The Venture Capital Investment Process.

Study of the
DACH Region Venture Capital Firms.

Evgenii Zasorin

Bachelor’s Thesis
Degree Programme in
International Business
2017
 Abstract

17 May 2017

Author(s)
Evgenii Zasorin
Degree programme
International Business
Report/thesis title Number of pages
The Venture Capital Investment Process. Study of the DACH and appendix pages
Region Venture Capital Firms. 58 + 2

The investment process described in the academic space decades ago has not undergone
any drastic changes. On the other hand, industries that venture capitalists invest into have
been constantly growing and new markets have been emerging. These undergoing changes
have also been influenced by the rapid development of the internet, technology and vast
changes in current trends. With this advancement come new challenges that VC investors
should tackle. There is a viable lack of information available on this subject. Therefore, there
is an explicit need for this research.

The aim of this thesis is to examine how venture capital firms make investment decisions
and what challenges they face along the way. The primary goal was set to reveal the best
practices from VC investors on how the investment process is structured at their firm.
Moreover, the goal was to investigate the obstacles that are encountered by investment
teams when making an investment decision.

This thesis is a qualitative research based on semi-structured interviews conducted with

middle and senior level employees of VC firms. The respondents comprised of well-known
VC firms located in the DACH region. The data obtained from the interviews was analysed
and examined for similarities and relationships. An inductive approach was applied to
explore the insights from the data and reveal patterns among the interviewed firms.

The research presented minor discrepancies to the investment process described in

academic literature. This reaffirms the notion that VC firms have not implemented any
significant amendments to the investment process. The main difference that was revealed
is the software reinforcement into the process which helps to streamline the overall workflow.
Considering the challenges that are encountered by investors, the most common one is the
speed of deal selection. The subsequent challenges are cognitive bias and shareholder
communication issues. This research presents a comprehensive overview of the top eight
challenges faced by VC investors from the investment process perspective. The main
strategies to mitigate those obstacles comprise of market experience, a solid term-sheet and
transparent communication with the parties involved in the transaction.

Supporting the results obtained, this thesis points out areas to be further researched. They
include a more expansive study aimed to reveal whether an optimised investment process
has a significant weight among other factors that affect the financial performance of a VC
firm. Furthermore, there is a need to conduct additional research to investigate which
strategies can be developed to mitigate each particular challenge.
Keywords
Venture Capital, Private Capital Markets, Entrepreneurship, Investment Process, Due
Diligence, Startup, Funding
Table of contents

1 Introduction ........................................................................................................................ 1
1.1 Research purpose and research question ............................................................... 2
1.2 Research scope ........................................................................................................ 3
1.3 Anticipated benefits .................................................................................................. 3
1.4 Research structure ................................................................................................... 4
1.5 Key concepts & abbreviations .................................................................................. 5
2 Introduction to venture capital ........................................................................................... 8
2.1 Definition of venture capital ...................................................................................... 8
2.2 The role of venture capital firms ............................................................................. 10
2.3 Stages of venture capital financing ........................................................................ 13
2.4 Structure of venture capital firms ............................................................................ 15
3 The venture capital investment process ......................................................................... 18
3.1 Deal sourcing .......................................................................................................... 21
3.2 Initial screening ....................................................................................................... 22
3.3 Due diligence .......................................................................................................... 24
3.4 Term-sheet and closing .......................................................................................... 26
4 Research methods .......................................................................................................... 28
4.1 Research approach ................................................................................................ 28
4.2 Research design ..................................................................................................... 29
4.3 The interviews ......................................................................................................... 30
4.4 Data analysis .......................................................................................................... 31
5 Research results ............................................................................................................. 32
5.1 The investment process structure .......................................................................... 32
5.2 Investing challenges and ways to resolve them ..................................................... 36
6 Discussion ....................................................................................................................... 45
6.1 Discussion of the results ......................................................................................... 45
6.2 Limitations of the research ..................................................................................... 48
6.3 Suggestions for further research ............................................................................ 49
6.4 Self-assessment and learnings .............................................................................. 50
References ........................................................................................................................... 52
Appendices........................................................................................................................... 56
Appendix 1. Interview Questions .................................................................................... 56
Appendix 2. Transcripts of conducted interviews ........................................................... 57
1 Introduction

There is a famous phrase that relates to entrepreneurship and business in general. Cash is
king. Entrepreneurs who run a company in its early stage of development, find it to be
financially challenging. In order to make their businesses stay afloat, founders seek the
funding outside of their own earnings, as the company is not generating enough profits at
this stage. The sources for early-stage financing vary vastly but generally categorized as
friends, family or investors. In most of the cases, friends and family cannot provide the
required amount of capital. Bank loans on the other hand are hard to obtain for newly
established ventures. Thus, founders resort to financial support from investors of different
types. Among all the other types of financing, venture capital firms provide best financial
and strategic support in line with their expertise and market knowledge.

Besides venture capital, companies have other options to raise additional funding. This
vastly depends on the stage of growth of the company. A team that only has a business
idea and approximate implementation plan can receive funding from business angels. This
transaction is exclusively based on hopes that the company will become big one day. When
a company has a ready prototype and some early traction, venture capital comes into place.
At the later stages of maturity with the six or more sales figures, the company can raise
additional capital through publishing their share on a stock exchange. This case is relatively
rare, as only a tiny fraction of the overall number of startups make it to this level. Debt
financing on the other hand is also an option, even though it implies numerous downsides
to financing innovative companies. Thus, venture capital is considered the best source of
financing for companies at the stages ranging from early traction to expansion in other
countries. (BDC 2017). However, unlike the venture capital industry, the startup
environment has undergone vast changes.

The startup industry has been changing rapidly during the last ten years. One of the most
visible changes is the decrease in the amount of resources, time and capital required to
launch a company (Roth, 2013). This has never been as easy as nowadays. As a result,
there is a skyrocketing number of technology companies launching worldwide. In order to
keep up with the technological progress, Venture capitalists embrace various solutions to
improve and streamline their decision-making process. Fund managers must be quick
enough to grasp the best deals in their respective industries. Therefore, they neglect the
quality of the process flow over speed. The investment process that they have built is not
aligned to the fast-pace startup environment. As a result, one can currently observe an
abundance of flaws and inefficiencies in the process, that should be resolved. (Chung,
Wessel 2012.)

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Investing in innovation is a highly risky business. Unlike the banks which are secured with
a collateral on a loan, VC investors take ownership in a company. Therefore, in case a
company went bankrupt, the initial investment will be lost. This notion explains why VC
investors are highly selective when it comes to committing capital to highly innovative
companies. In order to efficiently evaluate deals while acknowledging all the inherent risks,
a structural and standardized approach should be implemented. Hence the importance of
an optimized investment process is evident.

1.1 Research purpose and research question

The purpose of this study is to examine how the investment process is structured in venture
capital firms. More specifically, the process structure including documentation and decision
flow as well as the software support. Furthermore, determine which challenges venture
capitalists face while making an investment decision and what frustrations the team
members experience throughout the process. Among other conclusions, results of the
research should reveal the measures that venture capitalists embrace to tackle the
investment challenges. Therefore, the main research question can be worded in the
following way:

How do venture capitalists make decisions on financing innovative

companies?

Defined objectives of this study will be accomplished by answering the following

investigative questions:
1. How is the investment process structured in the DACH region venture capital firms?
2. What challenges do venture capitalists face throughout the decision-making process
and how do they address them?

There are several studies and academic literature available which describe the venture
capital through the investment process. However, these sources do not consider the
changes that the investment process has undergone with technological advancements in
the last decade. Moreover, the information that is currently available on venture capital
challenges mainly encompasses individual opinions and best practices. There is a viable
lack of available research and studies condoned on this subject. Thus, the need for a
comprehensive study on the topic is certain. The crucial elements of the investment process
are integrated into the research questions. Further explanation of the research approach
and methods can be found in the chapter four.

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1.2 Research scope

Investment process is a considerable part of the venture capital subject which could be
approached from different standpoints. The framework of this study is primarily based
around the investment decision process, but the research scope is further defined by
several criteria.

Considering the geographical demarcation of the research, there were two options available
– either the US or the European market. The US venture capital landscape is significantly
different from European. One of the reasons for that is the economic conditions in line with
the amount of capital available to investors. Moreover, the differences are explicit in their
investment strategies and the way firms operate. (Venturebeat 2016). Considering that the
case company operates exclusively in Europe, the location was chosen respectively.

There are currently more than 650 venture capital firms in Europe. All of them are
differentiated by the fund size, target investment sectors and geographic coverage among
other factors. (European Private Equity Activity 2014, 29.) The DACH region, comprising of
Germany, Austria and Switzerland, will be the primary focus for the firm’s investments.
Thus, based on the negotiations with the case company, the geographical coverage was
decided to be limited to that region respectively.

Since there is a low number of VC firms headquartered in the DACH region, the clear
majority were approached in that location, but with few delimitations. The approached firm
should have been operating on the market for at least one year and needed to have
investment focus on deals primarily coming from the DACH region. The firm size and its
investment focus was not demarcated by any parameter.

1.3 Anticipated benefits

This research will benefit the parties directly and indirectly involved in the VC industry. The
aspects discussed in this study are relevant to general partners, fund managers, associates,
analysts, entrepreneurs planning to raise venture capital and other stakeholders involved in
the venture capital industry. The main reason is the comprehensive approach to the subject
that incorporates essential elements of how VC firms operate internally.

For entrepreneurs, the results of the research will provide valuable information that can be
used when they are planning to raise funding from a VC firm. More specifically, by
recognizing crucial stages of the investment process, founders will have a greater chance
of successfully closing the financing round. This research could be seen as a one-stop

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resource for entrepreneurs to gain familiarity with the process of raising funding. Moreover,
understand which documents should be prepared before a potential investor requests them.

Explicit benefit for the case company is the opportunity to gain insights on how other VC
firms operate internally, which are otherwise not available to the public. With the information
obtained and analyzed, the case company will be able to optimize the internal process to
achieve better resource- and time-efficiency. Potentially, these insights, such as the
investment process structure and existing process challenges, will allow to drive better
investment decisions.

Being successful in the venture capital industry requires a great among of subject
knowledge combined with practical industry insights. This research will allow to gain a
deeper understanding in the cornerstone concept of how venture capitalists make
investment decisions. Furthermore, the interviews will uncover personal experience of
venture capitalists in making investments into dozens or even hundreds of companies. The
obtained information will allow to jump start one’s career within this industry.

1.4 Research structure

The structure of this research consists of six chapters and two distinct parts. Chapters one
to three are focused on the introduction to the study and the review of the literature.
Whereas the chapters four, five and six present the empirical findings and research results.
Below is the structure of the remainder of the research:

- Venture Capital
Chapter 2 & 3
- Role of VC firms
Literature Review
- Investment process

- Research approach
Chapter 4
- Research design
Research methods
- Data analysis

- Interview results
Chapter 5
- Key findings
Results

- Discussion of results
Chapter 6
- Limitations of research
Discussion
- Author’s reflections

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Figure 1. Visual representation of the research Structure.

The first chapter will introduce the research purpose, demarcation criteria and key concepts
that will provide the overview of the condoned study. The subsequent chapters will present
the theoretical groundwork and provide adequate theory for the empirical findings. Chapter
two defines the concept of venture capital and its role in financing companies. It further
describes the structure of a VC firm and how a venture capital firm makes money. The third
chapter will introduce the VC decision making process behind making investments in
companies. More specifically, which steps an investment team goes through before making
the final decision.

The second part of this research comprises of research methods, analysis and results as
well further discussion. Chapter four will introduce the research approach, including the
research design, data collection and data analysis methods. The succeeding chapter five
presents the analysis and results of the interviews with VC firms. The last chapter six is a
discussion of the research results where answers to the investigative questions are
presented. This chapter also includes limitations of this study as well as author’s self-
assessment and learnings.

