of the

double-degree master program with FH Aachen. I would also like to thank Constanze

Chwallek and Norbert Janz from FH Aachen for their encouragement and help.

This study has also greatly benefited from information, comments and suggestions by Yan

Alperovych, whose doctoral thesis was decisive for the choice of my research focus and who

advised me on the development of my questionnaire, Georges Nol, Benoit Leleux and Henri-

Franois Boedt.

I owe very special thanks to all participants in my empirical study who kindly received me for

interview. Their contribution enabled me to get valuable insight into real life practices of

venture capital decision making and to empirically verify my hypotheses and assumptions.

And last but not least, thanks are also due to my family and friends and all other people who

supported me, with special thanks going to Daniel Thies and Christopher Powell for proof-

reading this paper. Without their invaluable encouragement and help, the successful

completion of this work would not have been possible.


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Executive Summary

Venture capital as a source of finance is of huge interest to entrepreneurs. Their own financial

means are usually limited in the early stages of development of their start-up business andtraditional providers of external capital (like banks) are prevented from intervening because

of uncertainties and information asymmetries. Now in order to convince venture capitalists

(VCs) to invest their time, money and effort in a venture, entrepreneurs need to know about

the selection criteria they use to evaluate new venture investment proposals.

The scientific research literature has given much consideration to these selection criteria in

the past, mainly with a focus on private VCs. Only few studies addressed the particular

selection criteria of public VCs which, rather than being financially motivated, are based on

economic and social objectives. Given the observed differences between various categories of

capital providers (e.g. banks, business angels and venture capitalists) in terms of selection

criteria, differences may also be expected within the category of venture capitalists. So it

suggests itself to investigate whether and what kind of differences in selection criteria exist

between public and private VCs in order to subsequently make useful recommendations to

entrepreneurs.

After a review of the existing scientific literature, an empirical study with 15 VCs in Belgium

has been carried out. Data about the VCs objectives, decision-making process and selection

criteria has been collected through personal interviews and a comparison between public and

private VCs has been made.

The results show no major differences between the different types of VCs in relative

importance attached to the criteria related to the entrepreneur and management team, the

product and the market. However, striking differences were found for VC- and fund-specific

criteria, the financial aspects of an investment project as well as economically and socially

motivated criteria.

The main recommendations to entrepreneurs are to get to know about the knock-out criteria

of the different VCs and to establish a first personal contact. Subsequently, it is important to

be well prepared and to make all aspects of the investment project as well as potentialproblems and their solutions transparent.


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Executive Summary (franais)

Le capital-risque comme source de financement a un intrt particulier pour les entrepreneurs.

Leurs moyens financiers propres sont souvent limits dans les premiers stades dedveloppement de lentreprise entrepreneuriale et les incertitudes et asymtries dinformation

empchent les bailleurs de fonds traditionnels (tels que les banques) dintervenir. Alors, pour

convaincre les investisseurs de capital-risque dinvestir leur temps, argent et efforts dans un

projet entrepreneurial, les entrepreneurs doivent connaitre les critres de slection quils

utilisent pour valuer des nouveaux projets dinvestissement.

Ces critres de slection ont souvent t traits dans la littrature scientifique dans le pass,

pour la plupart en mettant laccent sur les investisseurs de capital-risque privs. Peu dtudes

se sont jusqu prsent penches sur les critres de slection spcifiques aux investisseurs de

capital-risque publics. Ceux-ci, plutt que dtre motivs par des rendements financiers, sont

bass sur des objectifs conomiques et sociaux. Etant donn les disparits constates entre les

critres de slection de diffrentes catgories dinvestisseurs (p. ex. banques, business angels,

investisseurs de capital-risque), des diffrences peuvent galement tre attendues lintrieur

de la catgorie des investisseurs de capital-risque.

Aprs avoir revu la littrature scientifique existante, une tude empirique sur 15 investisseurs

de capital-risque en Belgique a t mene. Par voie dentretiens personnels, des informations

sur les objectifs, le processus de prise de dcision et les critres de slection ont t collectes

et une comparaison entre investisseurs de capital-risque publics et privs a t ralise.

Les rsultats obtenus nont pas montr de diffrences majeures au niveau de limportance que

les diffrents types dinvestisseurs de capital-risque attachent aux critres lis lentrepreneur

et lquipe managriale, au produit et au march. Toutefois, des diffrences remarquables

ont t observes pour les critres relatifs aux investisseurs et leurs fonds, les aspects

financiers ainsi que les critres bass sur des objectifs conomiques et sociaux.

Il est ds lors recommand aux entrepreneurs de sinformer sur les critres dexclusion des

diffrents investisseurs de capital-risque et dtablir un premier contact personnel. Ensuite, il

est important dtre bien prpar et de rendre transparent tout aspect du projetdinvestissement ainsi que les problmes potentiels et leurs solutions possibles.


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Foreword

Majoring in marketing, I should ideally discuss and analyze a subject in the field of marketing

for this research project. As university papers and marketing studies often treat typical topicssuch as the influence of factor X on the purchasing behavior of customers or recent trends

like online sales and social media, I was keen on looking at marketing from another point of

view.

Nowadays, it is generally known that potential customers should be thought of very early in

the development process of a firm and its product or service. However, without appropriate

funding, a company will not even reach the stage of development at which it can market and

sell its product or service. Before any sort of marketing toward customers makes sense,

entrepreneurs have to do marketing toward investors. While potential customers are

seduced to purchase a product or service based on the AIDA model (i.e. create Awareness,

Interest, Desire and finally incite Action), potential investors have to be convinced in a

similar way to invest in a project long before that. Entrepreneurs have to create awareness

(proposal/deal origination), interest and desire (during the screening and evaluation process)

on the part of investors and finally convince them to invest their money, time and effort into a

project.

The purpose of this paper is to investigate the aspect of investment criteria used by one

particular type of investor that an entrepreneur may direct his/her convincing process to,

namely venture capitalists (VCs). During the screening and evaluation stage of their

investment process, VCs rely on a certain number of criteria in order to decide whether or not

to invest in a new venture investment proposal. Knowing about these criteria, of course, is

crucial for an entrepreneur or a management team that seeks funding. From the 1970s

onwards, this subject has been thoroughly studied and analyzed, using different data sets,

methodologies and analysis tools, but always with a focus on independent VCs. Public VC

agencies on the contrary have been looked at in order to study their raison dtre, their

objectives and their overall efficiency and performance.

After reviewing some of the related scientific literature and especially after having attended

two key events namely the defense of the doctoral thesis of Yan Alperovych in Lige and


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the euBAN matching forum in Aachen in April 2011 , a subject which has not received

much attention in the research literature yet could be detected. The focus of this paper will

therefore be on the differences in investment criteria between public and private VCs and the

related empirical study will treat the case of Belgium more specifically.


