Finance & Investing

Quick Study: How to Think Like a Venture Capitalist

In selecting investments, VCs take a unique approach.

August 17, 2023

| by Kelsey Doyle

Since the 1970s, venture capitalists have backed about one-third of all large publicly traded companies started in the U.S. That’s one of the remarkable findings from Ilya Strebulaev, a finance professor at Stanford Graduate School of Business who studies the inner workings of the VC industry.

Here, in the latest episode of our Quick Study video series, Strebulaev discusses what he’s learned about “the VC mindset” — their approach to investing in risky, high-growth startups.

Full Transcript

Ilya Strebulaev: My name is Ilya Strebulaev, and I’m a professor at the Stanford Graduate School of Business, as well as the founder and director of our venture capital initiative. Unless you know where to look, you might not see it, but venture capitalists or VCs are probably having a major impact on your life every single day. VCs are people who invest in small, risky, high-growth startups, and they often invest in companies that are trying to change our world. Think about Google, Microsoft, Facebook, Zoom. Many other tech giants, they were all funded by VCs back when they were very small companies. My team and I tracked the successful Covid vaccines and found about half are delivered by companies supported by venture capital, and even though it’s in the news a lot more during tech booms, this powerful sector of the economy predates the internet. My research shows that since the 1970s, the VC industry is behind about a third of all large publicly traded companies created in the United States.

So how do these influential people choose what ideas to fund? Even many company founders seeking venture capital money don’t really seem to understand the VC mindset, as I call it. That’s what my research set out to demystify. My team and I found that the most important stage is what’s referred to as deal selection. Deal selection is after they’ve already identified a startup to consider, but before VCs decide whether to invest in it or not to invest. During the deal selection process, VCs put every potential investment through something they call the deal funnel. On average, a hundred startups go into the deal funnel, and only one comes out, meaning that VCs invest in about one startup for each hundred that they consider.

The first part of the funnel is typically where VCs evaluate the business model and the startup idea. Often VCs will say, well, the market is obviously too small, so therefore we don’t have any interest. If the startup passes that stage, then VCs will typically meet with the founding team to evaluate them. Again, often enough, VCs will say, well, the business is interesting, but we’re not impressed by the founding team. That’s another startup squeezed out of the narrowing funnel. At the next stage, which relatively few deals reach, they’ll bring this startup to their partners, and then the partners will decide to proceed with a very careful due diligence on only some of the deals. On average, this entire process takes almost three months, and it’s highly selective. What we found was that the median venture capital firm considers about 400 deals a year and only invests in four.

The highly selective process benefits us all down the line. For example, my research shows that without venture capitalists, companies like Zoom might not have been identified, created, funded, or scaled up, and of course, had Zoom not existed, our experience during the Covid pandemic would’ve been quite different. This rigorous decision-making process can increase the success rate of companies that change our lives. So how can a business idea make it through the deal funnel? My team and I talked to almost 900 venture capitalists at over 700 firms asking these questions, many of those for the first time. We found that in order to try and minimize risk, VCs tend to concentrate on what I call the jockey rather than the horse. The jockey is the founders and the early management team of a company. In other words, the human element, the human capital, the horse is everything else, the product, business model, market technology.

Most VCs will not invest unless they have complete trust in that early management team, that they can execute on the idea. Even with the best horse, VCs figure that without a good jockey to ride it, it’ll not be winning the race. Switching together those hundreds of servers and conversations with venture capitalists, we started to get a clearer picture of who they are and who they aren’t. It turns out that the VC mindset is very different from other financial investors. They consider many more opportunities to start with. Other investors will not have as wide a deal funnel as venture capitalists. VCs are also much more ready to take on risks, and they’re much more likely to co-invest with other venture capitalists, so they’re part of a larger ecosystem. Because of all these differences, VCs have to come up with their own financial strategies because the standard financial models, like the ones we teach our MBA students here at Stanford, aren’t really applicable that much to early-stage companies.

Concepts like net present value or discounted cash flow techniques just aren’t that much in use. Since you can’t predict future cash flows of an idea or forecast revenue without reliable data, and the data for these startups just doesn’t exist yet. So if you’re not investing millions in startups, how does this all relate to you? Well, we can all probably benefit from thinking a little bit more like VCs, for example. People tend to be extremely risk averse, so are corporate decision-makers, and when you invest, that actually might not be a bad idea. But when you’re trying something new, either in your personal or professional life, being willing to fail and staying flexible is beneficial. That’s what the VC mindset is all about. VCs have a lot to teach us about doing plenty of research before making decisions, but also experimenting and keeping an open mind. That’s how you win big in business, and the same is true in life.

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