1.5 Key concepts & abbreviations

The purpose of this sub-chapter is to introduce key concepts and terms directly or closely
related to this research.

Business Angel
Also referred to an angel investor, is an individual who provides capital to early-stage
companies. Business angels help entrepreneurs to develop their business idea into a viable
product. The amount of investment that can be provided by an angel investor varies, but
typically ranges between five thousand to half a million euros. As a sub-category of equity
financing, the main goal of the investor is to make a return on the capital provided to a
company. (Debitoor 2017.)

Business Valuation
A method of estimating intrinsic economic or financial value of a company. In business
transactions, it determines the price of shares and therefore sale value. There are several
approaches to determining the value of a company, which includes market comparables,
discounted cash-flow valuation and other methods. (Investopedia 2017b.)

Due Diligence

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A set of actions aimed to research and analyze a company as a matter of preparation before
an investment is made. It subsequently determines the business and investment risks,
financial projections, business valuation and assessment of key business areas. (Webster’s
Dictionary 2016b.)

Initial Public Offering

An initial public offering, also IPO, is referred to a public sale of a company’s shares on a
stock exchange. Before this transition, the company is considered private, with a limited
number of shareholders. Through an IPO companies can raise additional capital to support
business expansion, further growth and to facilitate acquisitions. However, by being publicly
listed, the company needs to disclose all of its financial statements and other business
information. (Investopedia 2017c.)

Portfolio Company
Portfolio company is a company in which venture capital firm owns a certain equity through
investing fund’s capital. A set of companies therefore is referred to the fund’s portfolio of
investments. (Funding Post 2017.)

Startup
Startup is referred to a company in the beginning of its life-cycle that is perceived to grow
at a fast pace. Startup companies are usually considered to be grounded in highly
innovative technological industries. (Investopedia 2016c)

Venture Capital
Venture capital is money invested in shares or equity of private sector companies with an
aim of long-term growth potential. Usually viewed as an important source of funding to
finance company’s operations. (Investopedia 2017a.)

Venture Capital Firm

An investment firm that manages money of Limited Partners to gain financial benefit for its
shareholders. Venture capital firms usually invest money in private sector companies to
seek above-average returns. (Funders Club 2017.)

Shareholders’ Agreement
A binding agreement between the shareholders of a firm that defines the mutual obligations,
restrictions of actions, conflict resolutions and rights. It also describes the management of
the company, equity ownership as well as protection for the majority and minority positons.

6
The ultimate goal of the shareholders’ agreement is to treat all the shareholders’ fairly and
protect their rights. (Business Dictionary 2017.)

Term-sheet
Document that highlights key features regarding the agreement of an investment
transaction between two or more parties. It contains a list of terms and conditions upon
which the parties will operate in the transaction. A term-sheet lays out the major aspects of
the deal, therefore mitigating the possibility of any disputes that might arise. (Divestopedia
2017.)

Abbreviations

DD Due Diligence
GP General Partner
IC Investment Committee
IPO Initial Public Offering
LP Limited Partner
M&A Mergers and Acquisitions
SME Small and Medium Size Enterprises
VC Venture Capital

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2 Introduction to venture capital

Today, ideas matter the most. Whether it is an idea for a new service, product, or business
model. Entrepreneurs are regarded as the ones who execute their own ideas. The role of
small and medium size companies (SME) is paramount in any national economy. They drive
growth and innovation in the market, as well as provide jobs for the citizens. The developed
entrepreneurial sector is essential in fuelling country’s economic rise. To this date, SMEs
create roughly 65% of new net jobs (Bureau of Labor Statistics 2008). Moreover, these
types of ventures are transforming certain industries into high-end technology sectors by
cultivating innovation. All of that is followed by an unlimited amount of opportunities for
further development that entrepreneurs create in the system overall.

On the other hand, small and medium-sized enterprises (SMEs) are continuously tackling
several major problems. One of them is access to capital, which seriously undermines
ventures’ performance and long-term success. The probability of failure of a newly
established company is excessively high. Within first three years of operation 92% of these
companies fail. (Startup Genome 2012). There are scarcely any startups that do manage
to survive, and even those are barely staying afloat. Those firms lack employees, capital
and most of the time even customers. The vast majority tackle a challenge of scalability. In
order to switch from an “unpaved road” to a “highway”, founders of entrepreneurial firms
seek external funding and there are several reasons for that. Firstly, founders should
mitigate operational challenges that occur underway. Secondly, it is marketing and
promotion costs that limit companies’ capability to sell to a wider spectrum of potential
customers. Last but not least, to sustain growth and strengthen market position,
entrepreneurs ought to recruit the right people.

The above-mentioned problems can be addressed through a particular type of investment

which is referred to venture capital. Venture capital firms fill up the financing gap by means
of equity participation in an entrepreneurial firm. They offer capital, managerial support,
strategic mentoring as well as access to new markets through existing investment network
(Klonowski 2010, 2). Venture capitalists have become crucial to the development of startup
companies worldwide.

2.1 Definition of venture capital

Since its origin, the definition of venture capital has been revised many times. However,
one can underline the central idea of venture capital, as funding provided to private sector
companies aims to increase the pace of a company’s growth through capital infusion and
strategic support (Klonowski 2010, 3). The Oxford Dictionary defines venture capital as

8
capital invested in a new or expanding firm that involves high level of risk (Oxford Dictionary
2016). The definition of venture capital in the Webster’s Dictionary does not contradict to
the one above, it refers to capital committed to a company in exchange for a fraction of the
ownership (Webster’s Dictionary 2016b). The main resemblance of both definitions is the
notion of considering venture capital as a very risky investment.

The roots of venture capital can be revealed back in 1946, when bank landings were ruling
industries. Banks were willing to support borrowers who had collaterals and capable of
making timely payments of interest and principal. The requirements were high for
entrepreneurs to meet, thus they sought risk capital. During that time there was no constant
source of capital to support a venture’s development. Without wealthy family of friends, it
was hardly impossible to obtain necessary funding. To resolve that matter, the first publicly
traded risk capital firm was established in the USA. The industry grew slowly for 35
consecutive years until new capital source from pension funds came into place in the early
1980s. (Metrick & Yasuda 2011, 10.) The rapid growth advanced through the following 20
years, culminating in a memorable crash of Dot-com bubble (Investopedia 2016a).

Although more than half of the investments worldwide are made in the United States,
Europe and Asia are catching up. Within four years (2011-2014), China experienced a
dramatic 70% increase in the deal volume and almost doubled their invested amount in
private sector companies. Whereas Europe saw just a slight increase in the dollar amount
invested between 2011 and 2014. (EY 2015.) As a sub-segment of European venture
capital industry, the Central and Eastern Europe (CEE) showed a noticeable 2 times
increase in the amount of investments, where startup stage companies took a lead (EVCA
2014).

Nowadays, the view on venture capital has been altered towards a definition of a commonly
used source of equity financing for early-stage companies, which manifests its central role
in the firm’s development. The two major components that venture capitalists provide for
entrepreneurial firms are capital and knowledge aimed at exploiting market opportunities.
(Klonowski 2010, 4). Once an investment is made, the venture capitalist cooperates with
the firm’s internally operations to develop the further business. This activity implies close
collaboration of both parties by means of board or committee meetings, regular mentoring
and recruiting. In addition, venture capitalists conduct continuous business and risk
assessment to overcome hurdles which might be found down the road and increase firm’s
chances to succeed. This is usually referred to a term known as monitoring in the venture
capital investment process. (Metrick & Yasuda 2011, 9.)

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On the other hand, investors pursue long-term, above average returns from investee firms
to justify high risks involved in an investment. The most important part of the whole
investment process is to achieve a so called divestment or exit. (Klonowski 2010, 41.) To
maximise return on investment, venture capitalists allocate investments in firms, which
differentiate by firm’s stage of development, industry and geographic region. Moreover, the
necessity for this is to counterbalance underperforming investees by diversifying investment
portfolio with various entrepreneurial ventures. As for every financial intermediary, the
ultimate goal is to provide net returns for the shareholders.

In the VC industry, the main players are referred to as General and Limited Partners. The
venture capital firm, consisting of fund managers and employees, is the general partner
(GP), whereas the limited partners (LP) are the individual and institutional investors. Both
parties organise a partnership to establish a fund, which is seen as the main investment
vehicle of a venture capital firm. When raising a fund, LPs provide a significant part of capital
in the VC fund. Whereas, GPs are required to have skin in the game, usually supplying 1%
of the agreed fund’s capital size. (Metrick & Yasuda 2011, 41.)

When considering venture capital, it is important to distinguish it from the interchangeably

connected term private equity. The European Private Equity and Venture Capital
association characterizes the term private equity as equity capital provided to unlisted,
private sector companies (EVCA 2012). Moreover, private equity firms often support
development of new products and technologies, supporting working capital needs to
improve the balance sheet of a company. On the other hand, this association defines
venture capital as primarily a subgroup of private equity, intended to make equity
investments in the launch stage firms. Essentially, it focuses on entrepreneurial firms than
on mature businesses. The underlying idea of the differentiation between venture capital
and private equity is the variation between the sales process and acquisition. (EVCA 2007.)

In this thesis, the term venture capital will be used when describing investing into private
firms. Moreover, the title of venture capitalists will be applied when referencing to a manager
of a venture capital firm who holds ultimate responsibility of the fund’s investment in specific
firms and its portfolio of investee firms.

2.2 The role of venture capital firms

The funding needs of an early-stage firm constantly exceed the entrepreneur’s own
resources, resulting in sluggish concept development and increased odds of failure. To
overcome this hardship, additional funding should be sought elsewhere. Companies mainly
rely upon internal and external types of financing. Internal sources are generated by the

10
company and are usually limited. If the company is operating profitably, there is an option
to source additional capital from internally generated cash flow. Otherwise, in case of
unprofitability, the company can pay its liabilities by properly allocating working capital.
Moreover, necessary funding can be obtained from existing shareholders on a pro rata
basis. Further, this section outlines the most common sources of financing available for
entrepreneurial ventures and reasons why venture capital is considered the most suitable
option. (Klonowski 2010, 6.)

As early stage companies imply high risk, such financial institutions as banks are not willing
to provide funding, largely due to low capital security level. The process of obtaining a bank
loan is challenging and most importantly time consuming. Furthermore, banks usually
require strong credit and collateral. On the other hand, banks do not subscribe to the profits
that the company makes. Moreover, banks do not take any ownership of a company,
contrary to what VC and angel investors do. (OECD 2015, 20.) Despite the advantages of
this type of financing, the clear majority of early-stage companies cannot meet high
requirements set out by banks.

On the other hand, the company can be financed through an initial public offering on the
primary or secondary market. However, there are certain prerequisites to sell companies’
shares in the stock exchange. Thus, this option is only available to a limited amount of
companies. (Christofidis & Debande 2001.) It is perceived that the company which goes for
an IPO has successful operations for several years and already has an extensive record of
sales and profit. These companies are considered as market leaders in their industries
seeking additional funding to develop new product and technologies, expand their
operations and strategically acquire other companies or entities in the industry. (Klonowski
2010, 6.)

There is also an option to increase company’s capital through government-backed support

scheme or preferential treatment. That is provision of initial funding to test run company’s
concept and develop the business model. (UK Government 2016.) In addition, government
assistance can be in form of preferential tax treatments, grants or loans, which are usually
below a market rate. However, in the long term the government-based programs are not
sustainable, due to implied uncertainty and limitation. Finally, the process of approving
government assistance is time-consuming and does not provide any guarantee to be
granted to the company. (Klonowski 2010, 7.)