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CONTENTS

Acknowledgements ................................................................................................................... 5

Executive Summary ................................................................................................................. 7

Executive Summary (franais) ................................................................................................ 9

Foreword ................................................................................................................................. 11

List of Figures ......................................................................................................................... 15

List of Tables ........................................................................................................................... 17

Abbreviations .......................................................................................................................... 19

1 Introduction .................................................................................................................... 21

2 Literature Review ........................................................................................................... 31

2.1 Selection criteria of private VCs............................................................................ 31

2.1.1 An overview of previous studies ...................................................................... 31

2.1.2 Espoused vs. in use selection criteria .............................................................. 35

2.1.3 Selection criteria vs. success factors............................................................... 362.1.4 Evaluation uncertainty and overconfidence.................................................. 39

2.2 Specific objectives and selection criteria of public VCs....................................... 41

2.3 Trade-offs between various selection criteria....................................................... 43

2.4 Factors influencing the selection criteria and their relative importance ........... 45

2.4.1 The subdivision of the screening and evaluation phase................................ 45

2.4.2 First round vs. subsequent follow-up investments........................................ 47

2.4.3 Open-end vs. closed-end funds and related constraints................................ 47

2.4.4 The source of referral...................................................................................... 482.4.5 Syndication and investment consortia ............................................................ 49

2.4.6 Prior investment by BAs or VCs and government subsidies....................... 50

2.4.7 The compensation of fund managers .............................................................. 50

2.5 The impact of the recent financial and economic crisis....................................... 51

2.6 Public vs. private VCs: A synthesis ........................................................................ 55

3 Venture capital in Belgium ............................................................................................ 59


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4 Methodology ................................................................................................................... 65

4.1 Sample construction ................................................................................................ 65

4.2 Data collection .......................................................................................................... 66

4.3 Method of data analysis .......................................................................................... 68

5 Results and discussion .................................................................................................... 71

5.1 Selection criteria ...................................................................................................... 71

5.2 Trade-offs ................................................................................................................. 77

5.3 Influencing factors ................................................................................................... 80

5.4 The impact of the crisis ........................................................................................... 85

6 Conclusion ....................................................................................................................... 89

7 Limitations and suggestions for further research....................................................... 93

References ............................................................................................................................... 99

Appendix ............................................................................................................................... 107

I Semi-structured questionnaire ................................................................................. 107

II Relative importance of selection criteria median................................................ 112


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List of Figures

Figure 1: Search, experience and credence qualities and the venture capital process ............. 39

Figure 2: European private equity activity quarterly evolution ............................................ 53

Figure 3: Fundraising in Europe quarterly evolution ............................................................ 54

Figure 4: Investments in Europe quarterly evolution ............................................................ 54

Figure 5: Synthesis of relevant selection criteria ..................................................................... 55

Figure 6: Relative importance of selection criteria arithmetic mean .................................... 72

Figure 7: Relative importance of selection criteria median ................................................ 112


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List of Tables

Table 1: Sample segmentation type of VC / type of fund matrix ......................................... 81

Table 2: Sample segmentation type of VC / type of management compensation matrix ..... 85


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Abbreviations

BA Business Angel

BVA Belgian Venture Capital & Private Equity Association

EU European Union

EVCA European Private Equity & Venture Capital Association

GIMV Gewestelijke InvesteringsMaatschappij Vlaanderen

GP General Partner

IPO Initial Public Offering

IRR Internal Rate of Return

LP Limited Partner

LRM Limburgse ReconversieMaatschappij

M&A Merger & Acquisition

PMV ParticipatieMaatschappij Vlaanderen

R&D Research & Development

SBIR Small Business Innovation Research

SME Small and Medium-sized Enterprises

SoGePa Socit wallonne de Gestion et de Participations des entreprises

SOWALFIN SOcit WALlonne de FINancement et de garantie des petites et moyennes

entreprises

SRIB Socit Rgionale dInvestissement de Bruxelles

SRIW Socit Rgionale dInvestissement de Wallonie

US United States

VC Venture Capitalist or Venture Capital (depending on the context)


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1 Introduction

Before defining the research objectives of this paper, a brief review of some of the basics of

venture capital financing will put this study into context.

The main reason for venture capitalists (VCs) to exist is the difficulty of young

entrepreneurial firms to meet their financing needs through traditional mechanisms

(Gompers & Lerner, 2004, p. 157). Gompers and Lerner (2004) argue that entrepreneurs face

a number of difficulties which prevent traditional providers of external capital (like banks)

from intervening at least at a reasonable cost of capital. Among these difficulties,

uncertainty concerning the future development of the project or firm and information

asymmetry between the provider of capital and the entrepreneur can be named. Bazkaya and

Van Pottelsberghe de la Potterie (2008) add high risk, weak track record of the entrepreneurs,

a lack of tangible assets, long term growth potential rather than short term revenues and

turbulent, high-risk environments as other potential difficulties for young firms.

For this reason in the very early stage most entrepreneurs can only rely on funding from

the well-known FFFF, i.e. the founders, their families and friends or fools who are willing to

invest their money. However this capital is often not sufficient to cover the high initial

investment many entrepreneurs face.

This is where VCs or public, government-sponsored initiatives come into play. Olivier (2010)

provides an overview of the types of investor that intervene at different development stages of

a firm. He shows that during the earlier investment stages, mainly regional or university funds

as well as another type of investors not considered in this paper, namely business angels

(BAs), networks of BAs or BA funds provide funding. Many venture capitalists (public as

well as private) only invest at later stages, i.e. they provide expansion, replacement and

buyout capital (Leleux & Surlement, 2003, p. 87). Nevertheless, there are VCs that,

exclusively or in addition to investing in later-stage projects, provide money to early-stage

(seed and start-up) and early-growth firms.

By thoroughly screening and evaluating every project before an investment is made

(commonly referred to as due diligence), VCs can reduce uncertainty and perceived risk


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inherent in a company or project something that banks usually cannot do due to time

constraints and their limited knowledge of the entrepreneurs business and industry. When

setting up the term sheet, and later on the shareholders agreement, VCs know exactly what to

focus on in order to prevent potential future problems. Later on, with an active member on the

investees board, the venture capital company has access to a large amount of internal data

and information and maintains a close contact with the entrepreneurs something which

banks are never able to do to the same extent.

For VCs, the cost of information gathering is lower than for private or institutional investors

investing directly into start-up companies due to economies of scale (they represent a number

of investors), economies of scope (they invest in a number of start-ups) (Sahlmann (1990) as

cited in Fried & Hisrich (1994)) and a learning curve (Hall & Hofer, 1993). Amit, Brander

and Zott (1998) add that VCs due to their information-processing capacities have the

ability to reduce information asymmetries and hence to prevent from adverse selection and

moral hazard problems, two different types of information asymmetries. The first

phenomenon, which occurs from hidden information (Amit et al., 1998, p. 443), refers to

one party in a transaction having information that is not available to the other party. The

second phenomenon, also called hidden action, is observed when one party in a transaction

cannot (or can hardly) verify the true intentions and related actions of the other party, until it

might already be too late. This e.g. is the case for an investor who does not know for sure that

the entrepreneur he gave his money to will not simply take the money and run (Amit et al.,

1998, p. 443). The party who enjoys an informational advantage in the previous example

this would be the entrepreneur can then abuse this information asymmetry at the cost of the

other party.

All these advantages compared to traditional providers of external capital make venturecapitalists (among others) the right investors for intervening at an early stage of development

of an entrepreneurial business. As the Belgian Venture Capital & Private Equity Association

puts in on their website, venture capital investors not only provide equity capital, but

experience, contacts and advice when required, which sets venture capital apart from other

sources of business capital (Belgian Venture Capital & Private Equity Association [BVA],

n.d.).


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Among the above-mentioned VCs, we can find both private and public as well as captive and

semi-captive venture capital firms. Van Osnabrugge and Robinson (2001) and Leleux and

Surlement (2003) give some explanation as to what the differences between these types of

VCs are, which is complemented by the statements of various other authors in the following.

