An Overview Of Previous Studies

Published Date: 02 Nov 2017

Most of the venture capital investments in Russia have been conducted by domestic private and state-owned venture capital funds. The dominance of domestic venture capital funds is mainly due to Russia’s poor economic and political institute (court systems, corruption, and terrorism). In the 1990s, venture capitalists were generally interested in low-tech industries with military background. However, in the late 2000s, information technology (IT)–related firms accounted for about 50% of the VC-backed firms in the late 2000s. The percentage of investments in high-tech industries in Russia in the late 2000s has been on the same level with others compared with VC investments in other countries. It is also inconsistent with the profile of fast-growing private firms in Russia.

Finance of entrepreneurs are usually limited in the early stages of development of their start-up business and traditional providers of external capital (like banks) are prevented from intervening because of uncertainties and information asymmetries. Now in order to convince venture capitalists (VCs) to invest their time, money and effort in a venture, entrepreneurs need to know about the selection criteria they use to evaluate new venture investment proposals.

The scientific research literature has given much consideration to these selection criteria in the past, mainly with a focus on private VCs. 0nly few studies addressed the particular selection criteria of public VCs which, rather than being financially motivated, are based on economic and social objectives. Given the observed differences between various categories of capital providers (e.g. banks, business angels and venture capitalists) in terms of selection criteria, differences may also be expected within the category of venture capitalists. So it suggests itself to investigate whether and what kind of differences in selection criteria exist between public and private VCs in order to subsequently make useful recommendations to entrepreneurs. After a review of the existing scientific literature, an empirical study with 15 VCs in Russia has been carried out. Data about the VCs’ objectives, decision-making process and selection criteria has been collected through personal interviews and a comparison between public and private VCs has been made.

Introduction

Increase in competition and change in demographic trends and demand structures lead developing countries to follow different growth strategies and transform their economies. Knowledge-based sectors constitute the most important component of the transformed new economies. Life sciences encompassing many sectors including healthcare is among the top fields that influence this transformation.

In 2050, the World population will reach 9.3 billion. Apart from the increase, it is also aging rapidly. Aging, which has been a problem especially in the developed countries in the past, has rapidly felt in developing countries in recent years. The share of the population over age 65 in the World is expected to be 16% in 2010 (UN, Population Division Statistics, 2012). As the population is expected to increase to 140 million, the share of the population over the age of 65 will reach 22% by 2050 in Russia (UN, Population Division Statistics, 2012). Depending on these changes in the population composition, demand level and structure will also change. The demand for health services, food, water and energy will increase (0ECD, 2009). The expenditures on health services are increasing together with the changing illnesses and health service quality. This brings along quests of cost control and productivity increase. Along with the changes in trends, all these needs bring medical and pharmaceutical technologies to forefront and stimulate scientific publications and patents in the field. The commercialization activities intensify and the number and size of medical technology companies rise.

0n the other hand, in developing countries in other parts of the World, where the expansion of medical and pharmaceutical technology sector is relatively slow, such as Russia, financial support mechanisms and legal infrastructures regarding the protection of intellectual property must be formed. These mechanisms and the infrastructure enable innovations, facilitate economic transactions and create added value. Financial support to these activities might be given through risk and venture capital markets as well as institutional infrastructures that assume the role of these markets. Therefore, measurement of the efficiency and success of R&D supports in any form becomes crucial both for policy makers and investors in the market. This measurement requires determination of economic values of R&D processes and other intangible assets. Valuation is an established analysis in the areas of business and economics. It takes into account country, sector and company characteristics. Given that the commercialization activities in medical technology sector are shaped by country specific factors, the valuation of intellectual properties needs to be conducted specific to the sectors and the countries that they were born in. In this study, the economic valuation of a R&D project of a medical technology company in Russia was conducted. As a developing economy, Russia’s historical average annual growth rate over the period of 1999 to 2011 is 4.81%. With the increase in the number of medical technology companies, technology transfers, license agreements, patent activities, mergers and acquisitions are gaining importance in the sector. For the quick expansion of the medical technology sector in Russia, small companies, that enable commercialization of academic research, need to be established, risk and entrepreneurial capital markets need to be developed and foreign investment needs to be attracted. Venture capital as a source of finance is of huge interest to entrepreneurs. Their own financial means are usually limited in the early stages of development of their start-up business and traditional providers of external capital (like banks) are prevented from intervening because of uncertainties and information asymmetries. Now in order to convince venture capitalists (VCs) to invest their time, money and effort in a venture, entrepreneurs need to know about the selection criteria they use to evaluate new venture investment proposals. The scientific research literature has given much consideration to these selection criteria in the past, mainly with a focus on private VCs. 0nly few studies addressed the particular selection criteria of public VCs that, rather than being financially motivated, are based on economic and social objectives.