Another possibility for the company to raise money is by selling its shares. Such a
transaction can take place between two companies, or often a company and a strategic

11
investor from the same sector. It gives a possibility for the new shareholder to participate in
the following rounds of capital increases. However, there is a challenge of finding a new
partner which will assume ownership stake in the business, as larger firms prefer to take a
majority stake. Thus, leading to the case, where the founding entrepreneur loses control
over the business. (Klonowski 2010, 7.)

Table 1. The possibility of financing through different sources (Klonowski 2010, 8)

Early stages Expansion Stages
Seed Startup First Second Third Fourth
Stage Stage Stage Stage
Demand for capital Low High High High / Medium Low
medium
Possibility of Financing by:
Founder’s Capital High High Medium Low Low Low
Debt / bank loans Low Low Low Medium High High
Stock market Low Low Medium Medium High Low
Government programs High High High Medium Low Low
Net profits Low Low Low High High High
Sale of shares / capital increase Low Low Medium High High High
Venture capital Medium High High High High Low

The possibility of financing for entrepreneurial ventures hinges on several aspects; the
company’s development stage, its profitability, industry-specific features and the level of
risk involved. While larger companies with a track record of increasing sales and profitability
has wider spectrum of options, newly established companies are limited in the financing
sources that they dispose. (Klonowski 2010, 7.)

After all there is venture capital. Table 1 encapsulates various sources of financing available
to entrepreneurs in every stage of company’s development. It reaffirms the assumption that
venture capital is the most flexible and sustainable form of financing out of the other
available options mentioned above. Moreover, venture capital is not tight to any
geographical market thus, available to companies headquartered worldwide. (Klonowski
2010, 7.)

The main distinguishing feature of venture capital is its orientation on equity rather than
debt. Therefore, invested capital is not secured with any assets of the founder or the
company itself. On the one hand, it can be considered as an advantage for investee
companies, as when wind down of the company’s operations occurs, entrepreneurs are not
liable to liquidate invested capital. On the other hand, under above mentioned

12
circumstances, venture capital firm will only be able to recover a small portion or in the
worst-case scenario lose the entire investment. Hence, selection of the deals is a crucial
task for VC investors. They are extremely deliberate when it comes to picking companies
that they want to invest in. The priority is given to the companies that already signal high
growth potential and can potentially provide high returns to the VC firm. (OECD 2015, 78.)

In addition, venture capital is the only type of financing where an investor provides strategic
advising and development in line with the investment. Because VC firms subscribe to the
ownership of a company, they become board members and exert considerable influence
over the business operations. Hence, the investee company receives a bundle of services
that comprise of technical and management expertise, financial planning and other key
support functions. All of this is aimed to expand the company’s operations and increase
sales, with future expectations of above market returns through a successful exit. (OECD
2015, 79.)

As it can be noticed, the underlying function of venture capital is to provide above-market

financial returns, which is accomplished through selling equity of an investee firm at the end
of an investment period. This concept is usually referred to as an exit. Before VC investors
make a final decision to invest, they must research potential exit routes to liquidate an
investment. Those vary from a strategic sale to another firm, M&A or IPO. In case the exit
opportunity appears weak, the investor might hold back to committing capital. Thus, another
important consideration supervenes from this that impacts the decision to pursue an
investment. (Klonowski 2010, 9.)

Ultimately, venture capital plays an important role in the financial industry by filling in the
gap between funding provided to traditional type of businesses and highly innovative
companies. Successfully filling that void implies that VC firms need to generate high returns
on the invested capital to distribute it among own investors and attract new participants in
the future funds. In other words, the challenge is to mitigate significant investment risks and
consistently provide excellent financial returns. (Zider 1998, 4.)

2.3 Stages of venture capital financing

The financing is differentiated by a number of categories, including company’s growth stage.

According to D. Klonowski (2010, 12), there are six stages of financing that can be outlined
in two major stages: early-stage financing, meaning financing of newly established ventures
and expansion stages, where the capital is provided for mature businesses. The first
encapsulates seed, startup and first-stage financing, while expansion stage covers
subsequent rounds of financing. Sometimes these stages are preceded by the phase of

13
idea and concept formulation, so-called pre-seed stage, with an active involvement of angel
investors (The World Bank 2014). In practise, venture capital firms participate in manifold
funding rounds, compromising initial investment of seed capital, the provision of follow -on
investments and other subsequent stages of the company’s growth. These types of
investments are usually cyclical. The implicit in the company’s development are the
contrasting needs of business and capital support. Thus, specific types of venture capital
financing can be categorized by the development of the firm and when the financing is
provided. There are various features that differentiate by the financing stage including
product development, financial performance, management team completeness, business
risks and growth potential. (Klonowski 2010, 12.)

In case a firm has just set-up its operations to apply the conceptual idea into a workable
business model, the seed capital is usually required. This financing is a relatively small
amount of capital, generally between ten thousand to one hundred thousand dollars,
subsidized to founders to finance the development of a business model, conduct industry
and niche-market research and test a product viability. (Investopedia 2016b). At this stage
the main aim of capital provision is to validate a business idea and establish space for
further development of a firm’s operations.

Followed by seed financing is startup financing, provided to legally organized companies

that have developed a functioning product prototype and are ready to test its product-market
fit. At this stage raised funds will be dedicated towards further product development as well
as initial sales and marketing plan implementation. (Investopedia 2016b.) Usually, it is
implied, that the company has already settled the management team, iterated on a business
plan and conducted thorough market research. The investment size at this stage varies
from one hundred to three hundred thousand dollars (Klonowski 2010, 13).

Eventually the company can apply for the subsequent funding round which refers to first-
stage financing or round A. At this time capital is provided to companies that have validated
the product-market fit, meaning sufficient demand in a definite market niche, and ready to
commercialize their product. For a successful launch the entrepreneurial venture needs all
the required business components to commence manufacturing, market entry and primary
sales. (Klonowski 2010, 13.) Hereafter, a venture capital firm can provide follow-on
investment at the expansion and later-stage financing which usually takes place before
initial public offering and after commercial production. At this stage capital is provided to
expand to new markets, boost marketing efforts and improve the level of working capital.
(Investopedia 2016b.) Usually, expansion financing may include several funding rounds at
constantly growing valuations.

14
On the other hand, there is a possibility for mezzanine financing which is relatively rare, as
it implies providing capital very quickly without comprehensive due diligence and absence
or limited collateral from the borrower (Klonowski 2010, 13). Some of venture capital firms
also provide bridge financing to companies planning to go public. Investment is provided to
fill in the capital void between the expanding company and the IPO. (Investopedia 2016b.)
Occasionally, companies have to resort to bridge financing to proceed to the subsequent
rounds of funding.

As it can be seen, venture capitalists invest in companies at most of the stages in their
development. Some prefer to be actively involved in companies in the early stages of
development, striving to achieve a higher return on investment, while others commit their
expertise and capital on the later stages of a firm’s development when risks are minimised.
This investment strategy is usually defined by the management team of the firm during the
fundraising process. (Klonowski 2010, 14.)

2.4 Structure of venture capital firms

Venture capital firms are generally established as limited partnerships, which implies
involvement of the general and limited partners. The former referred to employees and fund
managers of the venture capital firm who are responsible for day-to-day management of the
fund. On the other side are the investors, “the limited partners”, who commit a certain
amount of capital to the fund. Nonetheless, it is important to mention that limited partners
are passive investors and do not undertake in running the business. In this structure, LPs
usually provide around 99 percent of the fund’s capital. In rare cases, where GPs did not
contribute their own capital, the LPs will be fully exposed to the loss of the investment if the
firm faces a setback. To mitigate this issue, the LPs request that the GP contributes the
remaining one percent to the venture capital firm. This contribution reflects the principle of
“skin in the game” or “winning together and losing together”. (Klonowski 2010, 15.)

Operation of a venture capital firm can be characterized as cyclical. The cycle starts from
fundraising a fund from LPs, proceeds to sourcing deals, followed by investing in startup
ventures, monitoring of portfolio companies; and finally to making exits from the deals and
returning capital to LPs and GPs. The cycle is renewed with an establishment of a new fund
by the management team. (Christofidis & Debande 2001, 11.)

A jointly organized fund will take about 2 years to allocate the capital and make investments
in 10 – 20 entrepreneurial ventures, depending on the fund’s investment strategy. After the
final closing of the fund, capital is then allocated among companies and returns, such as a

15
share of profits, are distributed to investors. A typical life cycle of a fund is 5 – 6 years and
is limited to 10 years, in which time the management team must carry out exits in all
investments. Upon the agreement of the partners, there is a possibility to extend the fund’s
life by 2-3 years. (Christofidis & Debande 2001, 10.)

Capital Providers Venture Capital Investees

Firms
Capital
2-3% Management
Limited Partners Information fee Information
Pension funds
Banks
Individuals General Partners
Corporations
Other Capital
20% of VC funds
realized profits
Entrepreneurs
IPOs/Trades/M&A
80% of VC funds
realized profits +
Principal
Equity

Figure 2. Venture Capital funds structure (Christofidis & Debande 2001, 10)

Figure 1 depicts the general structure of a VC firm. In setting-up a fund, the GP and LPs
prepare two agreements – the partnership and the management agreement. In venture
capital funds, GPs are compensated with management fees and carried interest, that are
reflected in the partnership agreement. In order to mitigate the differences of the
compensation structure, LPs create several restrictive covenants which the GP must follow.
(Metrick & Yasuda 2011, 30.) The latter establishes the investment committee and
supervisory board to address managerial aspects of the partnership between the two
parties. The investment committee, represented by the GP or fund managers, is responsible
for making recommendations on investment opportunities as well as determining how
investments are made. The supervisory board, usually on a quarterly basis, reviews the
status quo of the fund to manage financial operations. (Klonowski 2010, 16.)

As previously mentioned, venture capital financing is considered a long-run business, and

this implies that investors in the fund wait many years to realize returns. LPs invest directly
into the fund and indirectly into the fund’s portfolio companies to delegate the activities of
selecting, contracting, monitoring and exiting from investee firms. (Klonowski 2010, 16.)
These activities start immediately as soon as the partnership is legally established and the
investment process is triggered. To cover fund’s expenses, such explicit as rent and

16
salaries, LPs pay management fees to the GP. This amount is normally in between 2 and
2.5 percent of committed capital per annum and is paid out quarterly. There are different
variations of how this fee adjusts throughout the life of a fund; sometimes it remains constant
for the full life of the fund, but usually after a certain perod of time, the fees tend to drop.
(Ramsinghani 2014, 164.)

Table 2. Fund Management Fee Vesting Scenarios (Ramsinghani 2014, 164)

Fund Size Years Year Year Year Year Year Total GP Investable
(100$M) 1—5 6 7 8 9 10 fees ($M) Capital ($M)
Scenario 1 2.5 2.5 2.5 2.5 2.5 2.5 25.00 75.00
Scenario 2 2.5 2.25 1.75 1.5 1.25 1 20.25 79.75
Scenario 3 2.5 12.50 87.50

The table 2 illustrates the structure and timing of fees and its impact on the amount of
investable capital. In most cases LPs prefer to embrace “scenario 2” or “scenario 3” as
supported by the evidence that after the drawdown period the expenses incurred in the
fund’s operation are considerably lower. That could be explained partially by the fact that
the costs resulting in the investing process, such as deal-sourcing, due diligence, tax and
legal audit, do not occur anymore, and the monitoring stage is entered, resulting in less
capital requirement. Thus, Scenario 1, where the fees remain flat at 2.5 percent of the fund’s
committed capital, is relatively rare.

Besides management fees, investors are compensated with carried interests as a share of
profits. The term of carried interest is referred to realized profits from investments exit. This
is usually a split of 80/20, where LPs receive 80 percent and GPs receive 20 percent of the
profits of the fund. These proceeds are allocated in case preferred rate is achieved and the
initial investment is recovered. The preferred rate is usually called the hurdle rate, which
characterizes a certain return on the capital invested that must be achieved by LPs. Only
after that, GPs are entitled to receive their portion of realized profits. (Klonowski 2010, 17.)