Private VCs, also referred to as independent VCs, raise money in the competitive outside

environment from pension funds, corporations and individuals (Van Osnabrugge &

Robinson, 2001, p. 27). Achleitner (n.d.b), in the online version of the Gabler

Wirtschaftslexikon, explains that independent funds are not dependent on one single capital

provider but may act independently due to various investors holding shares in the fund. They

usually work with closed funds of predefined size and with known liquidation horizon, under

the legal framework of limited partnerships (Meyer & Mathonet, 2005). Typical fund terms

vary between 7 and 10 years, with extensions usually being possible (Meyer & Mathonet,

2005). Money will then be invested from those funds as interesting investment proposals are

identified, with investments in new projects usually occurring during the first 3 to 5 years of

the funds lifetime, i.e. during the investment period (interview partner, personal

communication, June 30, 2011). In the subsequent 5 to 7 years, only follow-up investments

will be made in already existing portfolio companies and finally, the exits will be prepared

(H.-F. Boedt, personal communication, June 22, 2011; interview partner, personal

communication, June 27, 2011). As soon as a successful exit is done, the return goes back to

the investors who then have the opportunity to put the money back into the fund or not,

depending on what the limited partnership agreement of the VC fund foresees concerning this

issue (Meyer & Mathonet, 2005; interview partner, personal communication, June 23, 2011).

Public VCs are born when government initiatives consist in direct government support.

Because one of the ways governments can support entrepreneurs is by providing directfinancial support to start-up firms (Oehler, Pukthuanthong, Rummer & Walker, 2007, p. 10).

In addition to or partly instead of the objectives private and captive VCs have which mainly

consist in yielding returns for investors or parent companies government-sponsored and

-managed VCs look at other effects of their investment. Among those, most notably,

innovation, economic growth, job creation or maintenance and the development of a specific

region or the whole country can be named. Attention needs to be paid when defining the term

public VCs as confusion might arise between publicly sponsored and publicly managed VCfunds. A publicly sponsored fund is a fund where all or a major part of the shareholders are


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local, regional or federal government entities but the fund as such can be a private corporation

managed by non-state employees. A publicly managed fund however is entirely or partly

sponsored by local, regional or federal government entities and in addition managed by civil

servants or government employees (Leleux & Surlemont, 2003, p. 82). Among industry

professionals, the term public VC is usually used for a fund that is entirely or partly

sponsored by government entities and in addition managed by civil servants or state

employees. The decisive characteristic for the classification as public VC is thus usually the

organization and management structure of the VC funds and less the source of capital. A fund

consisting of a majority of public capital which is managed independently, like a private

company, would consequently rather be considered as a private VC.

Although captive and semi-captive VCs are not in the focus of this paper, they will be briefly

described in order to present a complete picture of the different types of VCs that exist.

Captives are VCs which depend on a parent company such as a bank or an insurance

company and obtain the money they invest from this parent institution. Their funds often are

open-end as the parent company allocates money to the fund whenever it is considered

appropriate and evergreen as the returns made on exited portfolio companies re-enter the

fund, i.e. are recycled, and used for future investment in new projects (M. Olivier, personal

communication, June 17, 2011). Achleitner (n.d.a) differentiates between two notions of the

term captive fund. In a broader sense, it refers to a fund with one single capital provider

(i.e. one single source of funding) and may describe a corporate fund where the investor is an

industrial company. In the more narrow sense of the term however, it is used when the source

of funding is a financial institution such as a bank or an insurance company. A semi-captive

venture capital fund can be described as an intermediate type of fund between a captive and a

private fund (Achleitner, n.d.c). However, one may also find funds where capital is provided

together by corporate and public sources. Such funds can also be considered as semi-captivein some way even though they are an intermediate type of fund between a captive and a

public fund (interview partner, personal communication, July 1, 2011).

A type of risk capital investor that does not perfectly fit into one of the above-mentioned

categories is the university-related VC or university fund. If the best-fitting category had to be

chosen, then university funds probably would be considered as public rather than private.

Nevertheless, they present several particularities. University funds closely collaborate withone or several universities and their technology transfer units in order to finance university


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research projects and spin-offs or university-related projects. Concerning the source of

capital, university funds are most of the time at least partially financed with public money

from local or regional government entities. The rest of the capital is then invested by banks,

insurance companies, institutional investors, industrial companies or private individuals into

the fund. Compared to public VCs, they sometimes work with closed-end funds. The focus

concerning investment stage, round and size is usually narrow for university-related VCs as

they intervene at the earliest stage, i.e. at seed or even pre-seed stage (to bridge the gap

toward[s] private early stage financing (European Commission, Directorate-General for

Enterprise and Industry, 2009)).

As potential investors in start-up companies, the above-mentioned types of VC funds are of

fundamental importance in the considerations of entrepreneurs who seek financing. Now for

entrepreneurs to get access to this enormously important source of funding during an early

stage of their business, they have to know the investment criteria sought by VCs during the

screening and evaluation phase of their investment process (Hall & Hofer, 1993). Chen, Yao

and Kotha (2009) say that entrepreneurs have to sell their venture plans to potential

investors (p. 199) and that they have to convince them to invest their money, time and

effort (p. 199). Knowing how to do that and what really matters to VC investors may help

entrepreneurs increase the likelihood of their obtaining funding (Chen et al., 2009, p. 199) as

they will be better prepared when meeting the investors.

Scientific literature has given much consideration to venture capitalists decision making and

investment criteria from the 1970s onwards. Various authors in the field investigated which

investment decision-making criteria venture capitalists use to evaluate investment proposals

that are presented to them and which of these criteria they consider most important. These

studies mainly looked at private VCs and many of the early studies come from the UnitedStates which can be considered as the cradle of venture capital. Among them, Wells (1974)

(as cited in Tyebjee & Bruno, 1984), Tyebjee and Bruno (1984) and MacMillan, Siegel and

Subba Narasimha (1985) can be named. Later on, research on VC investment criteria has

been done in Europe too (e.g. Muzyka, Birley & Leleux, 1996; Colin & Stark, 2004).

Concerning public VCs however, research literature mainly focused on their raison dtre,

their objectives and their overall efficiency and performance (e.g. Lerner, 1999; Leleux &

Surlemont, 2003; Lerner, 2004; Alperovych, 2011). Their specific investment criteria andrelated selection of investment projects have not received much attention yet, and even less so


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in direct comparison with the investment criteria used by private VCs. This consequently is

the purpose of the present paper, which is organized as follows.

In the next two subsections, the research objectives will be stated and the research questions

will be defined. Section 2 will make a review of the existing literature on the various areas of

interest in the field of VC investment criteria. Section 3 gives an overview of the Belgian VC

industry which is in the focus of the empirical study done in the context of this research

project. Section 4 is dedicated to the design and execution of this study. Section 5 will present

and discuss the results. Finally, section 6 concludes the paper and section 7 addresses

potential limitations and suggestions for future research .

1.1

Research objectives

First of all, this paper is an attempt to complete the research literature and the general

knowledge on VC investment criteria by studying the criteria used by public and private VCs

to evaluate new venture investment proposals in direct comparison. Although probably using

similar selection criteria for the evaluation of investment proposals, it is expected that, due to

differences in investment objectives and various factors surrounding the investment decision,

public and private VCs weight those selection criteria differently.