Given the observed differences between various categories of capital providers (e.g. banks, business angels and venture capitalists) in terms of selection criteria, differences may also be expected within the category of venture capitalists. Therefore, it suggests itself to investigate whether and what kind of differences in selection criteria exist between public and private VCs in order to subsequently make useful recommendations to entrepreneurs. After a review of the existing scientific literature, an empirical study with VC in Russia has been carried out. Data about the VC’s objectives, decision-making process and selection criteria has been collected through interviews.

The results show no major differences between the different types of VCs in relative importance attached to the criteria related to the entrepreneur and management team, the product and the market. However, striking differences were found for VC- and fund-specific criteria, the financial aspects of an investment project as well as economically and socially motivated criteria.

The main recommendations to entrepreneurs are to get to know about the knock-out criteria of the different VCs and to establish a first personal contact. Subsequently, it is important to be well prepared and to make all aspects of the investment project as well as potential problems and their solutions transparent.

This study aims to prove a case study of valuation of a R&D project of a medical technology company operating in Russia. It is important to conduct case studies and valuation analysis for venture capital firms to elaborate on the sector's financial, economic and policy dynamics in developing economies. This study provides discussions on these sectorial dynamics from a perspective of a developing market economy. The importance of medical technology for the World and thereby for Russia is presented in the literature review section. The base section covers real options and discounted cash flow methods (DCF) implementations. The last section provides the overall evaluation of the study.

Literature review

An overview of previous studies

Private VC funds are most often organized as limited partnerships. The investors providing their capital to the fund called limited partners (LPs) and the fund managers being referred to as general partners (GPs). Agreements between LPs and GPs define the terms and conditions of the fund (including investment objectives, fund term and fund size). The most important objective for private VCs is investor return that related to the fund managers’ return. Management fees are base compensation, but the carried interest is the biggest part of managers compensation and provides a variable, performance-based incentive (Meyer & Mathonet, 2005). A "hurdle rate" makes sure that "general partners are only compensated for over-performance" (Meyer & Mathonet, 2005). To achieve excellent returns for LPs and GPs, VCs want to make sure they only have the best companies in their portfolio. The identification of superior concepts, i.e. "the selection of high-potential investment projects, and later on the active involvement in and monitoring of the funded portfolio companies contribute to attaining these return objectives" (Alperovych, 2011). This work considers on the initial selection of investment proposals and on the investment criteria.

The selection criteria VCs use to evaluate investment proposals (often referred to as investment criteria in research literature) studied in different ways, with various samples, survey methods and analysis techniques. The following studies and research papers contributed on how venture capitalists make their investment decisions: (Tyebjee & Bruno, 1984).

In the 70s, a study of eight VC firms by Wells (1974) found that management commitment, the product, the market, marketing skills, engineering skills, the marketing plan, financial skills, manufacturing skills, the entrepreneur’s references, other VC participants in the deal, industry and technology as well as the exit method are important for a VC’s investment decision.

Tyebjee and Bruno (1984) estimated the importance of venture characteristics grouped into 5 categories, such as:

market attractiveness (size, growth, access to customers),

product differentiation (uniqueness, patents, technical edge, profit margin),

managerial capabilities (skills in marketing, management and finance as well as the references of the entrepreneur(s)),

environmental threat resistance (technology life cycle, barriers to competitive entry, insensitivity to business cycles and downside risk protection)

cash-out potential (opportunities for a successful exit with capital gains through M&A or IP0).

They believed that investment decisions are based on expected return and perceived risk. Their analysis showed that expected return is determined by market attractiveness and product differentiation. But perceived risk is determined by managerial capabilities and environmental threat resistance.

The best known and most cited research on VC investment criteria is the one by MacMillan and others (1985). They suggest a well-fitting metaphor to describe their work. No matter how convincing the horse (product), the horse race (market) or the odds (financial criteria) seem, "it is the jockey (entrepreneur) who fundamentally determines whether the venture capitalist will place a bet at all" (p. 119). They explained a business plan i.e. the detailed explanation of the business idea is necessary but not sufficient. It is just a 1st proof of the jockey’s ability to ride. MacMillan et al. (1985) used 5 categories of criteria in their study, with a total of 24 criteria being evaluated. The most important criteria were:

the entrepreneur’s personality (capable of sustained intense effort, able to evaluate and react well to risk, articulate in discussing venture, attends to detail);

the entrepreneur’s experience (thoroughly familiar with the target market, demonstrated leadership ability in the past, track record relevant to the venture);

characteristics of the product or service (proprietary or protectable product);

characteristics of the market (target market enjoys significant growth rate);

financial considerations (return equals at least 10 times my investment within 5-10 years, investment can easily be made liquid through IP0 or sale).