17
3 The venture capital investment process

In order to successfully close an investment deal, venture capitalists must go through a

multistage process. The conventional VC decision-making process consists of three crucial
stages: deal-sourcing, due-diligence and monitoring. After the fund is raised, the investment
process is triggered. At this stage, an investment team evaluates incoming deals and
decides whether to proceed with due diligence. The full assessment of the company,
including tax and legal audit, is set off after a letter of intent is signed. The due diligence
step is crucial as it helps to reveal all the nuances and investment risks of a deal. If the
outcome of due diligence is positive, the management team signs a term-sheet with a
company, to set out its terms and conditions for the investee company. This includes such
aspects as investment tranches; the board representation; reporting to investors; disclosure
of financial information to shareholders; investee and investor rights; etc. (Christofidis &
Debande 2001, 14.) Moreover, all the potential issues and conflict reasons are addressed
in the term sheet to avoid futile costs, save time as well as resolve conflictual issues in an
effective manner. After all the necessary legal documentation is prepared and the final
version of term-sheet is signed by both parties, the investment deal is concluded.
(Klonowski 2010, 38.) This thesis lays out a more expansive view on the venture capital
investment process.

The traditional model that was introduced by academics in mid 1980s was a five-stage
investment process that included following stages: deal origination, screening, evaluation,
deal structuring and post-closure activities (Tyebjee & Bruno 1984, 1051.) While this model
was explicit and simplistic, it neglected the complexity of the screening process when
evaluating prospect investment opportunities.

18
 1st Model 2nd Model Klonowski

Deal Generation Origination Deal Generation

Screening VC-frim specific screen Initial screening

Due diligence phase I

Generic Screen
and internal feedback

Evaluation First phase evaluation

Second phase Pre-approval

Structuring
evaluation completions

Due diligence phase II

Closing
and internal approvals

Deal completion

Post-investment
Monitoring
activities

Exit

Figure 3. Various models of venture capital investment process (Klonowski 2010, 27)

To eliminate drawbacks of the previous model, the second model was brought in to mitigate
the intricacy of the decision-making process. This model encompassed comprehensive
screening process, particularly the steps before the investment deal is concluded. The
screening process is divided into four stages as shown in Figure 2. While VC firm specific-
screen and generic screen are focused on a holistic assessment of the business, further
evaluation steps are more complex. The first-phase evaluation step triggered the process
of the proposal analysis. During this stage, VC gathers additional information from the
company and outside sources to do a background check on both business and founders.
The aim for a VC at this stage is to gain more understanding of the company and reveal
potential investment risks. In the second-phase evaluation, the VC conducts a full due
diligence on the investment opportunity to address the risks as well as deal obstacles. In
case an outcome of the second-phase is positive, all legal documents are prepared and the
deal structure is defined. (Fried & Hisrich 1994, 31.) The downside of this model, however,
is that it omitted critical post-investment activities such as monitoring and exit. Therefore, a
more comprehensive model by D. Klonowski was introduced.

19
The Klonowski model consolidates the other initially suggested models and focuses on
optimising the venture capital investment process. The model has brought in a more
complex approach to processing deals. One of the distinguishing features is the separation
of the due diligence stage into two phases. This structure of the process allows to eliminate
extra costs, as the DD phase one only focuses on the internal assessment of the opportunity
by the VC firm team. In case the outcome of the first assessment round is positive, the VC
firm can already sign a term-sheet. Afterwards, external evaluation of the deal is completed,
where the VC firm incurs expenses from external consultants. This model allows investors
to save time and resources as legal and tax due diligence is completed only when a term -
sheet is signed. (Klonowski 2010, 27.)

Moreover, the Klonowski model outlines various approval stages that venture capitalists
undergo before a final decision is made. Thus, this model highlights the importance of
decision approval bodies in the name of the investment committee and the supervisory
board. It provides an explicit structure to the criteria that must be met at each stage in order
for a deal to be further approved. On the other hand, this model was selected due to the
internal documentation that it discusses. For a successful completion of a deal, a VC firm
needs to prepare at least ten documents which are further reviewed by IC. This undoubtedly
highlights the scrutiny that investment teams face due to the requirements set by the firm’s
LPs. (Klonowski 2010, 28.)

The following research will examine a more simplistic version of the Klonowski model, which
yet covers all the crucial steps of the venture capital investment process. The reason
primarily being the discrepancies in the sequence of steps across various firms. Hence, a
more holistic view on the process is brought up. The process stages described in this study
are depicted below in Figure 3.

Deal Initial Due Term-sheet Monitoring

Sourcing Screening Diligence and Closing and Exit

Figure 4. The simplified version of the investment process

Furthermore, the stage of monitoring and exit is not going to be studied below, as it does
not convey any relevancy to the purpose of the following research. The investigative
questions will be answered by examining the process until the point when then final decision
to invest is made. The sections that follows in this chapter present an overview of the key
stages of the investment process in VC firms.

20
3.1 Deal sourcing

The stage of deal sourcing refers to the VC firm’s efforts in generating a high-quality deal
flow of investment opportunities. There are various sources from which prospective deals
may come. The job of a VC investor is to generate a critical mass of quality deals into its
pipeline. Therefore, the deal flow defines a potential of a VC firm to provide high returns.
This stage is usually argued to be the most important and the most challenging for any
venture capitalist. (Metrick & Yasuda 2011, 137.)

To get a more comprehensive view on the deal sourcing, one can examine ratios of new
opportunities to closing deals in the venture capital investment process. (Ramsinghani
2014, 194.) Venture capitalists source hundreds of potential investment deals, but close
deals with one or two companies per each hundred generated. With that being said, if a VC
firm is not able to generate a steady and sufficient deal flow, less investment opportunities
are reviewed, and thus, decisions will be made from a smaller pool of investment proposals.
(Klonowski 2010, 55.)

New Opportunities

Initial Screening
6,5 %

Meetings
5,1 %

Due Diligence
3,2 %

Closing
2,3 %
Figure 5. Ratios of different stages to new opportunities (Ramsinghani 2014, 194)

Depending on the firm’s investment strategy, there are around ten investments made yearly.
This implies that to make ten investments per year, a VC firm should generate at least 500
deals. Therefore, with each successive stage of the process, a VC firm narrows down the
number of investment opportunities that qualify to receive funding. It is crucial to define
adequate criteria that sorts out great opportunities from poor with each step. (Metrick &
Yasuda 2011, 137.)

21
Venture Capitalists embrace a variety of strategies to generate a steady flow of investment
opportunities. Those VC firms that have been present on the market for a long time, are
able to develop a sound reputation, equalling to having a better deal flow. Most of the
successful VC firms with high returns, rely on the deals that come from their network.
However, newly established VC firms have harder times when it comes to sourcing
promising investment opportunities. The best deals are usually considered to be generated
within the network of a VC firm. (Ramsinghani 2014, 194.) An example of such are referrals
from portfolio companies and entrepreneurs. Some VC firms have entrepreneur-in-
residence position in their firm to source new deals which the fund will then back. A person
in such position is primarily responsible for sourcing new deals and making introductions to
other entrepreneurs. The venture capitalists that successfully employ such strategy to
source investment opportunities are among the top five percent worldwide. (CIO 2013.)
Furthermore, other most common strategies for sourcing investment opportunities are
participating on specialised events, trade-shows, networking and cold-calling deals of a
fund’s industry interest. (Metrick & Yasuda 2011, 137.)

The other source for new investment opportunities can be proposal to co-invest from other
VC firms. The following strategy is known as syndicate investments. The advantage of this
approach is the informational advantage that another investor possesses. Therefore, the
deal has already been internally assessed for its commercial potential. Potentially, a
syndicate investment can increase the odds of a company to become successful, when two
or more venture capitalists share their expertise and knowledge in one place. (Lerner 1994,
17.)

The deal flow process is triggered when the VC firm is contacted by a company with an
explicit need to raise funding. At this step venture capitalist receives information about an
investment proposal that can be confidentially disclosed, usually a company presentation,
also referred as a pitch-deck. Then, the investment opportunity is logged into the firm’s
database as a lead opportunity. After reviewing the investment opportunity for the fit with
the firm’s investment strategy, the VC arranges an internal deal meeting to decide whether
to progress with the deal or not. In case the decision cannot be made, more information is
requested from a company. Otherwise, the next stage of the investment process is
triggered. (Klonowski 2010, 30.)

3.2 Initial screening

Venture capitalists receive a vast amount of investment proposals, that they need to review
in a time-efficient manner. Performing the initial screening follows as soon as the deal flow
is generated. The main objective at this stage of the process is to assess all the incoming

22
deals for their investment attractiveness. At this stage, it is important to rapidly filter out all
the deals that do not meet the firm’s investment criteria and reveal promising investment
opportunities. (Klonowski 2010, 31.) The assessment is based on the information available,
usually a pitch deck, business plan and financial projections. The team obtains additional
information through the VC firm’s network, third-party sources and information available
online, as customers’ feedback, reviews and media coverage. The VC firm also arranges a
meeting with the company to further discuss the investment opportunity. (Metrick & Yasuda
2011, 137.)

The managing partner of the venture capital firm assigns a team, usually consisting of one
or two people, led by a deal leader, to conduct an analysis of the investment proposal. This
team is responsible for conducting a preliminary analysis of the investment opportunity. At
this stage, the main goal that is set for the team is to evaluate commercial potential of a
deal. The assessment criteria behind the initial screening is different for each firm as it
relates to the investment thesis of a VC investor. (Klonowski 2010, 78.)

The preliminary assessment of a company relates to macro and micro level considerations.
On the macro level, the team examines the overall market condition, its growth, level of
maturity, competition as well as important transactions, such as IPOs, M&As and
liquidations, made in the last five to ten years. The micro level assessment comprises of
considerations regarding the core business areas, such as the management team, product
or service, market, competition and finances. Moreover, venture capitalists assess the do-
ability of an investment prospect in terms of the deal structure and expected returns. The
other crucial aspects of decision relate to the company’s current and future financial
performance, business valuation and the deal terms. (Metrick & Yasuda 2011, 140.)

Other important aspects to be addressed during initial screening is the company’s

commercial attractiveness; projections on the industry growth; market-related experience
of the management team as well as the potential to liquidate the deal in the fund’s
investment time-frame. In case the deal is rejected, the team records in the database the
reasons for this decision. (Klonowski 2010, 78.) This allows to keep track of the past
decisions and reveal the flaws in case the rejected company achieved excellent results
against the odds of failure.

After the deal has been thoroughly reviewed, including preliminary assessment and
identification of key risks, venture capitalists prepare an investment memorandum, which
acts as the main document highlighting the key areas of a deal (Klonowski 2010, 32). An
investment memorandum presents crucial information explaining the company overview,

23
inherent risks and the terms of the deal (Syndicate Room 2017). In case an investment
opportunity is doable and the terms are favourable, the managing partner forms a due
diligence team.

3.3 Due diligence

Once the company has passed the screening stage it is subjected to a further
comprehensive assessment. The full company assessment, also referred to as due
diligence, is crucial for several reasons. First and foremost, it allows to reveal risks and
potential obstacles for a deal completion. Moreover, during this stage a VC investor
identifies where deal breakers might arise and how they can affect the investment.
Secondly, it allows to establish trust between the management team and the VC firm. At
this point of time, the VC investor initiates more frequent communication with a potential
investee company. Ultimately, the main task of due diligence stage is to address hard deal
questions. (Metrick & Yasuda 2011, 140.)

