A Model of Venture Capitalist Investment Activity

The paper describes the activities of venture capitalists as an orderly process involving five sequential steps. These are (1) Deal Origination: The processes by which deals enter into consideration as investment prospects, (2) Deal Screening: A delineation of key policy variables which delimit investment prospects to a manageable few for in-depth evaluation, (3) Deal Evaluation: The assessment of perceived risk and expected return on the basis of a weighting of several characteristics of the prospective venture and the decision whether or not to invest as determined by the relative levels of perceived risk and expected return, (4) Deal Structuring: The negotiation of the price of the deal, namely the equity relinquished to the investor, and the covenants which limit the risk of the investor, (5) Post-Investment Activities: The assistance to the venture in the areas of recruiting key executives, strategic planning, locating expansion financing, and orchestrating a merger, acquisition or public offering. 41 venture capitalists provided data on a total of 90 deals which had received serious consideration in their firms. The questionnaire measured the mechanism of initial contact between venture capitalist and entrepreneur, the venture's industry, the stage of financing and product development, ratings of the venture on 23 characteristics, an assessment of the potential return and perceived risk, and the decision vis-à-vis whether to invest. The modal venture represented in the database was a start-up in the electronics industry with a production capability in place and seeking $1 million (median) in outside financing. There is a high degree of cross-referrals between venture capitalists, particularly for the purposes of locating co-investors. Factor analysis reduced the 23 characteristics of the deal to five underlying dimensions namely (1) Market Attractiveness (size, growth, and access to customers), (2) Product Differentiation (uniqueness, patents, technical edge, profit margin), (3) Managerial Capabilities (skills in marketing, management, finance and the references of the entrepreneur), (4) Environmental Threat Resistance (technology life cycle, barriers to competitive entry, insensitivity to business cycles and down-side risk protection), (5) Cash-Out Potential (future opportunities to realize capital gains by merger, acquisition or public offering). The results of regression analyses showed expected return to be determined by Market Attractiveness and Product Differentiation (R2 = 0.22). Perceived risk is determined by Managerial Capabilities and Environmental Threat Resistance (R2 = 0.33). Finally, a discriminant analysis correctly predicted, in 89.4% of the cases, whether or not a venture capitalist was willing to commit funds to the deal on the basis of the expected return and perceived risk. The reactions of seven venture capitalists who reviewed the model's specification were used to test its validity.