Among the 10 criteria meant as essential (meaning that without these criteria being met, the investment will be rejected), 5 were related to the entrepreneur. They also underlines importance of a good management team. But whether a complete balanced team is a condition for receiving VC finance or not stays controversial. Later Lerner (2004) found that a lot of VCs put their own "hand-picked manager" (p. 17) showing a track record of successfully managed similar start-ups at the head of the entrepreneurial firm, which means that a complete team does not seem to be absolutely necessary.

Risk inherent in the investment project and the ability to manage it also is important. MacMillan et al. (1985) distinguish between competitive risk, bail-out risk, investment risk, management risk, implementation risk and leadership risk. All risks can be managed by meeting the certain investment criteria.

MacMillan, Zeman and Subba Narasimha (1987) include the chemistry between the VC and the entrepreneur(s) and the VC’s intuition and gut feeling into the range of important investment criteria.

Hall and Hofer (1993) could not find evidence for the importance of the entrepreneurial team or the business strategy of the venture. This is highly surprising given the results of other prior and later studies.

Lerner (2004) listed criteria similar such as promising technology, flexible and experienced management team, market size, fulfillment of market needs and adds the feedback from existing or potential customers is an important element.

To highlight differences in evaluation business plan between bankers, VCs and BAs, Mason and Stark (2004) provide a list of criteria that has been established from the thought segments. The criteria mentioned by VCs in decreasing order of frequency:

market (potential and growth, demonstrated market need, level and nature of competition, barriers to entry),

financial considerations (cost and pricing, projections of revenue stream, value of the equity, likely rate of return and exit route possibilities),

entrepreneur/management team (background, experience, track record, commitment and enthusiasm, range of skills),

strategy (overall business concept),

product/service (nature of the product/service, uniqueness, distinctiveness, innovativeness, quality, performance, appearance and aesthetic appeal, function, flexibility)

the business plan (the whole package).

If the decision-making process is considered as a persuasion process, as in the study by Chen et al. (2009), two entrepreneur-related decision criteria are taken into account: passion for the project and readiness to make business plan. This study added more psychological criteria to the criteria mentioned so far and Chen et al. (2009) thought that "perceived preparedness might be the "missing link" between a set of objective criteria [that] VCs may or may not use in their investment decisions" (p. 212).

Manigart, Wright, Robbie, Desbières & De Waele (1998) focused on the financial valuation side. They studied the valuation process of VCs for the appraisal of new investment projects. They wrote that VCs 1st investment in intensive information gathering by consulting various sources. Then assess the investment risk and the required rate of return. Finally value the investment proposal with different methods. They were able to find factors that influence risk inherent in a project and the resulting required return. The main risk indicators were related to the skills of the management team and the characteristics of the product and market of the firm. The main factors influencing the required rate of return were degree of innovation, length of investment, general economic conditions and sector and whether the exit is planned in advance or not.

The required rate of return as a evaluation criteria strongly depends on the degree of risk involved in an investment project. Early-stage (seed or start-up) projects require higher expected returns as they in general involve a high degree of risk.

Petty (2009) highlighted its dynamic nature with selection criteria being continually updated by the VC firm over time. This happens based on VC firm-internal events and circumstances as well as changes in the investment environment.

Espoused vs. in use selection criteria

A study by Zacharakis and Meyer (1998) analyzes the apparent lack of insight that experts such as VCs have into their own decision making. By comparing the investment criteria enumerated by VCs when directly asked and the investment criteria they really rely on (actual "in use" criteria), it becomes apparent that information overload (business plan, own due diligence, external information, etc.) causes noise and hinders VCs to truly understand how they finally make investment decisions (Zacharakis & Meyer, 1998). Although some of the criteria enumerated in VC investment criteria research are definitely used for decision-making, the relative importance that these prior, self-report studies found might not be correct. As the results of Kollmann and Kuckertz (2010) suggest, VCs "tend to over-stress criteria irrelevant to day-to-day business, while under-stressing significant criteria concerning the profitability and survivability of a given venture" (p. 746).

Shepherd (1999) tested eight investment criteria for their relative importance and – when asked directly (espoused criteria) – VCs considered all of them as being equally important. However, when looking at the criteria actually "in use" that have been gathered with a "real time" data collection method during the decision-making process, especially industry-related experience outweighed the other criteria and seems to be the most important factor "in use".