Due-diligence process may take several forms. Some VC firms complete internal and
external due-diligence at once, others split the process into several stages. In their research
consisting of conversations with venture capitalists and other researchers, Metrick and
Yasuda (2011, 140) have discovered that the clear majority of the VC firms have the similar
process structure for due diligence, that goes in the following way: preliminary due-
diligence, term sheet and final due diligence. The part of due diligence completed before a
term-sheet is singed varies by firms and sometimes even by deals within the same firm.
However, the more competitive the deal is, the quicker a VC firm will provide a term sheet
to founders. This allows the firm to eliminate competition from other investors and conduct
a thorough secondary assessment, as most of the term sheets will give an investor
exclusivity rights. This implies that the investee company is not allowed to initiate any
negotiations with other investors.

D. Klonowski (2010, 33) in his book likewise proposes a three-stage due diligence process,
which is as follows: due diligence phase one and internal feedback, pre-approval
completions and due diligence phase two and internal approvals. Another common variation
of the due diligence process is broken up into a pre-term-sheet stage and a post-term-sheet
stage (Metrick & Yasuda 2011, 139). The process is formed in this way to address the
complexity and the scope of a company analysis at this stage of the investment process.
Despite the similarity of these two approaches, various VC firms embrace different internal
flow of the due diligence stage of the process. Given this divergence, we will treat the due
diligence process as one step.

24
The process starts from the decision by an internal approval body, represented by the
investment committee, that provides feedback on initial screening of a deal. The investment
committee is responsible for approving deal to advance further in the process. Once the IC
is positive with the outcome, the team of a VC firm initiates due diligence of a company. The
preliminary aim is to reveal an explicit picture of the company’s valuation and financial
forecasts. It allows the VC firm to evaluate potential return, how expensive is the company
to buy-in an equity stake and what percentage of the overall equity it consists of. (Klonowski
2010, 33.)

Following, the investment team creates a list of issues and concerns related to the deal,
which is updated on continuous basis. It is refined throughout conducting due diligence and
after conversations with founders of the company. The list of key issues ultimately serves
as a basis for a final due diligence assessment as well as a formation of the deal terms.
(Klonowski 2010, 35.)

During this stage, the investee firm and the venture capitalist together develop financial
projections and forecasting. Preparation of cash budget allows to determine any cash
shortages or excessive cash balances, therefore when external cash will be needed. This
preparation gives the VC a holistic picture on financial side of the business, however it is
not sufficient alone. The investment team then does calculations on assumptions of the
firm’s future growth and earnings to reveal a range of business valuation. The assessment
is focused on the key business drivers to determine potential return in a worst-case, base-
case and best-case scenarios. Eventually, the goal is to understand commercial
attractiveness of a deal through the lens of financial forecasting. (Klonowski 2010, 106.)

Subsequently, the VC team prepares a list of questions based on the internal analysis, that
could not be answered without the input of the company. This list is then sent to the
founders, whose task is to provide written material on related issues to further address them
during a meeting with the VC firm. (Klonowski 2010, 33.) As soon as most of the materials
are collected from the company and the due diligence phase is almost completed,
investment terms negotiation is commenced. A draft version of the term sheet is prepared
and shared with founders by the venture capitalist team. This is a generic version developed
internally to initiate the formation of terms and key criteria of the deal. (Klonowski 2010,
137.)

The final steps of due diligence process comprise of accounting, tax and legal investigation.
Because this step is completed by external parties, the VC team preliminary prepares a
budget for the anticipated services to be provided by consultants. Additionally, industry

25
experts might be invited to bring in their market-specific experience relevant to this stage of
the process. As a result, the investment memorandum is updated to include all the key
findings and risks identified during the diligence. This document is then presented to the IC
for their assessment. (Klonowski 2010, 38.)

As mentioned earlier, an optimized due diligence process helps venture capitalists to reveal
key risks and downsides of any opportunity. The main task at this stage is to find the best
strategy to address the risks of a deal in the most efficient way. Furthermore, a VC investor
should find a comfortable amount of ambiguity that he can deal with, as no person or
algorithm can predict future of a company’s growth. (Ramsinghani 2014, 129.)

3.4 Term-sheet and closing

After the due-diligence list is finalised and internal memorandum is updated, the venture
capitalist further negotiates the terms and conditions of the deal and eventually signs the
term-sheet with founders. The main goal at this stage is to agree under what conditions the
VC firm will commit capital to a company. Careful DD provides a detailed overview of all the
inherent risks which are to be addressed at this stage of the process. (Klonowski 2010,
137.)

Upon positive feedback of the IC based on the DD results, the investment team prepares
rea term-sheet. It acts as a cornerstone agreement to all the subsequent legal documents.
This document focuses on such aspects as: price of the deal, rights and provisions for the
VC firm as well as provisions that affect the relationship between founders of the investee
company and the venture capitalist. It is the underlying document that specifies how the
deal is structured. (Klonowski 2010, 137.) Moreover, in case a conflict occurs between a
VC investor and a company, both sides can always resort to the term-sheet.

There are numerous strategies that VC investors implement during this stage. The job of
the team is to address the risks of the deal and develop certain conditions that would allow
to reveal how returns are going to be made. At this stage, the negotiation leverage
constantly moves from one party to another. The VC investor wants lower valuation to obtain
more shares at the same deal price, whereas the founders have an interest to have a higher
valuation for less ownership dilution. The ultimate task when singing this document is to find
a compromise of how an investment is going to be made that suits both parties.
(Ramsinghani 2014, 290.)

The main idea of a term-sheet is to provide all the parties involved in the transaction with a
condensed agreement that specifies their rights and on key features. This step is

26
considered the most critical moment in the deal completion process, prior to presenting a
complete investment package to the IC. It usually takes several rounds of discussions for
both parties to agree on the terms of the deal. (Klonowski 2010, 187.)

Following, deal negotiations are finalized and preliminary set of legal documents is
presented. The finalisation of the deal is commenced with the feedback provided by the IC.
Therefore, all the necessary legal documentation is ready to be signed by both parties at
this stage. This includes shareholder’s agreement, articles of association, subscription
agreements and other crucial legal instruments. Afterwards, the investment is approved by
the board via formal resolution. The transaction is considered to be closed, as soon as the
term-sheet and the final contracts have been accepted and signed. According to the terms
specified, the VC investor then transfers money to the investee company. (Ramsinghani
2014, 290.)

27
4 Research methods

This chapter aims to present the research methods, design and the approach of the study
to the reader. The respondents comprise of venture capital firms headquartered or
demonstrating investment activity in the DACH region. The study has been performed by
means of semi-structured interviews and direct interactions with team members of middle
and senior level. The aim is to gain insights on an investment process and challenges faced
by VC firms. The following showcases how the interviews are structured and with which
information is planned to be sought after. Moreover, the choice of research methods and
data analysis is further presented in the chapter.

4.1 Research approach

The research will be performed as a qualitative study based on semi-structured interviews.

The reasoning behind is to gather a more insightful and comprehensive picture on the
decision-making process. Furthermore, the essential data could not be obtained by
statistical or numerical means. Personal experience and practices of venture capitalists are
the main source of data, being a central part of the research. Thus, interviews will allow to
interact directly and ask follow-up questions as well as rapidly respond to
misunderstandings that may occur during an interview.

In order to gain comprehensive answers to investigative questions, the qualitative approach

has been chosen. More specifically, as it is the most suitable for obtaining specific
information on the open-ended questions. Thus, the study objectives will be fulfilled by
conducting semi-structured interviews. This research method will allow to explore and
assess different options, rather than draw definite conclusions. Therefore, the investment
process will be examined in considerable depth with a few respondents.

The information obtained will mainly comprise of experiences, views and best practices from
team members of VC firms. In order to analyze the gathered data in a way that allows to
reveal patterns across interviewed firms, the research approach will be inductive. This way
is also justified by the fact that no hypotheses were introduced in the beginning of the study.
Moreover, the focus is to obtain the information on practical ways venture capitalists
approach the investment decision process. Inductive reasoning aims to explore the insights
from collected data to reveal patterns and relationships (Research-Methodology 2016).

The purpose of the research is to study the investment process structure, including
documentation and decision flow, and reveal similarities and distinctions among various VC
firms. Moreover, establish whether there are correlations and patterns in challenges that

28
VC firms face individually and evaluate which of those are more frequent within the DACH
region venture capital ecosystem. Furthermore, relate the challenges with frustrations that
employees experience throughout the investment process and reveal the solutions that
venture capitalists currently implement. Lastly, develop a foundation for further research on
this subject.

4.2 Research design

The research is designed in the way that allows to collect sufficient information to answer
the investigative questions. A set of questions that interviewees will be asked descend from
general to more specific issues. The questionnaire is divided into three parts, which are as
follows: interviewee information, overview of a VC firm and the investment process itself.
The interview questions were prepared with the support of several stakeholders involved in
the venture capital industry.

The first few questions are aimed to gauge interviewees on the following matters: their
position at the firm and the degree of their involvement in the investment process. This set
of data will allow to assess the quality of provided information and address the issue of
reliability and validity. The following questions focus on examining the general information
about the firm. More specifically, the size of the firm, both from the perspective of employees
and funds under management as well as the investment strategy. Obtained information in
this section will help to further identify patterns and relationships within the investment
process.

The next part of the questionnaire aims to explore the investment process and challenges
that occur along the way. The first set of questions provides answers to its overall structure.
In order to build a holistic picture of an investment process, the questionnaire includes
aspects related to the decision framework and documentation, both internal and external,
that is circulating within the firm. Moreover, it provides answers on how internal
communication is handled throughout the process between the VC firm and a company.
The flexibility aspect of an investment process is addressed by examining guidelines that
are set for the employees. Furthermore, venture capitalists are asked whether there any
software solutions implemented internally.

The last group of questions focuses on identifying the investment process challenges and
how they are tackled. At last, the issues of frustrations that team members experience
during the process are covered. This part is designed in a way to understand the obstacles
that venture capitalists face and their respective background. Therefore, the study will be

29
able to provide comprehensive answers to the investigative questions. The methods for
data collection and analysis are discussed in detail in the subsequent sub-chapters.

4.3 The interviews

According to the demarcation criteria on selection of key respondents, interviews were

conducted with VC firms that have an office in Germany, Austria or Switzerland (DACH)
and show investment activity in that region. Twenty firms in total were approached with a
request for an interview, from which eight agreed to participate, which gives a response rate
of 40%.

One of the hardships that occurred when collecting the data was that the research about
VC challenges is firm specific and comprise of personal experiences of a particular person
interviewed. Moreover, the literature and previous studies of this subject are limited or
narrowed down to the view of several U.S. firms. Thus, involvement of the people
interviewed into the decision-making process had to be checked to assess credibility of the
information obtained.

The interviewed firms have an excellent reputation with a solid presence in their respective
investment fields. On average, these firms have been on the market for around eighteen
years, as counting to year 2017. Distribution by country is as follows: one in Austria, three
in Germany and four in Switzerland. Target sectors of the firms vary, whereas the majority
have a focus on investments in technology companies in their respective industries.
Furthermore, the average VC interviewed has already raised four rounds with a cumulative
of 300 million euros under management. The number of exits is also substantial, averaging
approximately 60 investments. When it comes to the respondents, the prevailing majority
are at the senior level positions with a high level of involvement in the process.

The data collection has been mainly performed via Skype interviews with senior and middle
level employees. The interviews ranged between 30 and 40 minutes and were recorded
and later on transcribed. While the interview questions served as a base, respondents were
asked follow-up questions to obtain sufficient amount of information. Before conducting
actual interviews, a mock-interview was conducted with the case company. By doing so, it
was possible to test questions and the extent to which they could answer the investigative
questions.

