The Big Question: How Can Start-Ups Attract Investors?

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Hal Weitzman: What are venture capitalists looking for when they invest in start-ups? Is the business idea more important, or the team pitching the idea? And what does it mean for entrepreneurs?

Welcome to The Big Question, the monthly video series from Chicago Booth Review. I’m Hal Weitzman, and with me to discuss the issue is an expert panel.

Ira Weiss is a clinical professor of accounting and entrepreneurship at Chicago Booth, where he teaches advanced MBA courses in tax strategy, private equity, and venture capital. He’s also a partner at Hyde Park Venture Partners, an early-stage venture-capital fund. Steven Kaplan is the Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth. He’s also the faculty director for the Polsky Center for Entrepreneurship and Innovation at Chicago Booth. His research focuses on private equity, venture capital, and corporate finance, and he serves on the boards of several companies. Kathy Wanner is an operating partner at Abundant Venture Partners, an incubator for companies focusing on improving human wellness, human performance, and human engagement. She formerly worked for Adams Street Partners, the global private-equity firm.

Panel, welcome to The Big Question.

Steve Kaplan, let me start with you. You’ve actually done some research on what venture capitalists are looking for in start-ups. So what did you find?

Steve Kaplan: So this was a paper that I wrote with three other people: Paul Gompers at Harvard Business School, Ilya Strebulaev at Stanford, and Will Gornall at UBC [University of British Columbia]. We surveyed over 800 venture capitalists, which basically got all the venture capitalists in the world. So it was a very nice survey.

And I would say there are three things that are probably most interesting. The first thing is, we asked them, of the three key things that you do, what’s most important? And what they do is they source deals, and then from the deals that they source, they select. And then from among those that they select, then they help them. So we asked, which of those three things was the most important? And surprisingly to me, they said that selection was the most important of those three. So that’s one.

Two: we asked them, what was most important in the deals that succeeded or failed, and also what was most important in the selection process? And we basically gave them the choice of “management” or “the business.” And pretty, you know, I would say not maybe overwhelmingly, but certainly the majority felt that the team was more important than the business. So that’s finding two.

And finding three: we asked them what metrics they used to evaluate the business. Did they use discounted cash flow? Did they use multiple of invested capital, or something else? And I guess it wasn’t surprising that they didn’t use discounted cash flows. They tended to use multiple of invested capital. But what was surprising is, you know, some fraction of the early-stage people, 10–20 percent, said they didn’t use anything at all. And so I would say those are the three most interesting findings. There’s a whole lot of other things, but—

Hal Weitzman: Just on that last point, if they didn’t use anything at all, what were they going with?

Steve Kaplan: You gotta ask these two!

(Panelists laughing)

I have no idea. You know, it may be . . . Well, ask them and then I’ll—

Hal Weitzman: OK, Kathy Wanner, does that chime with your experience?

Kathy Wanner: It certainly does. I think if you think about venture capital in the marriage of folks who have ideas with the folks who have capital, I would say that sometimes there’s a very big idea. There might not be a market that’s defined. There might not be a company in its space that currently exists. And so to speak of, there really aren’t metrics that you would typically find in a finance coursework that would be applicable to try to analyze the opportunity. So it depends, is my answer, on the opportunity they’re going after.

Now, if it’s a late-stage venture fund—and that I mean somebody who’s already making investments in a company that exists already, so it has metrics, it has revenue, it may have no cash flow to speak of, but there are things that are tangible that you can measure—that might be an example where you could actually use some metrics.

So it depends on, really, what business you’re evaluating.

Hal Weitzman: Ira Weiss, what about this idea of the team being more important than the idea itself?

Ira Weiss: I think, so at the early stages, it always generally feels like the team is the most important thing because without a really good team, you’re just not going to be able to get the idea to go anywhere. So as time goes on, as the businesses mature, then I think the team itself becomes a little less—the original team becomes less important, and it’s a little bit easier to. . . Actually, following on some of the research that Professor Kaplan has done on the jockey versus the horse, early on it feels like the team is super important on the jockey side, and then later on, you know, the horse is really important. It’s a little bit easier to switch out the team.

Hal Weitzman: Right, because Steve Kaplan, some of your earlier research, which Ira just referred to, this “jockey versus the horse,” found that the idea kind of was really the thing that venture capitalists should be investing in, more than the people.