Selection criteria vs. success factors

According to Riquelme and Watson (2002), VCs have implicit theories about what makes a venture successful and based on these beliefs, they define decision or selection criteria in order to evaluate a venture’s potential to be successful in the future. Whether the venture characteristics (upon which these selection criteria are based) will actually lead to success is not always proven. Riquelme and Watson (2002) further explain that many researchers who focused on selection criteria in VC decision making in the past simply assumed that the criteria they determined were valid and thus associated with success. 0ne reason for this approach is the difficulty to establish a relationship between decision criteria and actual future success of a venture. However, they say it is crucial to know whether the identified criteria actually work and lead to future business success. 0therwise, VC decisions based on those criteria can become a real disaster instead of a success.

Zacharakis and Shepherd (2001) discuss the availability bias which suggests that VCs often make "a decision about a current venture on the basis of how it matches past successful or failed funded ventures" (p. 325). Zacharakis and Meyer (1998) had suggested that VCs should use checklists with key criteria when evaluating venture proposals. These could then be updated "over time as certain funded ventures succeed and others fail" (p. 74). Whether this is a viable way of doing remains questionable due to potential differences in venture characteristics and changes in the investment environment which are likely to occur between the funding of two ventures. In their study, Riquelme and Watson (2002) compare VCs’ beliefs and theories about attributes associated with success and failure with attributes actually observed for successful and failed SMEs. The most important attributes associated with success, which they collected from prior studies on successful SMEs, are managerial attributes (experience, ability, complete team, organizational flexibility, cash/cost/location/strategy planning), marketing practices (responsiveness to market, market niche or broad market, build company image), product-related factors (competitive advantage) and financial resources. VCs mentioned a balanced, determined and committed team with a good track record, a growing protected market and a product with an above-average chance to succeed (competitive advantage, patent protection). The most relevant attributes associated with failure of SMEs are management inadequacies (inexperience, personnel problems, lack of planning), financial planning and control problems (lack of initial capital, poor record keeping, poor internal controls), marketing and product deficiencies (inadequate marketing, product/service weakness (too old/new or inferior)), unfavorable economic conditions and fraud. VCs considered lack of experience (managers cannot adapt to changing needs, incomplete team, incompatible personality traits), the fact that things take longer than planned and a too sophisticated product as potential reasons for a failure. Riquelme and Watson’s (2002) overall conclusion is that VCs’ beliefs and theories about attributes associated with success largely match the actually observed attributes of successful SMEs, which allows the guess that VCs base their decisions on the "right" selection criteria.

Achleitner, Kaserer, Wagner, Poech and Brixner (2007) find that the degree of innovation and the market timing are crucial for venture success. Entrepreneur characteristics such as a solid academic background may increase the degree of innovation and therefore the likelihood of success (Achleitner et al., 2007).

Due to the numerous uncertainties and the high degree of unpredictability involved in entrepreneurial projects, Lerner (2004) suggests that the entrepreneurs’ ability to adjust to changes in the broader environment (trends, marcoeconomic events, etc.) is a critical success factor.

A phenomenon that has received a lot of attention in previous research is the apparent outperformance of decision aids compared to a VC’s own assessment in the selection of high potential investment proposals (Zacharakis & Meyer, 2000; Zacharakis & Shepherd, 2005). A decision aid is a statistical model that "decomposes the decision into its component parts [and] helps the VC to focus on a series of smaller decisions" (Zacharakis & Shepherd, 2005, p. 677). As framework of reference for new investment proposals, the criteria and their relative weights as determined from the past decision-making behavior of the VC are fed into the model. The advantage that such decision aids have compared to a VC’s own evaluation is that they are consistent in their decision-making and able to generate more accurate decisions (Zacharakis & Shepherd, 2005).

What the authors in the field of decision aids usually did was calculating the aforementioned hit-rate for the VC’s own assessment and for the statistical decision model in order to know which method worked best. As opposed to that, namely calculating the hit-rate for statistical models based on espoused criteria, Mainprize et al. (2002) tried to create a model based on known success attributes ("attributes of viable ventures" as they call it) that helps VCs to standardize their evaluation of business plans. They suggest 15 decision cues to assess 6 attributes of viable ventures which are then used by the model to predict profitability and survival of a venture. These attributes and decision cues are innovation (new combination, product-market match), value (net buyer benefit, expected margins, sufficient expected sales volume), persistence (potential for repeat purchases, long-term need, sufficient resources available), scarcity (non-imitable, non-substitutable), non-appropriability (slack, hold-up) and flexibility (uncertainty minimized, ambiguity reduced, level of core competence). Their findings show that hit-rates were more consistent and accurate for their decision aid (based on known, viable venture attributes) than for other models based on espoused criteria.

A research project led by Alperovych and Hübner (2008) analyzes the influence of the compatibility between life cycle stages of the entrepreneurial company, its product and external market factors on performance and returns of the portfolio company. Their main result is that "top performing portfolio companies have had much more favorable combinations of external conditions and internal return factors to generate superior returns and vice versa" (p. 3).