Due to the nature of the research and the insights obtained, the names of VC firms,
interviewees’ names, their job responsibilities as well as transcripts from the interviews have

30
not been publicly disclosed in this thesis. The collected data from VC firms include sensitive
information on the investment process structure and internal operations.

4.4 Data analysis

Upon transcription of the interviews, the data collected was analysed and crucial information
relevant to the investigative questions was elicited. Despite that some numerical data was
collected, this research uses exclusively qualitative data analysis methods. Moreover, in
order to visualise crucial insights, illustrations such as graphs, figures and direct quotations
were used selectively. The process of data analysis is divided into three stages. Firstly, all
the interviews are transcribed and preliminary read. Afterwards, relevant and crucial data
points are elicited from the interviews through the lens of the investigative questions. Lastly,
the information collected is analysed for coherence, similarities and patterns.

The author’s personal experiences and observations in the VC industry have been used as
a guiding tool of the analysis and results formulation. The information obtained from the
questions was investigated to reveal similarities and differences across the firms
interviewed. Furthermore, an active search for patterns within the collected data was
performed.

Rather than approaching data analysis vertically, where each respondent is treated on its
own, the horizontal method has been chosen. This allows to analyse data across all the
respondents and create a wholesome picture over the investment process. Hence, provide
imperative base to answer investigative questions. Moreover, since revealing correlations
with the information obtained could not be achieved, the questions has been analysed and
treated individually. The investigative questions were also approached independently to
provide explicit results to the reader.

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5 Research results

This section presents the results of the interviews with VC firms in the context of
investigative questions. The theoretical background outlined in the chapters two and three
supports formulation of the results to answer the main research question. The results will
be drawn in two parts, corresponding to each investigative question respectively.
Furthermore, the questions are demonstrated in the statement format, following the same
order as the interview questionnaire, which can be found in Appendix 1.

5.1 The investment process structure

This subchapter focuses on providing answers to the investigative question that aims to
describe how the investment process is structured at the VC firms in the DACH region.
Specifically, observations related to the documentation, decision framework and team
collaboration behind the process. The aspects related to this investigative question are
thoroughly researched and answered successively in this section.

Q1. Structure of the investment process

According to VC firms interviewed, the process of making an investment decision might take
from 4 weeks and up to 52 weeks. On average, it takes about 20 weeks to close an
investment in a company. However, it takes longer for deals in such sectors as Health-Tech
and Life-science as well as for investments in later-stage companies. These industries
require a more profound and time-consuming product assessment, with a focus on
company’s patents, environmental and regulatory issues as well drug feasibility studies. On
the other hand, for deals at a later-stage of growth, venture capitalists need to analyse more
data points resulting in a more comprehensive due diligence. The distinction comes from
the fact that for early-stage deals available information is limited or non-existent, and
decision is primarily based on an early traction of the company, thus requiring less time to
decide on an investment.

The firms interviewed share the same structure of the investment process as depicted in
chapter three. The process starts when a potential opportunity is being sourced and
evaluated. Deals mainly come from three sources – passive deal-flow, network and
proactive approach. Afterwards, the VC firm evaluates the deal based on a certain “tough”
investment criteria to reveal whether a company fits VC’s investment strategy. The
interviews have shown that two out of eight firms evaluate deals in several clusters, where
each has a specific industry focus. Then the investee company is invited for a presentation
to pitch their business idea to the investment team. In case the outcome of the meeting is

32
positive, the investment team proceeds with evaluation of an investment opportunity on a
more in-depth level, usually referred to as due diligence. This step is followed by preparation
and signing of a term-sheet. During the next stage of the process, investment committee
provides feedback on the deal and partners makes a final decision. Subsequently, all the
legal documentation is finalised and signed by all parties. Even though the flow of the
investment process appears similar in all VC firms, there are distinctions at certain stages
of the process.

The research has shown that every second VC firm signs a term sheet before the full due
diligence process is completed. Out of these four firms, three separate the due diligence
process into Commercial and Tax & Legal assessment, where the latter is completed after
the term-sheet with an investee company is signed. Furthermore, for those VC investors
who initiate DD later in the process, it varies deal by deal.

Q2. Decision-making framework

All of the VC firms interviewed follow the same decision framework, where initial decision
on pursuing a deal is made by a single person, either a junior team member or more senior
person, depending on the firm size. The decision as whether to proceed or not with further
deal assessment is then made by an investment team or an investment manager. The
investment team usually consists of one junior team member and one or several senior level
persons, who act as a “deal leader” until the investment is made. Afterwards, the final
decision is made by an IC and approved by one or several managing partners. The typical
decision-making framework is concisely described by one of the respondents:

“The first decision is with the investment manager; the second decision is with
the investment team; and the third and final decision is with the Investment
Committee.”

As it can be noticed, the farther down into the process the more partners are involved in the
final decision making. However, one of the respondents noted that within their hybrid firm
structure, private investors can complete a full-decision cycle and make an investment on
their own.

Q3. Documentation requirements throughout the process

At the initial stage of the process, all respondents stated that they request the same
underlying document – a pitch-deck or a business plan, which usually provides a brief

33
overview on crucial aspects such as team, product, market opportunity and other relevant
information regarding the investment opportunity. Some companies, however, stated that
along the pitch-deck they might request additional information such as financial records,
capitalisation table and most recent KPIs to assist them in preliminary company analysis.
As a company further advances in the process, an investment team requests additional
information and documentation relevant to the assessment. This documentation is typically
the same across all the VC firms, but varies based on the maturity of a company.

Besides legal paperwork, venture capitalists internally prepare a centralised document

which assists IC and managing partners in making the final decision. This document is
usually called an investment memorandum and captures relevant deal information,
gathered throughout the whole investment process. It ultimately serves the purpose of
describing the decision rationale. The interviews have shown that the purpose of investment
memorandum varies by firms. It is crucial for some firms that the IC have the appropriate
knowledge regarding the investment opportunity to make a final decision. Whereas Its
purpose for other firms could be more seen as a memo, serving as an alert to the deal and
seeking advice regarding the due diligence. Regardless, investment memorandum includes
information on key features and terms of the deal, summary of DD results, investment risks
and investment reasoning.

Q4. Collaboration with an investee company throughout the process

To ensure efficient communication between the VC and the company, all of the interviewed
firms arrange frequent calls and meetings with founders throughout the process to support
the team in various operational tasks. The respondents have specified that their
teams promote strong collaboration and exchange of information with a company to
accelerate the deal assessment and to address challenges in the early stages of the
process.

Each of the respondents have stated that they assign several team members to an investee
company to enable support in communication, information exchange as well as operational
issues. In most cases, an investment manager or a business analyst and a partner are
responsible for a deal. The main mode of communication has been reported to be phone
calls and emails as well as several face-to-face meetings along the process. The underlying
idea of communication between a VC firm and a company is well described by one of the
venture capitalists interviewed:

34
 “It is basically a permanent Q&A process. The team provides us with the
documents they have and then communication is triggered. It goes back and
forth until all of our questions are answered.”

Several interviewees have noted that with some companies, connection is established
months before the opportunity is considered. This allows them to make observations on
company’s traction, achievement of KPIs as well as the team development before preparing
an investable case. Moreover, one of the firms have specified that they can already make
introductions to their network before investment is even made.

Q5. Are there clear guidelines set for the investment process? How flexible is the
process?

The interviews have shown that venture capitalists have clearly outlined crucial and major
stages of the investment process. Furthermore, certain guidelines exist to guide the
investment team on which information should be obtained and definitive criteria that has to
be met to progress to the next stage. However, some stages the process are flexible enough
to close the deal in a shorter period of time. This is ensured with an internal checklist that
specifies critical aspects that should be considered before a deal is closed and investment
is made. Moreover, before finalizing the deal certain documents have to be provided as well
as the completion of certain aspects.

The flexibility depends on a range of variables, from the industry knowledge to previous
relationships with the founder team. This notion is well expressed by one of the interviewed
firms,

“We do have guidelines but every case is different and it always depends on how well
we know the market, industry and how well we understand the product. Our process
is definitely flexible and sometimes we are also very quick in making a decision if it is
the team that we know well. However, sometimes it takes longer because it’s a bigger
investment. There are a lot of variables that determine the flexibility of process.”

Furthermore, the process flexibility is also dependent on the firm size and the number of
people involved in the decision-making framework.

Q6. IT software that supports the investment process

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Software reinforcement is one of the ways for VC investors to speed up the process and
gain advantage of a streamlined workflow. The interview question was aimed to answer
whether a certain VC firm has any IT solutions that support the investment process and if
so – how. All the respondents have stated that they use at least one software solution to
support their decision-making process. Software mentioned in the answers could be
grouped the following way:
• Dealflow;
• Collaboration;
• Information & knowledge management.

Most of the interviewees engage with a basic software stack that includes such tools as:
Google Apps, Microsoft Office, Dropbox, a CRM tool and a task management tool. These
tools fall in all of the categories mentioned above. When it comes to the dealflow software
category, all VC investors have internally implemented a rather akin dealflow database that
stores data points on current and potential investment opportunities. Some of the
interviewed VC firms, specifically two out of eight, have an in-house built dealflow database,
whereas others purchase Software-as-a-Service deal-flow solutions.

As for collaboration group, most of the communication between a VC and the company is
done through e-mail. Internally, however, some venture capitalists implement a team
collaboration software, such as Slack, to communicate on ongoing projects and other
operational issues.

The difference in a software stack across firms comes from venture capitalists who use
market intelligence platforms, since gaining access is costly and may not fit the budget of
some firms. In the interviews with VC firms, a few (three out of eight) mentioned that they
have access to such platforms in order to gain leverage from information on technology
trends, insights on recent transactions as well as reports on industry activities.

5.2 Investing challenges and ways to resolve them

This section presents top challenges identified in the interviews, as well as how VC investors
are approaching them. Furthermore, points of frustration with the process are described
below. Interview questions and results in this sub-chapter are related to the investigative
question two, which intends to answer what obstacles venture capitalists face throughout
the decision-making process and how they address them. Due to the level of precision of
this investigative question, the results in this section are solely based on the data emerged
from the interviews.

36
Q7. Challenges faced throughout the process

On almost a daily basis, VC firms are faced with various challenges, some being age-old
and some brand new. These also vary from operational and administrative to the ones of
behavioural origins when making an investment decision. The interviewees were asked to
describe the biggest challenges they have been facing throughout the investment process.
The result of the interviews revealed the following top eight challenges:

1. Speed of deal selection. Venture capitalists receive tremendous amount of applications

every month that should be sorted and analysed. This task is time consuming and might
take up to two weeks in order to be completed. Thus, the more time is spent on evaluating
a single deal, the less time is left to consider other opportunities in the deal-flow funnel.
Moreover, in case a company has a huge growth potential, other investors will come into
place. Hence, the teams must be quick when evaluating promising investments and sorting
out great opportunities from poor as early as possible in the process.

2. Cognitive bias. This challenge highlights the impact of reasoning flaws in the venture
capital decision making process. Cognitive bias mainly implies human thinking errors which
can lead to illogical and poor judgement, preventing VC investors from making rational
investment decisions. This might be decisions affected by the previous experience, opinions
of external parties and public perception.

3. Shareholder communication issues. Companies that raise financing rounds at a later

stage of growth might encounter a situation when they have a high number of shareholders.
That, in turn, creates a hardship of communicating and negotiating on deal terms with a
new investor. When there is a vast number of shareholders in a company, it becomes more
complicated to manage all the parties involved. As a result, it takes more time and resources
to close a deal.

4. Data availability. This concern can be viewed from two different angles. Firstly, data
availability of deals at earlier stage of development. Specifically, how to gain access to
companies in the beginning of their operations but already demonstrating stable growth.
However, some venture capitalists see this as an advantage, sourcing deals that are not
yet on the radar of other investors. Secondly, this also implies availability of decision-making
resources. This implies lack of publicly available data on an industry, market and
competition information. Furthermore, the struggle reinforces when investors enter
negotiations with companies that create new markets.