Steve Kaplan: So it was very . . . this is an interesting discussion that we’re having. So in that paper, what I did is I took a number of companies that had gone public, where I had a very early business plan. The business plan that the first venture capitalists funded. And basically, with one exception, they were all doing when they went public what they started out doing.

And so you have, you know, take Grubhub. Grubhub: you know, what was it doing in our business plan competition? It’s what it does today. Take eBay. eBay started doing something and that’s what it’s doing today. Facebook: Facebook is the same. So you can go on and on. Whole Foods even. Starbucks. You can go on and on, and they’re doing the same thing, which led me to say, OK, you better get the business right or you’re not going anywhere.

And so that’s why, you know, when the, the VCs say they’re focusing on the team, I’m a little bit . . . I don’t know surprised, but I’m kind of, I’m more of a horse person in that if I don’t like the idea or don’t think it’s going anywhere, I won’t touch it. That’s my question to you: If you don’t like the idea or you don’t like the business, do you go there?

Kathy Wanner: I would say there is the art. Venture capital is an art versus a science. And I think—Steve has alluded to this—I think it’s actually a delicate balance between the team and the idea, and I do believe that you have to demonstrate some kind of value proposition or have the ability to articulate your idea clearly. And I think that’s what weeds the people out pretty early.

But at the end of the day, you’re giving the capital to people to go execute on their idea, so it does not surprise me that folks feel like the idea, you know, is second to the people executing it. But, you know, venture capital is an art, and getting that mix right and evaluating which components of each of those sides you should process in your decision-making, it is really where the art comes in.

And I think that’s the important, key distinction here, and you’ll see that successful firms, successful venture firms are those that have individuals within their organization that can look at it from both sides. And I think in the end, as they come together and make decisions on a consensus basis, you know, hopefully you end up with a . . . the sum is greater than its parts.

Hal Weitzman: And when we’re talking about the team, are we talking about how impressive the individuals on that team are, or is it something to do with the chemistry between the members of the team?

Kathy Wanner: I would say it’s both, right, because venture funds are 10-year partnerships. Oftentimes 12, maybe 14. And so you have to make sure that if these are the individuals that are going to execute on that business that you can get along with them. You’ll oftentimes serve as board or advisors on the side, so chemistry does play into it. But I do think there has to be a sense of gravitas with the entrepreneur coming in and pitching—

Steve Kaplan: But is that the founder, or is it the whole team?

Kathy Wanner: Typically, I would say, at the early stages, it’s the founder and the partner or the cofounder, right, because oftentimes they’re just coming in and articulating to you where they see a value proposition or where they see a problem they have a solution for. I mean, venture is either funding innovation on the technology side or its funding innovation on the business-model side. And so they have to be able to articulate, in their relevant expertise areas, what they’re trying to solve or what they’re going after. And so, I do think, at the early stage, it is the founder. It is the founder.

Hal Weitzman: So, Ira Weiss, does that mean that it’s really important to put on a kind of a good performance? That the pitch itself is. . .

Ira Weiss: Well, actually I would say it’s much more than the pitch. I mean, I think the pitch is a piece to it, but at the really early stages, you want to dig into the founders’ background: How successful have they been at the other things they’ve done, where does the idea come from, how effective are they, how persistent are they? Can they attract really good other talent? Because that’s so important. So I think the pitch is a piece of it. I would say it’s a less-important piece than the founders’ background and the success they’ve had before and, kind of, where they’re coming from with it, with the investment.

Hal Weitzman: I see. OK, and what about the idea of sort of having a very charismatic founder?

Steve Kaplan: Well, what the VCs said in a survey was the I think, the two most important things were, first, industry experience—so knowing where the problem was—and second of all, was ability. Now we didn’t define ability—unfortunately, because that can be many things. But I don’t think it means charisma. The third or fourth thing, they said, was passion. So maybe passion is charisma, although passion could also mean being persistent. So the charisma is probably less important there.

But I think it is the case that the reason why, I think, Kathy and Ira agree that people focus on the founder is that even if you have a great idea, if the founder can’t attract people, that’s a problem. And so, I think that’s, you know, that would be . . . I would still say, you know: stay away from the idea if the business isn’t going to work, because a great founder’s not gonna fix it. But why do the VCs say they focus on the founder? Because I think they would say if the founder can’t attract people, then he or she’s going to fail too, which leads you to believe you need both a good jockey and a good horse to really push something.