Secondly, these potential differences have, among others, implications for entrepreneurs. A

very practical motivation behind this study consequently is the aim of giving advice to

entrepreneurs who approach different types of risk capital providers in order to obtain

funding. Entrepreneurs need to be aware that different types of capital providers look at

business plans from different perspectives (Mason and Stark, 2004, p. 227) and evaluate

investment projects in different ways and based on different criteria. These differences have

been studied and highlighted by Mason and Stark (2004) for banks, business angels and

venture capitalists in order to give entrepreneurs the opportunity to maximize the likelihood

of their obtaining finance. If these three categories differ in terms of investment decision-

making criteria because they have different expectations and want to achieve different

objectives, one might also expect differences in decision-making criteria between public and

private VCs as they may pursue different objectives. No research has yet been done on such

potential differences within the category of venture capitalists. The second objective of thispaper is thus to advise entrepreneurs on under which circumstances and how to approach each


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category of VCs and upon which elements (related to potential selection criteria) to place the

emphasis when presenting an investment proposal.

In order to find out about the above-mentioned potential differences and to give valuable

advice to entrepreneurs, the following research questions will be addressed.

1.2

Research question & sub-questions

The main research question addressed in this paper is as stated in the following paragraph.

How do the selection criteria that public venture capitalists use during the

screening and evaluation phase of their investment process to evaluate new

venture investment proposals differ from those used by private venture

capitalists?

Based on this research question, several sub-questions have been determined that will address

different aspects of the broader research question.

Sub-question 1: Which selection criteria do private venture capitalists use during

the screening and evaluation phase of their investment process?

Sub-question 2: Which specific objectives do public venture capitalists have and

how does this influence the selection criteria they use during the screening and

evaluation phase of their investment process?

Sub-question 3: What kind of trade-offs do venture capitalists make between

various selection criteria?

Sub-question 4: Which factors do have an influence on selection criteria and their

relative importance?

Sub-question 5: To what extent did the recent financial and economic crisis have

an impact on the activity of venture capitalists and their selection criteria?


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In order to clearly identify and narrow down the objectives and the focus of this paper,

various terms and concepts used in the research question and in the sub-questions should be

defined.

While some authors of prior scientific literature about venture capitalist investment criteria

investigated individual-level decision making, others concentrated on group-level decision

making within the VC team or organization. For the purpose of this study, no focus will be

placed on either type of decision making. We rather analyze general decision-making

practices and related investment criteria as used by the investment managers and the

investment committee of VC firms and funds. The term venture capitalists should thus be

taken in the broadest sense of the word, including individual VCs, teams of VC investment

managers and the VC investment committee.

A general differentiation between private, public, captive and semi-captive VCs as well as

university-related VCs has already been made earlier in this introductory part. In the context

of this study, as highlighted by the research question and the associated sub-questions, the

main focus is on private and public VCs (and university funds, which are treated separately

for the empirical part of this study, although their investment objectives and behavior may

rather be considered as public than as private). Given that the boundaries between the

different types of VCs are not always clear, the various elements differentiating private,

public and university funds will be considered in order to place each of them into the category

that best represents its characteristics. Concerning the difference between private and public

VCs, the organization and type of management of a given VC usually matters most in order

to place it into either category.

The focus of this study is on investment proposals submitted by new ventures, i.e. ventureslooking for early-stage (i.e. seed and start-up) and early-growth capital (Zacharakis &

Shepherd, 2005). Olivier (2010) explains the various stages as follows. While financing of the

seed stage of a company refers to a relatively small amount of capital provided to an

entrepreneur to prove a concept, start-up financing comprises financing provided to

companies for use in product development and initial marketing and financing provided to

launch the first product / service into market, build distribution channels and start selling.

Early-growth financing is used for working capital [provided to a company] to stabilize and


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develop market potential. The company could be producing and shipping but may not be

showing profit [yet].


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2 Literature Review

2.1

Selection criteria of private VCs

2.1.1 An overview of previous studies

Private VC funds are most often organized as limited partnerships, with the investors who

provide their capital to the fund being called limited partners (LPs) and the fund managers

being referred to as general partners (GPs) (Meyer & Mathonet, 2005). A number of

agreements between LPs and GPs define the terms and conditions of the fund, including

among others investment objectives, fund term and fund size (for detailed information seeMeyer & Mathonet, 2005). The most prevalent objective for private VCs and their fund

managers (GPs) seems to be investor return, which is closely related to the fund managers

own return. In addition to management fees, which are considered as a base compensation,

the carried interest represents the biggest part of the fund managers compensation and

provides a variable, performance-based incentive (Meyer & Mathonet, 2005). A hurdle rate

makes sure that general partners are only compensated for over-performance (Maxwell,

2003a as cited in Meyer & Mathonet, 2005, p. 33).

In an attempt to achieve extraordinary returns for LPs and GPs, VCs want to make sure they

only have the best companies in their portfolio. The identification of superior concepts, i.e.

the selection of high-potential investment projects, and later on the active involvement in and

monitoring of the funded portfolio companies contribute to attaining these return objectives

(Alperovych, 2011). This paper focuses on the initial selection of investment proposals and

on the investment criteria used in this context.

The selection criteria VCs use to evaluate investment proposals (often referred to as

investment criteria in research literature) have been thoroughly studied, in many different

ways, with various samples, survey methods and analysis techniques, since the mid-seventies.

Among others, the following studies and research papers contributed to shed light on how

venture capitalists make their investment decisions: Wells (1974) (as cited in Tyebjee &

Bruno, 1984); Poindexter (1976) (as cited in Tyebjee & Bruno, 1984); Tyebjee and Bruno

(1984); MacMillan et al. (1985); Hall and Hofer (1993); Muzyka et al. (1996); Zacharakis


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and Meyer (1998); Shepherd (1999); Mainprize, Hindle, Smith and Mitchell (2002);

Riquelme and Watson (2002); Mason and Stark (2004); Lerner (2004); Zacharakis and

Shepherd (2005); Khanin, Baum, Mahto and Heller (2008); Chen et al. (2009); Kollmann and

Kuckertz (2010).

In the 1970s, a study of eight VC firms by Wells (1974) (as cited in Tyebjee & Bruno, 1984)

found that, by order of relative importance, management commitment, the product, the

market, marketing skills, engineering skills, the marketing plan, financial skills,

manufacturing skills, the entrepreneurs references, other VC participants in the deal, industry

and technology as well as the cash-out (exit) method are important for a VCs investment

decision.

Two years later, Poindexter (1976) (as cited in Tyebjee & Bruno, 1984) studied a sample of

97 VC firms and found out that, among others, quality of management, expected rate of

return, expected risk, management stake in firm, venture development stage, investor control

and tax shelter considerations play a role as investment criteria.

Tyebjee and Bruno (1984) looked at the importance of various venture characteristics

grouped into five categories, namely market attractiveness (size, growth, access to

customers), product differentiation (uniqueness, patents, technical edge, profit margin),

managerial capabilities (skills in marketing, management and finance as well as the

references of the entrepreneur(s)), environmental threat resistance (technology life cycle,

barriers to competitive entry, insensitivity to business cycles and downside risk protection)

and cash-out potential (opportunities for a successful exit with capital gains through M&A or

IPO). They suggest that investment decisions are, after all, based on expected return and

perceived risk. Their analysis shows that expected return is determined by marketattractiveness and product differentiation and perceived risk is determined by managerial

capabilities and environmental threat resistance.

One of the best known and most cited research papers on VC investment criteria is the one by

MacMillan et al. (1985). They use a well-fitting metaphor in order to describe their findings.