And finally, even if espoused VCs investment criteria do not perfectly reflect known attributes of successful ventures, they are useful for entrepreneurs in order to know what to prioritize when applying for funding. As Kollmann and Kuckertz (2010) put it, a lot of research studies done in the past have been more useful for entrepreneurs seeking funding than for VCs looking for appropriate investment criteria that increase the likelihood of picking successful ventures.

Evaluation uncertainty and overconfidence

The majority of research that has been done on VC investment criteria during the past thirty years focused on the relative importance of these criteria for VC investment decision making. A recent study by Kollmann and Kuckertz (2010) analyzes a closely-related phenomenon, namely the "specific uncertainty associated with the evaluation of each single criterion" at different stages of the investment process. It is widely accepted that knowing about the relative importance that VCs attach to the different criteria they use for assessing the quality of an investment proposal is essential. However, if there is a high degree of uncertainty involved in the evaluation of a specific criterion, VCs will probably be more careful in supporting their investment decision with this criterion and rather concentrate on more tangible and certain criteria. Kollmann and Kuckertz (2010) use search, experience and credence qualities as a theoretical framework for their analysis. This theory enables the description of goods by "search qualities which are known before purchase, experience qualities which are known costlessly only after purchase, and credence qualities which are expensive to judge even after purchase" (Darby & Karni, 1973, p. 69).

This framework can easily be used in the case of VCs who want to assess the quality of a venture (the good) and who use a number of investment criteria – which fall into either of the three above-mentioned categories – to describe the venture proposal. While a search quality e.g. would be whether a venture is active in an industry of interest for the VC, which is easy to determine with certainty, the effort and endurance of an entrepreneur would rather qualify as experience quality. The real commitment of the entrepreneur however can never be assessed with certainty and thus is a credence quality associated with a high degree of uncertainty.

The degree of uncertainty concerning the evaluation of the different selection criteria decreases when moving from initial screening to thorough evaluation and deal structuring in the venture capital decision-making process. This is reflected in the proportion of search, experience and credence qualities used in the evaluation of the different criteria. This decrease in uncertainty is probably due to a greater amount of time and effort allocated to the evaluation of an investment proposal and a higher level of information available during the course of the venture capital decision-making process (Kollmann & Kuckertz, 2010). Kollmann and Kuckertz’s (2010) main conclusion is that criteria related to the entrepreneur or management team are of exceptional relevance but at the same time very difficult to evaluate, especially in the early screening phase. Therefore, an important suggestion they make to entrepreneurs is to be transparent, to collaborate closely with the VC and to show preparedness and commitment right from the beginning in order to minimize uncertainties as much as possible.

Zacharakis and Shepherd (2001) examine another phenomenon related to the VC investment decision, namely the overconfidence involved in predicting the future success of new ventures. Although VCs are considered as experts in this field, overconfidence often biases their decision and significantly reduces their decision accuracy. For their study, Zacharakis and Shepherd (2001) define overconfidence as "the tendency to overestimate the likely occurrence of a set of events" (p. 311), which in the case of VC decision making is the "likelihood that a funded venture will succeed" (p. 311). Their main findings show that overconfidence increases with more information being available to VCs and with unfamiliar framing of the information (i.e. information presented in a way VCs are not familiar with). More information obviously suggests that better informed decisions can be made. However, more information also makes a decision more complex, is often not fully considered and consequently only increases confidence about and not accuracy of the decision.

There are several ways of reducing overconfidence which VCs should know about. Counterfactual reasoning involves thinking about potential future deviations from assumptions that a decision is based upon (some sort of what-if scenarios) and the "humbling effect" occurs when negative feedback from past decision is received, which unfortunately usually only happens years after an investment was made (Mahajan, 1992; Russo & Schoemaker, 1992). Decision aids may also reduce overconfidence by increasing decision accuracy (Zacharakis & Shepherd, 2005).

Specific objectives and selection criteria of public VCs

Governments play a major role for economic growth, the promotion of entrepreneurship and venture firms and the development of the VC industry. They set the legal and fiscal framework for investors and funds, boost or curb investments by private and institutional investors and – most important for this paper – they often opt for direct public intervention (Leleux & Surlemont, 2003; 0ehler et al., 2007). This may mean creating a public fund or being directly involved in private or corporate funds. When directly intervening in VC funds, Leleux and Surlemont (2003) state that ""mixed constraints" objective functions" (p. 97) characterize the public fund’s investment decisions. Governments pursue a number of "politically [and] socially motivated" (p. 86) objectives like regional development, industry restructuring or employment creation, which they try to combine with traditional private sector return objectives in order to make their investment cycle self-sustaining. These objectives however are often conflicting and hard to reconcile. If public VCs then decide to give the priority to economic and social policy objectives, they may have a tendency to offer "capital at marginal (below market) rates of return to entrepreneurs" (Leleux & Surlemont, 2003, p. 99).