Hal Weitzman: OK, you kind of preempted my next question, which was about, if you had an imperfect idea, could a really good, you know, team pull it off, even by changing the idea slightly? If you really believe in the people, could they—

Steve Kaplan: I’m skeptical about that because I didn’t see that in the IPOs, but I’m curious as to what—

Ira Weiss: I actually think it’s true as long as the market is strong. So I think, you know, and I forgot who had said this, but, you know, you want an “A” team: an “A” team with a “B” idea is better than a “B” team with an “A” idea. But I actually think the market itself is important because it may be that the original product needs to be, you know, the team needs to pivot or they need to tweak it. As long as the market itself is strong enough, an “A” team hopefully can figure it out.

There are a few high-profile cases that may or may not have shown up in your data. Companies like Slack and Twitter, and even locally Groupon, where the original idea was in many ways completely different than the really successful thing that came out of the founding team. And I think it would have been hard to do that without a special founding team.

Steve Kaplan: Right, and Slack, Twitter, and Groupon would be three exceptions, and then I can give you a hundred in the other direction. That’s the . . .

(laughing)

Ira Weiss: Well, and there are these cases also: sometimes people talk about the product itself occasionally being so strong—I think this is relatively rare, but—the product itself is so strong that it can almost carry beyond the success of the team and how good the team is. So, you know, Twitter and Slack might have been that case. Even if the founding teams were strong, the, the product itself was so widely used so quickly and had the right kind of effects that it just really took off.

Hal Weitzman: Kathy, what about this idea that a really good team could even work on an idea that wasn’t quite there.

Kathy Wanner: I guess I’m a believer in people, in their talent. So I would say, yes, I think it comes . . . the odds of success are probably different depending on where you come in at the life cycle of the company.

So if the company’s already been operating and it has operational inefficiencies that are just really difficult to make it compete, maybe against a low-cost provider, or there’s just some subtle nuance to the business where it’s difficult to execute, it just may not, there might not be any team that’s good enough to run that.

But if you’re coming in before there’s a determined product market fit or if you’re coming in before the technology has been totally innovated, I think then you know you can sort of tweak it and turn it and point it in directions that perhaps maybe lend themselves to being more successful, even though the idea didn’t start off so great.

I think people have the ability to pivot and take ideas and execute differently and, sort of, see around corners and where you can apply there . . . But it really does depend on the lifecycle of a company and where it’s at.

Hal Weitzman: Right, now let’s go back to this idea about having some significant minority, let’s say 10 percent or so, of venture capitalists having no financial metrics whatsoever when they do their investing. How is that possible? I mean, what are they—

Ira Weiss: I was almost surprised that that statistic wasn’t higher at the early stages, just from my intuition. I think it’s that VCs over time hopefully develop intuition about the size of the market and how big the success can be, and then kind of back into what needs to be done.

So if it’s a software company, everyone knows you want to have 90 percent software margins. And then once you know the market size itself, even if you’re not writing the rest of the things down, like the discounted cash flow, you can back into, this will be a very large success if it ends up with X percent of the market.

Hal Weitzman: OK.

Steve Kaplan: And I think that would be a, you know, Facebook, right. When it started going viral, you could say, OK, I’m going to invest in this because I know it’s going to be worth something without doing so much of the numbers. And I think, you know, as Kathy said earlier, as the stage gets later, in the data you saw that the later-stage investors, they do the numbers. They almost all do. It was the early-stage people where it would be harder to forecast early on exactly what the cash flows would be. But you might know, Gee, this is going to be a big hit.

Kathy Wanner: And let’s face it, every management team that comes through the doors when you’re evaluating a business, they’re the most optimistic set of folks that I’ve ever met. So even if you do do metrics off of numbers that you’ve been, they’ve shared with you, you do oftentimes have to take a little bit of a discount.

I mean entrepreneurs are eternal optimists by nature, and so you often see that in the economics and the projections and the business plan. So even the other, you know, 90 percent that are doing analytics, you have to sort of think about: How are they doing those analytics? Where are they getting the assumptions? How are they looking at market size, so on and so forth.

So it wasn’t surprising to me, and I think your number was like 17, 18 percent when you went down to the early stage and to the continuum, which, you know, in my experience, is probably true.

But to Ira’s point, folks already had the expertise built up. And so there’s not a spreadsheet or a model you need to build. If you’ve been spending your whole life in a particular vertical, you have a good intuition and sense of really what’s going on and what makes a business work there. So . . .