No matter how convincing the horse (product), the horse race (market) or the odds (financial

criteria) seem, it is the jockey (entrepreneur) who fundamentally determines whether theventure capitalist will place a bet at all (p. 119). They further explain that a business plan,


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which is the complete and detailed explanation of the business concept (product/technology,

business model, market potential and competitive environment), is necessary but never

sufficient. It is only a first proof of the jockeys ability to ride. MacMillan et al. (1985) used

five categories of criteria in their study, with a total of 24 criteria being evaluated. In order of

decreasing relative importance within their category, the most important criteria were: the

entrepreneurs personality (capable of sustained intense effort, able to evaluate and react well

to risk, articulate in discussing venture, attends to detail); the entrepreneurs experience

(thoroughly familiar with the target market, demonstrated leadership ability in the past, track

record relevant to the venture); characteristics of the product or service (proprietary or

protectable product); characteristics of the market (target market enjoys significant growth

rate); financial considerations (return equals at least 10 times my investment within 5-10

years, investment can easily be made liquid through IPO or sale). Among the ten criteria most

often rated as essential (meaning that without these criteria being met, the investment will be

rejected), five were related to the entrepreneur, showing to what extent he or she is relevant to

the investment decision. They also stress the importance of a balanced management team,

without which nearly half of their sample would not invest no matter how glamorous the

other aspects of the proposal are. Whether a complete balanced team is a condition for

receiving VC finance however remains controversial. About twenty years later, Lerner (2004)

points out that a lot of VCs put their own hand-picked manager (p. 17) showing a track

record of successfully managed similar start-ups at the head of the entrepreneurial firm,

which means that a complete team does not seem to be absolutely necessary.

Perceived risk inherent in the investment project and the ability to manage it also play an

important role. MacMillan et al. (1985) differentiate between competitive risk, bail-out risk

(risk of not exiting the investment when wished), investment risk (risk of total loss),

management risk (risk of mismanagement of the venture), implementation risk (risk related toproduct and marketing development failures) and leadership risk (risk related to an

entrepreneur unable to lead others). All these risks, according to them, can be managed by

making sure that certain investment criteria are met.

MacMillan, Zeman and Subba Narasimha (1987) include the chemistry or fit between the VC

and the entrepreneur(s) as well as the VCs intuition and gut feeling into the range of

important investment criteria.


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Hall and Hofer (1993) could not find evidence for the importance of the entrepreneurial team

or the business strategy of the venture. This is highly surprising given the results of other

prior and later studies.

Lerner (2004) enumerates criteria similar to those found by prior authors (promising

technology, flexible and experienced management team, market size, fulfillment of market

needs) and adds that, if available, the feedback from existing or potential customers is an

important element to consider.

Based on an attempt to highlight differences in business plan evaluation between bankers,

VCs and BAs, Mason and Stark (2004) provide a list of criteria that has been established from

the thought segments of their verbal protocols. The criteria most often mentioned by VCs in

decreasing order of frequency counts were market (potential and growth, demonstrated

market need, level and nature of competition, barriers to entry), financial considerations (cost

and pricing, projections of revenue stream, value of the equity, likely rate of return and exit

route possibilities), entrepreneur/management team (background, experience, track record,

commitment and enthusiasm, range of skills), strategy (overall business concept),

product/service (nature of the product/service, uniqueness, distinctiveness, innovativeness,

quality, performance, appearance and aesthetic appeal, function, flexibility) and the business

plan (the whole package).

If the venture capital decision-making process is considered as a persuasion process, as in the

study led by Chen et al. (2009), two major entrepreneur-related decision criteria are taken into

account: passion for their project and preparedness with regard to their business plan. This

study adds a more psychological dimension to the criteria mentioned so far and Chen et al.

(2009) suggest that perceived preparedness might be the missing link between a set ofobjective criteria [that] VCs may or may not use in their investment decisions (p. 212).

Manigart, Wright, Robbie, Desbires & De Waele (1998), who rather focused on the financial

valuation aspect, studied the valuation process of VCs for the appraisal of new investment

projects. They say that VCs first invest in intensive information gathering by consulting

various sources, then assess the investment risk and the required rate of return and finally

value the investment proposal with different methods. Based on their empirical study, whichamong others looked at Belgium (in combination with the Netherlands), they were able to


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determine factors that influence risk inherent in a project and the resulting required return.

The main risk indicators identified for the Belgian subsample were related to the quality

(skills) of the management team and the characteristics of the product and market of the firm.

The main factors influencing the required rate of return were degree of innovation, length of

investment, general economic conditions and sector and whether the exit is planned in

advance or not.

The required rate of return (or the multiple that investors expect to receive on their

investment) as a selection criteria highly depends on the degree of risk involved in an

investment project (H.-F. Boedt, personal communication, June 22, 2011). Very early-stage

(seed or start-up) projects thus require high(er) expected returns as they in general involve a

high degree of risk.

An addition that Petty (2009) makes to what previous researchers found about the screening

and evaluation phase of the venture capital decision-making process consists in highlighting

its dynamic nature with selection criteria being continually updated by the VC firm over time.

This happens based on VC firm-internal events and circumstances as well as changes in the

investment environment.

2.1.2 Espoused vs. in use selection criteria

A study by Zacharakis and Meyer (1998) analyzes the apparent lack of insight that experts

such as VCs have into their own decision making. By comparing the investment criteria

enumerated by VCs when directly asked and the investment criteria they really rely on (actual

in use criteria), it becomes apparent that information overload (business plan, own due

diligence, external information, etc.) causes noise and hinders VCs to truly understand howthey finally make investment decisions (Zacharakis & Meyer, 1998). Although some of the

criteria enumerated in VC investment criteria research are definitely used for decision

making, the relative importance that these prior, self-report studies found might not be

correct. As the results of Kollmann and Kuckertz (2010) suggest, VCs tend to over-stress

criteria irrelevant to day-to-day business, while under-stressing significant criteria concerning

the profitability and survivability of a given venture (p. 746).


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Shepherd (1999) tested eight investment criteria for their relative importance and when

asked directly (espoused criteria) VCs considered all of them as being equally important.

However, when looking at the criteria actually in use that have been gathered with a real

time data collection method during the decision-making process, especially industry-related

experience outweighed the other criteria and seems to be the most important factor in use.

2.1.3 Selection criteria vs. success factors

According to Riquelme and Watson (2002), VCs have implicit theories about what makes a

venture successful and based on these beliefs, they define decision or selection criteria in

order to evaluate a ventures potential to be successful in the future. Whether the venture

characteristics (upon which these selection criteria are based) will actually lead to success is

not always proven. Riquelme and Watson (2002) further explain that many researchers who

focused on selection criteria in VC decision making in the past simply assumed that the

criteria they determined were valid and thus associated with success. One reason for this

approach is the difficulty to establish a relationship between decision criteria and actual future

success of a venture. However, they say it is crucial to know whether the identified criteria

actually work and lead to future business success. Otherwise, VC decisions based on those

criteria can become a real disaster instead of a success.

Zacharakis and Shepherd (2001) discuss the availability bias which suggests that VCs often

make a decision about a current venture on the basis of how it matches past successful or

failed funded ventures (p. 325). Zacharakis and Meyer (1998) had suggested that VCs

should use checklists with key criteria when evaluating venture proposals. These could then

be updated over time as certain funded ventures succeed and others fail (p. 74). Whether

this is a viable way of doing remains questionable due to potential differences in venturecharacteristics and changes in the investment environment which are likely to occur between

the funding of two ventures.