37
5. Information exchange. Documentation flow is extremely important when it comes to the
issue of time- and resource-efficiency. The problem occurs when founders of a company
do not deliver required information in time, which in turn, slows down the whole process. It
becomes even more challenging when the inaccurate data is presented. The task of the
investment team is to ensure that all the materials provided by the company is structured,
coherent and up-to-date.

6. Revealing a deal breaker too late. This challenge at first might seem ambiguous, but it
has a high impact in the investment decision. A deal breaker, if discovered too late in the
process and unable to negotiate through, is a factor that prompts the firm to discontinue
their investment discussion. This could also include risks that were not addressed early
enough in the communication. One of the investors has stated that once an opportunity is
selected, serious risks might arise and it becomes difficult to terminate the process when a
significant amount of time and money has already been invested.

7. Process flexibility. All the VC firms have a structural background to how they make
investment decisions. Each company in the pipeline should go through particular steps to
receive funding. However, from the perspective of a VC firm, some deals need to be closed
in a shorter period of time. Thus, some firms tackle the challenge of being quick and flexible
in making a decision, while following the structure of the process.

8. Deals competition. When venture capitalists source investment opportunities with high
growth potential, they will most likely encounter competition with other firms. Such challenge
may arise when a company is communicating with other investors on better terms. The job
of an investor is to close an investment before other firms discover the opportunity.

Below is the figure with a breakdown of challenges among VC firms based on their
frequency, depicted by the number of firms who reported to face each challenge:

38
Figure 6. Top challenges VC investors face throughout the decision-making process

Analysis of the data reveals that speed in selection of deals and cognitive bias head the list
as the top VC challenges, encountered by the half of the interviewed firms. The third place
is the issue of shareholder communication, followed by the challenge of data availability,
both of which can be observed in three out of eight firms. Successive is the issue of
revealing a deal breaker too late in the process. Finally, the last three challenges have been
revealed to be single cases observed in only one out of eight firms.

Speed of deal selection is an important challenge which needs to be further discussed.

Sourcing and selecting deals can easily turn into a very time-consuming task when the
number of opportunities is overwhelming. In order to overcome this hardship, venture
capitalists apply a variety of methods to screen and pick the best deals to invest in. The
research has shown that on average it takes up to 2 weeks before an investment is
considered attractive and can be advanced for further evaluation. If a VC team spends
excessive amount of time on deal assessment, other opportunities in the pipeline can
potentially be missed out upon. Hence, the shorter it takes to screen a single deal, the larger
pool of opportunities can be assessed in the same time frame.

Moreover, other challenges can supervene from this one, such as competition with other
investors. In case a company is having investment negotiations with several VC firms, the
one with the most optimised process for the speed is more likely to close the deal on better
terms. On the contrary, in case not enough time is dedicated to a company, late
identification of deal-breakers might arise. Thus, the main goal of a venture capitalist is to
find a golden mean between being quick in assessment of deals and addressing crucial
deal aspects.

39
As for cognitive bias, venture capitalists strive to answer the question of how to make a
process rational and data-driven rather than emotional and biased. One of the interviewed
firms elaborated that when one of the partners makes a preliminary decision as to whether
he wants to invest or not, the angle of further deal analysis corresponds to that decision —
biased by the initial perception of the deal attractiveness. Another firm stated that decision
makers, being ex-founders, might be biased by a great product with high potential and can
neglect underlying risks to the deal. Considering this matter, one of the respondents has
stated the following:

“Rationality in decision making is very important. You cannot be black and white on
your arguments and that is very difficult. You will always be able to find a reason why
not to invest. How do you then keep the process rational and data-driven? I think that
is the biggest challenge any VC investor has – how to find a balance of following
emotion and gut feeling versus just relying on pure data.”

On the other hand, the IC is also biased in their decisions based on the feedback and
personal experiences of external parties. One of the main tasks of a VC is to have a
structured, close to programmed approach in order to avoid cognitive bias when selecting
great opportunities that create consistency in providing outstanding financial results.

Venture capitalists are apt to face the same challenges, in one form or another. The
interpreted data helped to reveal certain patterns and similarities across firms. Out of all
challenges that the respondents have mentioned, there are several of a similar category –
rapidity in selection of deals, deal competition and process flexibility. If a bigger picture is
drawn, time aspect lays in the core of those challenges. To be more precise, process
optimisation for the time-efficiency. If one would try to find a way to mitigate those three
challenges, the solution would be to create a process which will allow to make investments
in a matter of couple weeks or even days. The research has shown, however, that it takes
at least a month to make an investment decision with the current process that venture
capitalists employ.

On the other hand, two out of eight challenges are operational – shareholder communication
issues and information exchange with founders. The first one has been of a significant
challenge for one of the respondents:

“It is challenging to work with other investors, because everyone has their own
expectations and their own processes and sometimes they are very different.

40
 The same concern applies to working with companies that have numerous
founders.”

The latter, related to the information exchange, implies a scenario when a company does
not meet the deadlines or provides inaccurate information. This challenge is present for two
of the eight VC firms interviewed.

With the constant development of technology related industries, VC investors face

numerous challenges that should be addressed in order to provide excellent financial
returns to their shareholders. Being aware of what weaknesses your investment process
has, one could develop strategies to overcome existing challenges and improve the way
how decisions are made.

Q8. Frustration points that team members experience throughout the process

Frustrations that VC firm employees experience along the process are heavily related to the
challenges discussed above. The interview data yielded that most of the frustrations for the
investment team happen at the stage of due diligence and signing a term-sheet. As
supported by the literature review and conducted interviews, due diligence is the most
comprehensive stage of the whole investment process. It is the most time and resource
consuming and it might bring numerous challenges. Most of the venture capitalists
interviewed tackle the problem of undertaking excessive amount of work that could have
been earlier prevented. Another point that was already discussed in the section related to
the challenges is the notion of deal-breakers. This frustration is well summarized by one of
the partners interviewed:

“It can be frustrating if you go into due diligence and at the very last day you
find out that there is something that breaks the deal, which could have been
discussed in the beginning of due diligence process and not four weeks into
it, when we have already spent a lot of time and money.”

Following that, negotiation and signing a term-sheet is another part where an investment
team struggles. One of the respondents stated that sometimes, after their team and the
company mutually agrees on the terms and conditions, founders decide that some points in
the term-sheet are not valid anymore. Hence, the VC firm needs to initiate another round of
negotiations, incurring additional resources and time.

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Several other VC investors mentioned that another source of frustration can be
collaboration with founders of a potential investee company. The context of this struggle is
poor information exchange and time management. Moreover, it implies different scenarios
where founders do not meet deadlines or certain milestones within the assigned period.

Q9. Measures to mitigate the challenges and overcome frustrations

VC firms develop various internal solutions to tackle existing challenges and frustrations.
These solutions range from such simple methods as frequent communication with an
investee company to accessing market intelligence platforms.

One of the firms interviewed responded that they had developed an internal catalogue on
“red flags” which helps to assess human factors that might affect the success of an
investment. For instance, founder’s attention to personal status, as buying an expensive car
or flying first class, might negatively reflect the financial side of a business. Thus, the
investment team will address financial planning issues more carefully. Such catalogue helps
to address significant risks related to the team category of the investment decision. Besides,
the same firm organises workshops at least three times a year to discuss challenges that
are faced individually within the team.

Another firm has also responded to have clear guidelines and checklists when considering
an investment:

“All of our partners are ex-founders and sometimes they get very excited about an
opportunity and fall in love with a product after the first meeting with founders, which
is also a reason why we now set up clear guidelines. Because if you make a definitive
decision early in the process, you miss clear sings for risks and downsides of the
deal.”

On the other hand, two of the eight VC firms interviewed resort to a term-sheet when dealing
with various challenges. It allows to address major foreseeable deal risks revealed during
the due diligence stage. Thus, this evidence again highlights the importance of an
exhaustive company assessment.

Sooner or later, a VC investor tackles a problem of negotiating on investment terms with

the shareholders. During this stage, the ultimate task is to build trust and credibility with all
the parties involved. As mentioned by one of the partners at a VC firm, it eventually comes
down to communicating, negotiating and finding a compromise with various shareholders.

42
Another way to tackle existing challenges is to build a standardised investment process that
allows to treat all the companies equally and internally inform everyone about current deals.
Furthermore, most of the firms interviewed agree that transparency of internal processes
within a firm is crucial. The reason being is that a VC investor can timely address existing
hardships and develop correction plan, which consecutively impacts the bottom-line of
making smart investment decisions.

For other firms, experience is the fundamental principle to overcome existing challenges.
The more investments you make, the better investment thesis and rationale you develop.
Furthermore, long-time presence in a particular industry allows to gain vast amount of data
on growing and failing companies as well as the reasoning behind. Hence, VC investors
can challenge their investment hypothesises to drive better decisions in the future.

Lastly, in order to address the issues of absence of up-to-date publicly available industry
information, some firms purchase subscription to access databases with research and
studies on markets and competition. These platforms provide VC investors with
informational edge through delivering most recent news on market developments and
transactions. Furthermore, with such data, investors are able to support their decision with
a deeper level of understanding of macro trends and probable market developments.

Q10. Investment process iterations

Taking into consideration process shortcomings, VC firms were asked on how frequently
they revisit their investment process. Interviews have shown that only one firm has seldom
changes and improvements. The rest have ongoing adjustments and improvements of the
investment process. Nonetheless, six out of eight venture capitalists did not implement any
major changes in the process since the establishment of the firm.

Monitoring the whole process and collecting feedback from investment teams allows to
iterate on the process and implement minor improvements. For instance, one of the firms
organises internal meetings after each exit from an investment to understand how the
process can be developed:

“It is an ongoing process. We arrange internal meetings to discuss what was

done right and wrong while pursuing a deal. Every time after an exit we have
a learning session to understand what we can improve in the future.”

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An analysis of data shows that all interviewees adhere to the main process framework that
has been implemented in their firm since the beginning of its establishment. However, some
VC investors adjusted certain stages of their investment process. For instance, one of the
firms has stated that, after assessing their process, the investment team decided to send
legal documentation before initiating due diligence rather than after. This allowed them to
shorten the time-frame of making an investment decision and obtain exclusivity rights earlier
in the process.

To recap the key points, the research has shown that most of the VC investors rarely
implement any major changes to their process of making an investment decision. However,
all the firms responded that they constantly monitor their process for internal inefficiencies
and continuously amend them.

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6 Discussion

There are several conclusions one can derive from the research of venture capital firms in
the DACH region. First and foremost, the VC investment process has not undergone any
drastic changes from when origins of venture capital industry can be found. This raises
questions concerning innovation of VC firms. The changes that can be observed are mainly
related to implementation of software solutions that help to optimise and streamline the
process in search for maximum efficiency. Secondly, the speed of selecting deals is one of
the major challenges for venture capitalists, in line with cognitive bias that can impact the
final investment decision. These challenges are relevant for half of the interviewed firms,
followed by challenges concerning operational issues. In order to address these challenges,
VC investors experiment with different solutions. However, currently they all come down to
the experience of an investment team.

6.1 Discussion of the results

There are numerous approaches to how VC investors decide to invest capital in a company.
It can be viewed from different lens, such as the investment thesis, personal experience,
assessment criteria and other aspects. However, all of this is gathered under the investment
process, which defines the stages and steps an investor should go through before he makes
a final decision to commit capital. It is no doubt the main tool that gives necessary structure
to making investments. This research allowed to reveal the investment process in all the
details, supported by the actual practises from various well-known VC firms.