Ira Weiss: But I would say also, on the entrepreneur side, even if, you know, 10–20 percent of VCs don’t use these evaluation metrics, I would still do my own model. You want to have a model that you update, no matter how detailed, just so you know yourself because sometimes you start a company and maybe you don’t realize the market size is small or how profitable it can be or what the margins will be. So I do think it’s important for the entrepreneur to build those things up themselves. Maybe not a full discounted-cash-flow analysis, but at least enough to know that they’re going after something attractive.

Steve Kaplan: And let’s be clear. I tell the entrepreneurs: put together a business model, understand how your business works, do forecasts. So I tell them to do it. As an investor, I would do the same thing, because you want to have a sense how much cash are we going to need, and how big can we get? But it is true, you know, clearly there is some minority of people who don’t do that, and are, you know, successful.

Kathy Wanner: But I would say the analytics and the business model are all an opportunity for the venture folks and the entrepreneur to calibrate on: What valuation should I pay? And so it’s not unrealistic to think, even though the market doesn’t exist or the addressable market isn’t really known, that you do put something on paper, as Ira has suggested, because it, one, provides a little bit of a roadmap for the way forward, to measure milestones. If you remember, there’s a lot of financing risk.

And what I mean by that is, folks raise money for a company and then they have to come back for more money because they didn’t quite get to a point where they’re making money yet. So they have to go back and say, hey, can I have more, please? And so the business plan and the analytics and all of that keep the entrepreneur and the venture folks honest, right? These are the things that we agreed to early on. And so I do think there’s a role for the analytics beyond just predicting what the returns are. I do feel like it’s a calibration around, what is my idea worth? I’m obviously optimistic that it’s worth this. The venture guy is always like, well, it’s probably only worth this.

And so I do think there is a role for the analytics at the early stage. I just don’t know that, if you look at the attributes of how folks make decisions, that at such an early stage, it should be a large component of the decision-making factors to get to your, yay or nay, I want to make an investment. Whereas, as you move along the continuum, then it becomes more relevant because you have those metrics that are established and you can quantify them better.

Hal Weitzman: Steve Kaplan, for entrepreneurs, is there anything else that they should—short of having a good business plan, which seems like solid advice—is there any other advice they should take from your research?

Steve Kaplan: I think the thing that is very clear is you’ve got people such as Kathy and Ira who are really focusing on the founder. And so, if you are a founder going to talk to them, you want to be, you know, buttoned up. And, you know, I have my tie on; he doesn’t, but. You want to be buttoned up in the sense that you want to convince them that you are the person to run it.

We had actually someone in class the other day who is a lawyer in Silicon Valley who was describing a case where he had an entrepreneur who, who was terrific and she went and spoke to one of the top VC firms in Silicon Valley and she was not prepared, and they didn’t give her the money. And then she went back and got prepared and got money from someone else.

But I think what you want to have come across, since they’re focusing on the founder: be prepared, be optimistic, make them understand that you are going to get it done. That’s very important, in addition to having a good idea.

Kathy Wanner: Well, I would say too, that having participated in some of Steve’s classes where they are presenting business plans, he often reminds these students: tell them what you already know as you’ve executed your idea. So are there customer experiences, are there technology experiences as you’ve built whatever you’re building that are relevant to the decision? Because it only lends more credibility to your story. I must have heard him say that at least you know six, maybe seven times during a class period, which I think, oftentimes entrepreneurs assume everyone in the room knows what they know.

And so, kind of speaking on what you already know, what you already have experience in can really create confidence in your ability that you know what you’re talking about, you know where the company is going, and you know what the problems are. So I must have heard you say that—

Steve Kaplan: That’s really a good point. So what they do and shouldn’t do is they start up here and sort of talk about the market and what a great opportunity it is. And that, you know, Kathy could say, Ira could say, I could say. What they’re better off doing is saying the details, such as: the customer I have, the things I know, and to say things that we can’t say, because—

Kathy Wanner: Or we don’t know.

Steve Kaplan: Or we don’t know, right, because we’re investing in them because we think they have something we don’t.

Hal Weitzman: Ira Weiss, how should entrepreneurs approach venture-capital funds?