In their study, Riquelme and Watson (2002) compare VCs beliefs and theories about

attributes associated with success and failure with attributes actually observed for successful

and failed SMEs. The most important attributes associated with success, which they collected

from prior studies on successful SMEs, are managerial attributes (experience, ability,complete team, organizational flexibility, cash/cost/location/strategy planning), marketing


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practices (responsiveness to market, market niche or broad market, build company image),

product-related factors (competitive advantage) and financial resources. VCs mentioned a

balanced, determined and committed team with a good track record, a growing protected

market and a product with an above-average chance to succeed (competitive advantage,

patent protection). The most relevant attributes associated with failure of SMEs are

management inadequacies (inexperience, personnel problems, lack of planning), financial

planning and control problems (lack of initial capital, poor record keeping, poor internal

controls), marketing and product deficiencies (inadequate marketing, product/service

weakness (too old/new or inferior)), unfavorable economic conditions and fraud. VCs

considered lack of experience (managers cannot adapt to changing needs, incomplete team,

incompatible personality traits), the fact that things take longer than planned and a too

sophisticated product as potential reasons for a failure. Riquelme and Watsons (2002) overall

conclusion is that VCs beliefs and theories about attributes associated with success largely

match the actually observed attributes of successful SMEs, which allows the guess that VCs

base their decisions on the right selection criteria.

Achleitner, Kaserer, Wagner, Poech and Brixner (2007) find that the degree of innovation and

the market timing are crucial for venture success. Entrepreneur characteristics such as a solid

academic background may increase the degree of innovation and therefore the likelihood of

success (Achleitner et al., 2007).

Due to the numerous uncertainties and the high degree of unpredictability involved in

entrepreneurial projects, Lerner (2004) suggests that the entrepreneurs ability to adjust to

changes in the broader environment (trends, marco-economic events, etc.) is a critical success

factor.

A phenomenon that has received a lot of attention in previous research is the apparent

outperformance of decision aids compared to a VCs own assessment in the selection of high

potential investment proposals (Zacharakis & Meyer, 2000; Zacharakis & Shepherd, 2005). A

decision aid is a statistical model that decomposes the decision into its component parts

[and] helps the VC to focus on a series of smaller decisions (Zacharakis & Shepherd, 2005,

p. 677). As framework of reference for new investment proposals, the criteria and their

relative weights as determined from the past decision-making behavior of the VC are fed intothe model. The advantage that such decision aids have compared to a VCs own evaluation is


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that they are consistent in their decision making and able to generate more accurate decisions

(Zacharakis & Shepherd, 2005).

What the authors in the field of decision aids usually did was calculating the aforementioned

hit-rate for the VCs own assessment and for the statistical decision model in order to know

which method worked best. As opposed to that, namely calculating the hit-rate for statistical

models based on espoused criteria, Mainprize et al. (2002) tried to create a model based on

known success attributes (attributes of viable ventures as they call it) that helps VCs to

standardize their evaluation of business plans. They suggest 15 decision cues to assess 6

attributes of viable ventures which are then used by the model to predict profitability and

survival of a venture. These attributes and decision cues are innovation (new combination,

product-market match), value (net buyer benefit, expected margins, sufficient expected sales

volume), persistence (potential for repeat purchases, long-term need, sufficient resources

available), scarcity (non-imitable, non-substitutable), non-appropriability (slack1, hold-up2)

and flexibility (uncertainty minimized, ambiguity reduced, level of core competence). Their

findings show that hit-rates were more consistent and accurate for their decision aid (based on

known, viable venture attributes) than for other models based on espoused criteria.

A research project led by Alperovych and Hbner (2008) analyzes the influence of the

compatibility between life cycle stages of the entrepreneurial company, its product and

external market factors on performance and returns of the portfolio company. Their main

result is that top performing portfolio companies have had much more favorable

combinations of external conditions and internal return factors to generate superior returns

and vice versa (p. 3).

And finally, even if espoused VCs investment criteria do not perfectly reflect knownattributes of successful ventures, they are useful for entrepreneurs in order to know what to

prioritize when applying for funding. As Kollmann and Kuckertz (2010) put it, a lot of

research studies done in the past have been more useful for entrepreneurs seeking funding

than for VCs looking for appropriate investment criteria that increase the likelihood of

picking successful ventures.

1slack refers to waste and inefficiencies reducing the rents from a strategy position (Ghemawat, 1991)2hold-up refers to a re-distribution of gains among economic actors (Ghemawat, 1991)


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2.1.4 Evaluation uncertainty and overconfidence

The majority of research that has been done on VC investment criteria during the past thirty

years focused on the relative importance of these criteria for VC investment decision making.

A recent study by Kollmann and Kuckertz (2010) analyzes a closely-related phenomenon,

namely the specific uncertainty associated with the evaluation of each single criterion at

different stages of the investment process. It is widely accepted that knowing about the

relative importance that VCs attach to the different criteria they use for assessing the quality

of an investment proposal is essential. However, if there is a high degree of uncertainty

involved in the evaluation of a specific criterion, VCs will probably be more careful in

supporting their investment decision with this criterion and rather concentrate on more

tangible and certain criteria. Kollmann and Kuckertz (2010) use search, experience and

credence qualities as a theoretical framework for their analysis. This theory enables the

description of goods by search qualities which are known before purchase, experience

qualities which are known costlessly only after purchase, and credence qualities which are

expensive to judge even after purchase (Darby & Karni, 1973, p. 69).

This framework can easily be used in the case of VCs who want to assess the quality of a

venture (the good) and who use a number of investment criteria which fall into either of the

three above-mentioned categories to describe the venture proposal. While a search quality

e.g. would be whether a venture is active in an industry of interest for the VC, which is easy

to determine with certainty, the effort and endurance of an entrepreneur would rather qualify

as experience quality. The real commitment of the entrepreneur however can never be

assessed with certainty and thus is a credence quality associated with a high degree of

uncertainty.

Figure 1: Search, experience and credence qualities and the venture capital process

(Kollmann & Kuckertz, 2010, p. 743)


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As shown in Figure 1, the degree of uncertainty concerning the evaluation of the different

selection criteria decreases when moving from initial screening to thorough evaluation and

deal structuring in the venture capital decision-making process. This is reflected in the

proportion of search, experience and credence qualities used in the evaluation of the different

criteria. This decrease in uncertainty is probably due to a greater amount of time and effort

allocated to the evaluation of an investment proposal and a higher level of information

available during the course of the venture capital decision-making process (Kollmann &

Kuckertz, 2010). Kollmann and Kuckertzs (2010) main conclusion is that criteria related to

the entrepreneur or management team are of exceptional relevance but at the same time very

difficult to evaluate, especially in the early screening phase. Therefore, an important

suggestion they make to entrepreneurs is to be transparent, to collaborate closely with the VC

and to show preparedness and commitment right from the beginning in order to minimize

uncertainties as much as possible.

Zacharakis and Shepherd (2001) examine another phenomenon related to the VC investment

decision, namely the overconfidence involved in predicting the future success of new

ventures. Although VCs are considered as experts in this field, overconfidence often biases

their decision and significantly reduces their decision accuracy. For their study, Zacharakis

and Shepherd (2001) define overconfidence as the tendency to overestimate the likely

occurrence of a set of events (p. 311), which in the case of VC decision making is the

likelihood that a funded venture will succeed (p. 311). Their main findings show that

overconfidence increases with more information being available to VCs and with unfamiliar

framing of the information (i.e. information presented in a way VCs are not familiar with).

More information obviously suggests that better informed decisions can be made. However,

more information also makes a decision more complex, is often not fully considered and

consequently only increases confidence about and not accuracy of the decision.

There are several ways of reducing overconfidence which VCs should know about.