Lerner (2004) suggests two important roles or objectives of public VC initiatives: certification to other investors and encouraging of R&D spillovers. He argues that public agencies should certify high-quality projects and give them a "stamp of approval" in order to increase the confidentiality of other investors and make them invest. As private VCs have shown to concentrate on a few industries currently "en vogue", such a stamp of approval could be interesting for industries that are rather neglected by private VC investors. A well-founded criticism of this certifying role lies in the doubt about government officials being able to overcome information asymmetries and to identify promising investment projects while other investors apparently cannot, especially if those other investors are private VCs with significant industry expertise. The criticism may however be unfounded, according to Lerner (2004), if the other investors are e.g. bankers with little insight into the business of an entrepreneurial firm and if those government officials are specialists and experts with significant expertise and insight. In practice however, this last hypothesis does not always hold. Nevertheless, a few years before, Lerner (1999) was able to detect a positive effect of the public "stamp of approval". He had studied the long-run performance of high-tech start-ups that received funds from the public SBIR program in the US (awardees) and found that those firms grew faster, showed a greater increase in employment and were more likely to obtain additional independent VC finance in subsequent years than their non-publicly funded peers. Although the SBIR program mainly works with monetary grants, the same effects are to be suspected from public VC interventions with equity or quasi-equity instruments. The second role of public VC initiatives, according to Lerner (2004), concerns R&D spillovers, i.e. positive externalities generated by certain activities of a company. For instance, innovations by a start-up company do not only benefit the company itself but may also create positive spillover effects for competitors, developers of complementary products and customers. The overall social and economic value of such spillovers may thus be a reason for government agencies to intervene in the funding of certain projects.

According to a study by Beuselinck and Manigart (2007), direct public interventions play a stabilizing role for the overall VC industry as they are "less opportunistically driven by the economic climate" (p. 29). In addition, interventions by public VCs can stimulate investments in those sectors or companies that may have difficulties to receive funding from private VCs – which emphasizes the complementarity of public and private VCs (Leleux & Surlemont, 2003; Beuselinck & Manigart, 2007). This objective of complementing the investments made by private VCs seems justified given the positive economic impact of venture-backed firms – compared to firms funded with other types of capital – in terms of employment creation, sales growth and fostering of innovation (Amit et al., 1998).

Deloitte (2009) describes the role that governments play for the VC industry, including recent trends. Governments always played an important role in fostering innovation and entrepreneurship. This becomes even more apparent when looking at current industries of interest for VCs such as cleantech or life sciences, which are regulated to a higher extent than e.g. the IT industry. Favorable government policies and regulations are required to make these areas develop and to encourage VCs to invest. Worldwide, VCs particularly stress the importance of favorable tax policies and increased government support for entrepreneurial activities (Deloitte, 2009).

The above-stated roles and objectives of public VC initiatives have an influence on their investment criteria in that they add a number of criteria to those used by private VCs and may change the relative importance and weighting of various criteria.

In addition to the influence of the specific objectives of public VCs, rules and regulations established by national or supranational entities add additional investment constraints and probably have an impact on selection criteria and their relative importance. Concerning direct government intervention in Europe e.g., government-sponsored initiatives that support SMEs have to make sure that they comply with European Union [EU] state aid rules (for more information, see De Harlez, Schwienbacher & Van Wymeersch, 2008; European Commission, 2009). These rules have been modernized in recent years in order to "target investments toward[s] objectives of the Lisbon strategy for growth, jobs [and competitiveness]" (European Commission, 2009, p. 4). Specific constraints, conditions, regulations and administrative procedures apply e.g. to investments falling into the "de minimis" (i.e. aids of small amounts) or the "risk capital aid" framework. The latter was put in place in order to encourage the creation of VC funds and the investment in high-growth SMEs. In addition, the European Union definition of SME has to be followed.

Summing up, the specific objectives of public VCs in contrast or in addition to the return objectives of private VCs are the promotion of entrepreneurship and innovation, social objectives such as job creation and maintenance, economic growth and regional development, the attraction of new businesses and investors to a certain region, industry development or restructuring and environmental objectives.