Ira Weiss: Well, if you think about the data in Steve’s research, they showed that VCs only end up investing in four out of 200 investments that they look at, so. And of that, only 10 percent of the investments are the entrepreneurs themselves directly reaching out to the VC. Ninety percent are, somehow, either the VC finding out about the company or the VC getting introduced to the company through their network in some way. So generally, we would always recommend a warm introduction. Find an advisor for the fund, find a successful portfolio company of the fund, get to know the founder of that portfolio company, and have that portfolio company introduce you to the fund or the specific VC.

Steve Kaplan: What about your professor?

Ira Weiss: Or your professor. I should mention that as well. But I would include professor in the network, whereas that’s a warm introduction. If you get it from your professor, it’s actually a very warm introduction.

Hal Weitzman: Does that chime with your experience, Kathy?

Kathy Wanner: Well, I would say so. I mean every venture capitalist believes they have proprietary deal flow, and I think that’s a fancy way of saying it comes in through our network. And I would say it’s probably true, although there is a whole side to the venture market where it’s the seed and incubator stage, where oftentimes those groups of individuals see a white space where a company doesn’t exist or operate, or they see a problem and they write a business plan, and they’re oftentimes looking for somebody to come in and execute on the idea. So it really, again, depends on, to beat the drum, where the company is in its lifecycle.

But for the most part, I think a warm introduction is definitely the most attention you’ll get in terms of that organization and the time that they’ll take to read through the materials and to reach out and respond.

Hal Weitzman: Is that the advice you give your students, Steve?

Steve Kaplan: Oh, absolutely. Find somebody who knows the firm and, first of all, find a firm where they know your business or they know the industry you’re in, because you don’t want to have to educate them, and you want them to be able to evaluate you quickly and correctly and then help you. So, first of all, find someone who knows your business and can help you. And then once you’ve done that, figure out who you know who knows somebody at that firm and get an introduction. That is absolutely the way to go.

The other thing that was really interesting is the fact that about half of the VCs said that selection was the most important and only a quarter said deal flow and a quarter said value-add. And I was surprised because I thought they would say deal flow because they all talk about proprietary deal flow. I was surprised that they said selection was most important. So what do you two think of that?

Ira Weiss: When I found out that it was selection—before I would have guessed deal flow but then, after finding out selection and thinking about the investments I’ve made— then I was like, yes, selection makes a lot more sense than deal flow. Because when you think back on it, you think, I made these investments. This was a mistake. There were signs that I should have . . . there were clearly signs that I should have seen more carefully and I should not have made this investment. And then you feel very good about these. So you feel like it’s deal selection, even though some of it was probably good sourcing that you just had access to see all the opportunities.

Kathy Wanner: I would say that the wider your network and the more deals you see . . . is a good starting place. But if you’re not a good investor, you can see a thousand deals and still pick a crappy one. So I think, in the idea of knowing good from bad and just picking the good deals, it’s probably not too surprising to me that it was selection. What was surprising to me is the value-add piece that was only a quarter. If you think about the role of a venture capitalist in helping strengthen the management teams, introduction to customers, thinking through the financing as the company grows, you would think there would be a higher value placed on the role from that perspective in advising the company.

Steve Kaplan: Right, and it was even worse when we asked them what was the most important thing in success, and it was, like, zero. You know, my value-add.

Kathy Wanner: I did notice you used the word luck a couple times in the paper.

Steve Kaplan: They did. They did. They said—

Kathy Wanner: There is a fair amount of luck to this business and, you know, maybe that equals market timing, but luck does play a factor in whether or not a business takes off or not.

Ira Weiss: Well, and also the value-add. So you can have a lot of value-add on the part of VC, but what happens is, you make the investment and then, if it’s a good investment, like there’s all this magic that occurs that actually has nothing to do with you. And you can help, but there’s like this kernel of something very special happening that you, even with your value-add, I think, you wouldn’t attribute to yourself because it’s more like, you know, without you maybe the company would go like this and with you maybe it goes like this. So, to the entrepreneur, actually, there may be a lot of value in interviewing a new CFO, interviewing a new CRO, all those things that are very high value-add, but often there’s this kernel when it’s a good investment of something that’s, like, it’s a train that’s going in the right direction. And it doesn’t mean that it can’t go off the rails, but you will often not attribute your value-add to the success.

Hal Weitzman: Well, thank you very much. This has been a fascinating discussion.

My thanks to our panel: Ira Weiss, Steve Kaplan, and Kathy Wanner. For more research, analysis, and commentary, visit us online at review.chicagobooth.edu, and join us again next time for another The Big Question.

Goodbye.

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