Counterfactual reasoning involves thinking about potential future deviations from

assumptions that a decision is based upon (some sort of what-if scenarios) and the humbling

effect occurs when negative feedback from past decision is received, which unfortunately

usually only happens years after an investment was made (Mahajan, 1992; Russo &

Schoemaker, 1992). Decision aids may also reduce overconfidence by increasing decisionaccuracy (Zacharakis & Shepherd, 2005).


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2.2

Specific objectives and selection criteria of public VCs

Governments play a major role for economic growth, the promotion of entrepreneurship and

venture firms and the development of the VC industry. They set the legal and fiscal

framework for investors and funds, boost or curb investments by private and institutional

investors and most important for this paper they often opt for direct public intervention

(Leleux & Surlemont, 2003; Oehler et al., 2007). This may mean creating a public fund or

being directly involved in private or corporate funds. When directly intervening in VC funds,

Leleux and Surlemont (2003) state that mixed constraints objective functions (p. 97)

characterize the public funds investment decisions. Governments pursue a number of

politically [and] socially motivated (p. 86) objectives like regional development, industry

restructuring or employment creation, which they try to combine with traditional private

sector return objectives in order to make their investment cycle self-sustaining. These

objectives however are often conflicting and hard to reconcile. If public VCs then decide to

give the priority to economic and social policy objectives, they may have a tendency to offer

capital at marginal (below market) rates of return to entrepreneurs (Leleux & Surlemont,

2003, p. 99).

Lerner (2004) suggests two important roles or objectives of public VC initiatives:

certification to other investors and encouraging of R&D spillovers. He argues that public

agencies should certify high-quality projects and give them a stamp of approval in order to

increase the confidentiality of other investors and make them invest. As private VCs have

shown to concentrate on a few industries currently en vogue, such a stamp of approval

could be interesting for industries that are rather neglected by private VC investors. A well-

founded criticism of this certifying role lies in the doubt about government officials being

able to overcome information asymmetries and to identify promising investment projects

while other investors apparently cannot, especially if those other investors are private VCs

with significant industry expertise. The criticism may however be unfounded, according to

Lerner (2004), if the other investors are e.g. bankers with little insight into the business of an

entrepreneurial firm and if those government officials are specialists and experts with

significant expertise and insight. In practice however, this last hypothesis does not always

hold. Nevertheless, a few years before, Lerner (1999) was able to detect a positive effect ofthe public stamp of approval. He had studied the long-run performance of high-tech start-


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ups that received funds from the public SBIR program in the US (awardees) and found that

those firms grew faster, showed a greater increase in employment and were more likely to

obtain additional independent VC finance in subsequent years than their non-publicly funded

peers. Although the SBIR program mainly works with monetary grants, the same effects are

to be suspected from public VC interventions with equity or quasi-equity instruments. The

second role of public VC initiatives, according to Lerner (2004), concerns R&D spillovers,

i.e. positive externalities generated by certain activities of a company. For instance,

innovations by a start-up company do not only benefit the company itself but may also create

positive spillover effects for competitors, developers of complementary products and

customers. The overall social and economic value of such spillovers may thus be a reason for

government agencies to intervene in the funding of certain projects.

According to a study by Beuselinck and Manigart (2007), direct public interventions play a

stabilizing role for the overall VC industry as they are less opportunistically driven by the

economic climate (p. 29). In addition, interventions by public VCs can stimulate investments

in those sectors or companies that may have difficulties to receive funding from private VCs

which emphasizes the complementarity of public and private VCs (Leleux & Surlemont,

2003; Beuselinck & Manigart, 2007). This objective of complementing the investments made

by private VCs seems justified given the positive economic impact of venture-backed firms

compared to firms funded with other types of capital in terms of employment creation, sales

growth and fostering of innovation (Amit et al., 1998).

Deloitte (2009) describes the role that governments play for the VC industry, including recent

trends. Governments always played an important role in fostering innovation and

entrepreneurship. This becomes even more apparent when looking at current industries of

interest for VCs such as cleantech or life sciences, which are regulated to a higher extent thane.g. the IT industry. Favorable government policies and regulations are required to make

these areas develop and to encourage VCs to invest. Worldwide, VCs particularly stress the

importance of favorable tax policies and increased government support for entrepreneurial

activities (Deloitte, 2009).

The above-stated roles and objectives of public VC initiatives have an influence on their

investment criteria in that they add a number of criteria to those used by private VCs and maychange the relative importance and weighting of various criteria.


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In addition to the influence of the specific objectives of public VCs, rules and regulations

established by national or supranational entities add additional investment constraints and

probably have an impact on selection criteria and their relative importance. Concerning direct

government intervention in Europe e.g., government-sponsored initiatives that support SMEs

have to make sure that they comply with European Union [EU] state aid rules (for more

information, see De Harlez, Schwienbacher & Van Wymeersch, 2008; European

Commission, 2009). These rules have been modernized in recent years in order to target

investments toward[s] objectives of the Lisbon strategy for growth, jobs [and

competitiveness] (European Commission, 2009, p. 4). Specific constraints, conditions,

regulations and administrative procedures apply e.g. to investments falling into the de

minimis (i.e. aids of small amounts) or the risk capital aid framework. The latter was put

in place in order to encourage the creation of VC funds and the investment in high-growth

SMEs. In addition, the European Union definition of SME has to be followed.

Summing up, the specific objectives of public VCs in contrast or in addition to the return

objectives of private VCs are the promotion of entrepreneurship and innovation, social

objectives such as job creation and maintenance, economic growth and regional development,

the attraction of new businesses and investors to a certain region, industry development or

restructuring and environmental objectives.

2.3

Trade-offs between various selection criteria

As many previous studies of VC selection criteria only tried to establish a hierarchy of

importance based on the traditional Likert scale survey method, Muzyka et al. (1996) used

another approach. After having identified 35 investment criteria in scientific literature, they

realized their own survey where about seventy VCs were asked to make trade-offs between

pairs of independent criteria. For all 35 criteria, they defined three trade-off options (e.g.

market size: large, medium, small or expected rate of return: 25%). They

then created 53 matrices, each containing two selection criteria with their three different

trade-off options. Respondents were then asked to rank each of the nine possible

combinations of trade-off options. Their results indicate that leadership potential, industry

expertise and the track record of the entrepreneur or management team are ranked among thetop 5 criteria, followed by a sustained competitive position, marketing/sales capabilities and


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organizational/administrative capabilities of the team and the ability to cash out. Their

findings also suggest that the priority for VCs is a good business deal, even if it does not

perfectly fit with their investment strategy (e.g. round of investment) or their existing

portfolio. Geographical issues, i.e. the location of the business and its market relative to the

location of the VC fund, matter but are not the first element of consideration for decision

making.

A study by Sweeting (1991) found that UK VCs showed a certain preparedness to consider a

project with weaker management team if the business concept was otherwise sound good

product/market, proprietorial market position, good returns, and so on. He explains that this

was associated with the VCs themselves providing the necessary managers in the context of a

proactive management style. This is confirmed by Lerner (2004). Khanin et al. (2008) on the

contrary report what has acquired the status of conventional wisdom (p. 190) in the VC

industry: a more qualified (A) person with a worse (B) project is preferred to a less

qualified (B) person with a better (A) project. MacMillan et al. (1985) had been one of

the first to say that irrespective of the horse (product), the horse race (market) or the odds

(financial criteria), it is the jockey (entrepreneur) who matters most in the end. Zacharakis

and Meyer (1998) found that if little information about the market and the competitive

situation is available, then the entrepreneur matters most. If more information becomes

available to VCs, then their focus shifts from the entrepreneur to market characteristics.