Trade-offs between various selection criteria

As many previous studies of VC selection criteria only tried to establish a hierarchy of importance based on the traditional Likert scale survey method, Muzyka et al. (1996) used another approach. After having identified 35 investment criteria in scientific literature, they realized their own survey where about seventy VCs were asked to make trade-offs between pairs of independent criteria. For all 35 criteria, they defined three trade-off options (e.g. market size: large, medium, small or expected rate of return: <16%, 16%-25%, > 25%). They then created 53 matrices, each containing two selection criteria with their three different trade-off options. Respondents were then asked to rank each of the nine possible combinations of trade-off options. Their results indicate that leadership potential, industry expertise and the track record of the entrepreneur or management team are ranked among the top 5 criteria, followed by a sustained competitive position, marketing/sales capabilities and organizational/administrative capabilities of the team and the ability to cash out. Their findings also suggest that the priority for VCs is a good business deal, even if it does not perfectly fit with their investment strategy (e.g. round of investment) or their existing portfolio. Geographical issues, i.e. the location of the business and its market relative to the location of the VC fund, matter but are not the first element of consideration for decision making.

A study by Sweeting (1991) found that UK VCs showed a certain preparedness to consider a project with weaker management team if "the business concept was otherwise sound – good product/market, proprietorial market position, good returns, and so on". He explains that this was associated with the VCs themselves providing the necessary managers in the context of a proactive management style. This is confirmed by Lerner (2004). Khanin et al. (2008) on the contrary report what has "acquired the status of conventional wisdom" (p. 190) in the VC industry: a more qualified ("A") person with a worse ("B") project is preferred to a less qualified ("B") person with a better ("A") project. MacMillan et al. (1985) had been one of the first to say that irrespective of the horse (product), the horse race (market) or the odds (financial criteria), it is the jockey (entrepreneur) who matters most in the end. Zacharakis and Meyer (1998) found that if little information about the market and the competitive situation is available, then the entrepreneur matters most. If more information becomes available to VCs, then their focus shifts from the entrepreneur to market characteristics.

Zacharakis and Shepherd (2005) found that prior start-up experience of the entrepreneur or management team can substitute for prior leadership experience. In general, they observe that leadership experience matters most to VCs in environments with a greater number of competitors as a good leader can "act and react to the many possible, and a priori unforeseeable, competitive interactions" (p. 684). The European Private Equity & Venture Capital Association [EVCA] (2009) cites a quote of Bruce Golden from Accel Partners which gives an answer to the following question: How to evaluate an entrepreneur with no track record? He says that VCs then usually look at the history of success of the entrepreneur, i.e. whether he had high impact roles in the past and whether he fulfilled his or her duty with commitment and lead other companies to success.

Based on their findings, Chen et al. (2009) state that if an entrepreneur shows passion about his/her project but his/her business plan, i.e. the whole package, does not have the necessary substance, the deal will probably not be made. VCs tend to care about how prepared they perceive an entrepreneur is (with regard to the business plan) to assess his or her passion.

Factors influencing the selection criteria and their relative importance

A number of circumstances both internal and external to the VC investment decision-making process have shown to have an influence on how, and based on which criteria, investment decisions are made. The subdivision of the screening and evaluation phase

The decision-making process a venture proposal has to go through for evaluation before an investment decision is made has been described by various authors as "screening and evaluation phase" of the VC investment activity. Fried and Hisrich (1994) propose a six-stage VC investment process including two different screening and two different evaluation phases. Tyebjee and Bruno (1984) also provide a model of the decision process that contains a screening and an evaluation step and Sweeting (1991) uses deal screening and deal evaluation to describe this phase within the venture capital fund activity.

This screening and evaluation phase – when regarded as one big part of the investment decision-making process – in turn comprises various sub-phases, as suggested by Fried and Hisrich (1994). Their subdivision includes a VC firm-specific screen, a generic screen, a first-phase evaluation and a second-phase evaluation where each of these sub-phases can lead to a rejection of the investment proposal if it does not meet the VC’s investment criteria, which may differ from sub-phase to sub-phase.

During the VC-specific screen, particular attention is paid to criteria such as investment size, industry, geographical location and stage of financing (Fried and Hisrich, 1994). The generic screen is done based on the submitted business plan and any relevant knowledge that the VC may have related to the proposal, and usually only takes a few minutes. Hall and Hofer (1993) found that go / no-go decisions during this initial screening phase only take an average of less than 6 minutes.

For the subsequent, first-phase evaluation, VCs start collecting additional information on the submitted investment proposal (Fried and Hisrich, 1994). They then meet and talk to the entrepreneurs; some may even want to visit the entrepreneurs’ home and family in order to get a feeling of the environment they live in. They check references, look at the financial history if available and contact actual or potential customers. If there is no product on the market yet, the product concept may be discussed with potential future customers or opinion leaders. Sometimes, formal market research is carried out or – in the case of very early-stage investments – a technical evaluation is made. Early-stage investors often also consult the managers of their existing portfolio companies, especially if these companies operate "in closely-related industries" (Fried & Hisrich, 1994, p. 34).

