Why do VCs invest in a company?

angel-investorsScale-ups are hot right now, with institutions moving away from trying to develop start-ups towards trying to help such ventures scale to the vaunted unicorn status.  Of course, having the requisite financial support to achieve this level of growth is key, but there is much to suggest that the way finance finds its way to new businesses is a bit broken.

Whilst a recent study from Harvard found that experienced entrepreneurs are pretty good at judging the future prospects of a startup, there have also been studies suggesting that there is an inherent gender bias in the process.

Incomplete information

This reliance on instinct rather than cold, hard data is something that came up again in a recent study exploring the information on which investing decisions are made.

It found that investors typically make their decisions with scant information about the company.  What’s more, this is even the case if they undertake due diligence into the venture.  This isn’t so much due to ignorance on their part as much as it is the simple lack of much in the way of tangible product or sales data to go on.  As such, the investors are forced to rely on their instinct rather than the data, whether this is about the product or even the start-up team themselves.

The question then becomes, is that instinct fruitful?  Well, the answer is mixed, and complicated by the fact that investors weren’t actually hoping to make a return on each investment they made.  Indeed, they quite expected to lose money on many of them.  Instead, they were looking for those few investments with huge possibilities.

Backing a company that went on to great things was not just a financial boon, but also provided a social cachet whereby they were then associated with backing such a star.

Understanding what motivates

The study suggests that investors take a fairly holistic approach to their investments, using a combination of gut instinct and rational thought.  Experienced investors are realistic to accept that business plans are often to be taken with a pinch of salt, and the fact that they generally only have to report to themselves can mean they are free to follow those instincts rather than a prescribed method.

Interestingly however, this instinct did appear to be useful, as when investors were asked to pick out the best start-ups from a technology pitch competition, they successfully identified those that went on to float or be acquired.

This suggests that having a lack of information to go on should be no barrier to successful investing, and that more instinct based investing seems to be just as accurate as more formulaic investing of mature businesses later on.

The authors suggest that networking angel investors together to create a strong social network could be hugely beneficial to supporting entrepreneurship as they exchange some of these tips of the trade with one another.

With scaling up so high on the political agenda around the world, maybe this is food for thought for policy makers wishing to re-start the engines of growth.

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