Zacharakis and Shepherd (2005) found that prior start-up experience of the entrepreneur or

management team can substitute for prior leadership experience. In general, they observe that

leadership experience matters most to VCs in environments with a greater number of

competitors as a good leader can act and react to the many possible, and a priori

unforeseeable, competitive interactions (p. 684). The European Private Equity & VentureCapital Association [EVCA] (2009) cites a quote of Bruce Golden from Accel Partners which

gives an answer to the following question: How to evaluate an entrepreneur with no track

record? He says that VCs then usually look at the history of success of the entrepreneur, i.e.

whether he had high impact roles in the past and whether he fulfilled his or her duty with

commitment and lead other companies to success.

Based on their findings, Chen et al. (2009) state that if an entrepreneur shows passion abouthis/her project but his/her business plan, i.e. the whole package, does not have the necessary


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substance, the deal will probably not be made. VCs tend to care about how prepared they

perceive an entrepreneur is (with regard to the business plan) to assess his or her passion.

2.4

Factors influencing the selection criteria and their relative importance

A number of circumstances both internal and external to the VC investment decision-making

process have shown to have an influence on how, and based on which criteria, investment

decisions are made.

2.4.1 The subdivision of the screening and evaluation phase

The decision-making process a venture proposal has to go through for evaluation before an

investment decision is made has been described by various authors as screening and

evaluation phase of the VC investment activity. Fried and Hisrich (1994) propose a six-stage

VC investment process including two different screening and two different evaluation phases.

Tyebjee and Bruno (1984) also provide a model of the decision process that contains a

screening and an evaluation step and Sweeting (1991) uses deal screening and deal evaluation

to describe this phase within the venture capital fund activity.

This screening and evaluation phase when regarded as one big part of the investment

decision-making process in turn comprises various sub-phases, as suggested by Fried and

Hisrich (1994). Their subdivision includes a VC firm-specific screen, a generic screen, a first-

phase evaluation and a second-phase evaluation where each of these sub-phases can lead to a

rejection of the investment proposal if it does not meet the VCs investment criteria, which

may differ from sub-phase to sub-phase.

During the VC-specific screen, particular attention is paid to criteria such as investment size,

industry, geographical location and stage of financing (Fried and Hisrich, 1994). The generic

screen is done based on the submitted business plan and any relevant knowledge that the VC

may have related to the proposal, and usually only takes a few minutes. Hall and Hofer

(1993) found that go / no-go decisions during this initial screening phase only take an average

of less than 6 minutes.


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For the subsequent, first-phase evaluation, VCs start collecting additional information on the

submitted investment proposal (Fried and Hisrich, 1994). They then meet and talk to the

entrepreneurs; some may even want to visit the entrepreneurs home and family in order to

get a feeling of the environment they live in. They check references, look at the financial

history if available and contact actual or potential customers. If there is no product on the

market yet, the product concept may be discussed with potential future customers or opinion

leaders. Sometimes, formal market research is carried out or in the case of very early-stage

investments a technical evaluation is made. Early-stage investors often also consult the

managers of their existing portfolio companies, especially if these companies operate in

closely-related industries (Fried & Hisrich, 1994, p. 34).

During the last sub-phase of the screening and evaluation process described by Fried and

Hisrich (1994), the second-phase evaluation, VCs spend an increasing amount of time and

effort on the proposal(s) that made it through the first phases and eventually develop an

emotional commitment (p. 34) to it/them. Here, the goal is no longer to investigate

whether the proposal is interesting or not, but rather to determine potential problems and to

find out how to solve them. In the beginning of this phase however, a good estimation of the

structure of the deal and the valuation is required in order for the VC to not waste time on an

irrationally high-priced investment proposal. After this second-phase evaluation comes the

closing of the deal including last detailed negotiations and the structuring of the investment.

The boundaries between these different screening and evaluation phases are usually not

clearly defined, but somewhere at the beginning of the above-mentioned first-phase

evaluation starts what is commonly known as due diligence. Worrall (2008) makes a

distinction between pre and post term-sheet due diligence, which approximately correspond

to Fried and Hisrichs (1994) generic screen and first- and second-phase evaluation,respectively. While VCs make sure that the business plan and the technology are worth

further considerations before the term-sheet is set up, past term-sheet due diligence looks at

the company into much more detail, including corporate organization and history,

management and employee relations, intellectual property, financial and accounting matters if

available as well as information on sales plans, competition, public relations and R&D. She

also notes that each VC has its own due diligence checklist, which makes a broad

generalization difficult.


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VCs spend 10 to 15 minutes on the initial screening phase according to a study by Sweeting

(1991). Hall and Hofer (1993) differentiate between initial proposal screening and proposal

assessment, which they found to take a maximum of respectively 6 and 21 minutes. For the

initial go/no-go decision, the fit with VC-specific guidelines and long-term growth and

profitability of the industry are the most important criteria. For the more detailed assessment,

according to Hall and Hofer (1993), the source of referral determines the degree of interest

accorded to a proposal.

2.4.2 First round vs. subsequent follow-up investments

VC capital infusions are usually staged, i.e. subdivided into various investment rounds, in

order to give VCs the opportunity to abandon investment projects periodically (Gompers &

Lerner, 2004). The initial due diligence process based on the various investment criteria

enumerated earlier decides on whether or not a VC invests in a project, i.e. participates in

the first round of an investment. Later on, close monitoring and information gathering enable

the VC to assess whether he wants to participate in subsequent investment rounds. As Lerner

(2004) explains, in addition to investing in several rounds, VCs may disburse funds in

tranches even within one round. This especially happens in the initial phase of an

investment in order to make sure that money is not squandered on unprofitable projects

(p. 9) or that even worse the entrepreneurs run away with it. Taking a board seat and

intensive monitoring of entrepreneurs then enable a VC to decide whether the next tranche of

capital will be allocated or not. Sometimes this also depends on the completion of certain

activities or the reaching of a milestone. Although the continuous evaluation of a projects

progress based on monitoring and information gathering enables the VC to get a good idea of

the projects development, a detailed analysis based on a number of criteria is often done

before participating in a subsequent investment round. These criteria may not be exactly thesame as the initial investment criteria used during the due diligence process, or at least the

focus of attention or the weighting may have changed.

2.4.3 Open-end vs. closed-end funds and related constraints

Petty (2009) argues that VC-specific constraints like available fund capital, the timing of an

investment proposals arrival relative to the maturity of the fund and the composition of theportfolio at the time of the proposal (development stages of companies, geographic


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concentration) may bring VCs to adjust the relative importance of their selection criteria over

the lifetime of their fund.

The first two constraints are mainly true for independent VC funds as they are usually closed-

end and therefore constrained by a pre-specified [liquidation] date (Van Osnabrugge &

Robinson, 2001, p. 27). With a liquidation horizon of about 7 to 10 years in Belgium

usually 10 to 14 years in practice , independent VCs can only invest in very early-stage deals

in the beginning of their funds lifetime as the time to exit may take up to 14 years and all of

their investments have to be exited by the end of the fund (Van Osnabrugge & Robinson,

2001). The last constraint rather applies to those funds who wish to diversify and balance

their portfolio, which may be the reason for rejecting several new proposals based on what is

already in the portfolio. When approaching the end of the investment period of a fund, VCs

may want to invest the remaining fund capital in projects that show synergies with existing

portfolio companies or rather in a way that enables hedging less promising existing portfolio

positions (Petty, 2009).

2.4.4 The sour

Master Thesis - Danièle Müllender

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