After conducting the research, the first investigative question did not provide any surprising
results, rather reinforced the importance of a standardized process. The interviews have
not revealed any considerable discrepancies with the investment process described in the
academic space. However, the process that was revealed in the interviews is similar to the
one introduced by D. Klonowski. Specifically, the aspects related to the decision flow,
documentation and information flow, in line with the overall sequence of the process steps.

The analysis of interviews has shown that venture capitalists share a similar process
structure and investment stages, yet with certain distinctions. The main difference occurs
when a firm decides to pursue an investment opportunity further after the initial assessment
is completed and commercial interest is proved. Therefore, it has been revealed that half of
the interviewed firms sign a term sheet before completing a full due diligence process. The
primary reason is to speed up the process of closing an investment and obtain exclusivity
rights over other investors. However, those VC firms have also stated that some companies
might require a more profound assessment before a term sheet can be signed.

45
The research has also shown that all VC firms have clearly outlined crucial and major stages
of the process. Specifically, there are internal guidelines that employees of a firm should
follow. Formal steps are outlined, however some firms have better flexibility with the process
which gives them a possibility to close a deal in a shorter period of time. As for the decision-
making part of the process, the decision power transitions from an entry level employee to
a more senior person the further you go in the process. The internal approval bodies were
reported to be the same as described in the Klonowski model. However, one of the firms
has a hybrid fund, where decisions can also be made by independent individuals.

All the respondents have said to request the same document for completing an initial
assessment of an investment opportunity. This document is usually referred to as a pitch-
deck or a business plan. Some of the firms, however, might require additional information,
which could be the company’s financial record, capitalisation table and most recent KPIs.
Internally, on the other side, investment teams prepare a unified document that underlines
deal terms and investment reasoning, crucial risks as well as DD summary that is later
presented to the IC – the investment memorandum. This document possesses a high
importance in internal structure supported by the findings obtained during the literature
review.

Conducted interviews have shown that venture capitalists put an emphasis on strong
collaboration with investee companies, be it information exchange or operational tasks.
Frequent and transparent communication with a company helps them to accelerate deal
assessment and address challenges early in the process. Moreover, to further reinforce
collaboration, VC firms assign several team members to an investee company to enable
support in communication, information exchange as well as operational issues.

The discussions of software support have shown that most of the interviewed firms employ
a similar software stack, which includes tools in such categories as team communication,
file management, CRM and task management. On the other hand, the theoretical research
has only covered the implementation of internal dealflow database. Therefore, empirical
findings confirmed this information and revealed that all eight venture capitalists have an
internal database of deals to manage all the potential and current investment opportunities.
While the basic software support is the same for all firms, only a few have acquired access
to market intelligence platforms.

The answers to the second investigative question are solely based on the data elicited from
the interviews. Due to the lack of the information available about investing challenges that

46
venture capitalists face, the first-hand insights were obtained from the industry leading
investors. The issue of validity and reliability was addressed by interviewing senior level
people working at the firms with a long-time market presence. Thus, the challenges
discussed in this study are of a high relevancy and credibility.

As in every industry that deals with predictions of the future, venture capital likewise involves
a substantial amount of uncertainty. Picking truly promising investment opportunities can
be extremely complicated. The interviews were aimed to reveal the top layer of challenges
that venture capitalists face throughout the investment process. As these challenges were
identified and analysed for each firm, several patterns began to emerge. The study reveals
that the speed of deal selection is common across half of the interviewed firms. The same
number of respondents reported to face a problem of cognitive bias when making
investment decisions. Another challenge repeatedly raised is the issue of shareholder
communication, which occurs when an investor has to negotiate on terms with numerous
shareholders of an investee company.

Additionally, VC firms were interviewed on frustrations that they experience during the
process of making an investment decision. Specifically, at which steps of the process
investment teams struggle the most. The research has shown that nearly all frustrations
arise at the stage of due diligence and signing a term-sheet. The due diligence phase
implicates extensive deal analysis that requires substantial amount of time to be completed.
Some firms encounter excessive spending of time and resources, which with adequate
planning and time management, would not emerge. The slowdowns at the term-sheet stage
occur for several reasons, mainly due to numerous negotiation rounds that could have been
prevented if less number of shareholders would be involved in the process.

To approach the above-discussed challenges and mitigate points of frustrations, VC

investors attempt to implement various solutions. Contrary to the industry perception,
implementing software into the process is only a tiny part of all the other solutions discussed.
The majority of the respondents stated that flaws in the investment process can be resolved
mainly by gaining experience of investing in companies. The more investments one has
done, the better he can correct and adjust the decision process. On the other hand,
implementing checklists and guidelines helps VC investors to streamline the process and
optimise it for better flexibility. Therefore, in order to complete a deal, the investment team
requires less time and can avoid additional expenses.

Contrarily, when dealing with many shareholders, the term-sheet acts as the main
mechanism to mitigate risks and resolve internal conflicts. Therefore, a comprehensive due

47
diligence of a company aims to expose key risks of the deal which are later addressed in
the term-sheet. Furthermore, transparent and honest communication with shareholders is
the underlying principle to finding compromises.

6.2 Limitations of the research

This section presents criticism of the research approach and methods used. Moreover, the
obstacles and challenges encountered while writing this paper. One of the limitations to the
research is lack of academic background and previous studies of investing challenges
within the DACH region VC industry. The information that was obtained on the topic was
primarily articles and thoughts of some international VC firms. Thus, relevancy and quality
of such source in a border context is questionable.

On the other hand, there are limitations with the number of respondents who participated in
the interviews. Initially, it was planned to conduct around twenty interviews, from which five
would come from VC backed entrepreneurs. This quantity would increase the validity and
reliability of the study and provide better insights to the research questions. However, the
obstacle of accessing more respondents with the initially developed demarcation criteria
arose. Furthermore, interviewing entrepreneurs would significantly extend the overall scope
of the research.

Despite few changes from the original plan, the required depth level of the research was
achieved by conducting more extensive interviews with VC firms. Thus, the quality of
information gathered from the interviews is considered sufficient due to several reasons.
Firstly, the average interviewed VC firm has eighteen years of market experience. Secondly,
about 90% of people interviewed are employees of senior level positions. Moreover,
interviewed people have a high involvement in the process, covering the majority of the
investment stages.

The information obtained from the interviews is primarily best practices and personal
opinions of interview respondents. Due to the nature of the research and the interview
questions, venture capitalists might have chosen to not disclose certain information about
their investment process and how they mitigate challenges. Hence, the provided answers
could also be questioned.

Moreover, it was hard for respondents to evaluate and reveal what challenges they face
and how they tackle them when only a short description of the question was given. If there
would be no time constraint, the respondents might have provided more detailed or different
answers.

48
Another aspect of the research that can be criticized is the structure and interrelation of the
interview questions. Due to the vast amount of information gathered from each interview, it
was a challenge to reveal correlations between questions. This limitation mainly relates to
the design of the questionnaire. Thus, the focus has shifted on to treating and analysing
each question individually.

The results provide comprehensive view over the investment process that can be
beneficially used by stakeholders in VC industry. Despite the limitations discussed above,
the focus has stayed on understanding how the crucial process of VC firms is structured
and reveal the biggest challenges tackled when making an investment decision. The author
believes that this study highlights key aspects of VC investments and creates a solid base
for further research of how the VC industry works.

6.3 Suggestions for further research

Further research should be focused on studying crucial parts of the investment process on
a larger pool of respondents. Thus, to achieve a better and more complete picture, one
should approach greater number of firms at different locations and increase the overall
number of respondents. Moreover, it would be valuable to interview entrepreneurs and
gauge their experience of raising funding from a VC firm.

Suggestion for further research would also be to reveal correlations between the investment
process and the firm structure. Specifically, how do challenges that VC investors face
differentiate by the firm’s investment strategy, implying stages of financing and target
investment sectors. Another aspect to be considered is that the solutions to the investment
challenges discussed in this study do not address each challenge individually, rather
provide a general idea of how one could mitigate all of them. Thus, further research should
be aimed to provide answers on the ways of mitigation for each challenge.

Furthermore, one should conduct a more comprehensive research to reveal other VC

challenges and quantify their impact on making investment decisions. Furthermore,
investigate the sub-steps below the main stages of the investment process. This information
will allow to discover the differences and similarities of the process among various firms,
which could not be addressed in this study.

It would also be interesting to study whether traditional VC firms make any attempts to
implement data-driven algorithms, such as machine learning and artificial intelligence, into

49
their decision process. Hence, reveal whether quantitative data-driven algorithms can
mitigate human factor in making an investment decision and provide better results.

Further research should be aimed to study what differentiates top VC firms from median
ones. Specifically, reveal whether an optimised investment process has a significant weight
among other factors that affect financial performance of a VC firm.

6.4 Self-assessment and learnings

The main goal for conducting this research was set to identify current inefficiencies in the
venture capital model by evaluating investment process of top VC firms. The information
obtained should have been used in reengineering the decision-making process and
implementing it at a newly established VC firm. In this study one can find best practices that
could help to create an investment process that mitigates process weaknesses and
addresses above-discussed challenges.

This research has been extremely beneficial as I was able to gain tremendous amount of
knowledge, both in theoretical as well as the empirical part. The theoretical background that
was set for the study helped me to achieve thought structure and deep dive into details.
Practical part, on the other hand, made it possible to create an insightful picture of the
subject by interviewing with well-known VC firm in the DACH region.

It was a truly unique experience to interview venture capitalists and study their approach to
making investment decisions. I had an opportunity to reveal how top performing firms make
investments in companies at different stages of growth. Moreover, some VC investors
shared their views on the current state of the venture capital industry and the emerging
trends they observe. Such insights provide invaluable information to progress with one’s
career within this industry.

As a result, the study not only helped to gain market insights from well-known venture
capitalists, but also to obtain information on the best practices of investing in technology
companies. I had an opportunity to achieve exponential learning curve while writing this
thesis, primarily due to the evaluation of different standpoints from various sources,
including academic studies and practical examples from VC firms. This has given the
opportunity to form a comprehensive view over the investment process. The research
results gave new insights as to how venture capitalists currently operate in the industry.
Moreover, it provides a new perspective for further research on this subject.

50
Although, this study does not provide explicit recommendations, I believe that this research
provides the stakeholders and the case company with valuable insights on the challenges
that are currently present for VC investors and how the investment process can be
optimised to mitigate them. Moreover, it illustrates crucial aspects of the process behind
making investment decisions. This study is also beneficial for the interviewed firms as it
shows them how other firms within their region operate and what challenges they face. This
exchange of information would not be possible without this research, that provides a
complete overview on the decision process of well-known VC firms while treating each
respondent confidentially.

51
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Appendices

Appendix 1. Interview Questions

Interviewee:
Name:
Position:
Involvement in the process:

Overview of the VC fund:

Headquarter Location:
Year Founded:
Number of funds raised:
Funds under management:
Firm Size (FTE):
Organisation Structure:
Number of completed deals:
Exits:
Geographic coverage:
Target Sectors:
Investment Size:

Investment Process:
1. Please describe the investment process at your firm:
1.1. What is the typical duration of each stage in the process?
2. What organizational unit is responsible for making a decision to further pursue a deal?
2.1. Who has to authorise the decisions along the process?
3. What are the document requirements throughout the process?
3.1. What documentation is requested from an investee company?
3.2. What internal documentation do employees prepare for each deal?
3.3. What documents are passed on to the decision makers?
4. How do your team members collaborate with a company throughout the process?
5. Are there clear guidelines set for the investment process? How flexible is the process?
6. Is there any IT software that supports the investment process? If yes, how?
7. What challenges have you been facing throughout the investment process?
8. At which points do employees typically experience frustration with the process?
9. What actions/measures have been taken to overcome these challenges?
10. How frequently do you iterate on the investment process?

56
Appendix 2. Transcripts of conducted interviews

Available upon request from the author.

57