During the last sub-phase of the screening and evaluation process described by Fried and Hisrich (1994), the second-phase evaluation, VCs spend an increasing amount of time and effort on the proposal(s) that made it through the first phases and eventually develop an ""emotional" commitment" (p. 34) to it/them. Here, the goal is no longer to investigate whether the proposal is interesting or not, but rather to determine potential problems and to find out how to solve them. In the beginning of this phase however, a good estimation of the structure of the deal and the valuation is required in order for the VC to not waste time on an irrationally high-priced investment proposal. After this second-phase evaluation comes the closing of the deal including last detailed negotiations and the structuring of the investment.

The boundaries between these different screening and evaluation phases are usually not clearly defined, but somewhere at the beginning of the above-mentioned first-phase evaluation starts what is commonly known as due diligence. Worrall (2008) makes a distinction between pre and post term-sheet due diligence, which approximately correspond to Fried and Hisrich’s (1994) generic screen and first- and second-phase evaluation, respectively. While VCs make sure that the business plan and the technology are worth further considerations before the term-sheet is set up, past term-sheet due diligence looks at the company into much more detail, including corporate organization and history, management and employee relations, intellectual property, financial and accounting matters if available as well as information on sales plans, competition, public relations and R&D. She also notes that each VC has its own due diligence checklist, which makes a broad generalization difficult.

VCs spend 10 to 15 minutes on the initial screening phase according to a study by Sweeting (1991). Hall and Hofer (1993) differentiate between initial proposal screening and proposal assessment, which they found to take a maximum of respectively 6 and 21 minutes. For the initial go/no-go decision, the fit with VC-specific guidelines and long-term growth and profitability of the industry are the most important criteria. For the more detailed assessment, according to Hall and Hofer (1993), the source of referral determines the degree of interest accorded to a proposal.

First round vs. subsequent follow-up investments

VC capital infusions are usually staged, i.e. subdivided into various investment rounds, in order to give VCs the opportunity to abandon investment projects periodically (Gompers & Lerner, 2004). The initial due diligence process – based on the various investment criteria enumerated earlier – decides on whether or not a VC invests in a project, i.e. participates in the first round of an investment. Later on, close monitoring and information gathering enable the VC to assess whether he wants to participate in subsequent investment rounds. As Lerner (2004) explains, in addition to investing in several rounds, VCs may disburse funds in tranches – even within one round. This especially happens in the initial phase of an investment in order to make sure that "money is not squandered on unprofitable projects" (p. 9) or that – even worse – the entrepreneurs run away with it. Taking a board seat and intensive monitoring of entrepreneurs then enable a VC to decide whether the next tranche of capital will be allocated or not. Sometimes this also depends on the completion of certain activities or the reaching of a milestone. Although the continuous evaluation of a project’s progress based on monitoring and information gathering enables the VC to get a good idea of the project’s development, a detailed analysis based on a number of criteria is often done before participating in a subsequent investment round. These criteria may not be exactly the same as the initial investment criteria used during the due diligence process, or at least the focus of attention or the weighting may have changed.

0pen-end vs. closed-end funds and related constraints

Petty (2009) argues that VC-specific constraints like available fund capital, the timing of an investment proposal’s arrival relative to the maturity of the fund and the composition of the portfolio at the time of the proposal (development stages of companies, geographic concentration) may bring VCs to adjust the relative importance of their selection criteria over the lifetime of their fund.

The first two constraints are mainly true for independent VC funds as they are usually closed-end and therefore constrained by a "pre-specified [liquidation] date" (Van 0snabrugge & Robinson, 2001, p. 27). With a liquidation horizon of about 7 to 10 years – in Belgium usually 10 to 14 years in practice –, independent VCs can only invest in very early-stage deals in the beginning of their fund’s lifetime as the time to exit may take up to 14 years and all of their investments have to be exited by the end of the fund (Van 0snabrugge & Robinson, 2001). The last constraint rather applies to those funds who wish to diversify and balance their portfolio, which may be the reason for rejecting several new proposals based on what is already in the portfolio. When approaching the end of the investment period of a fund, VCs may want to invest the remaining fund capital in projects that show synergies with existing portfolio companies or rather in a way that enables hedging less promising existing portfolio positions (Petty, 2009).

The source of referral

In his study, Petty (2009) considers the source of the proposal which may have an influence during the decision-making process. Tyebjee and Bruno (1984) mention three different types of deal origination: referral (referred deals or projects), cold contacts (cold calls by entrepreneurs) or technology scans (active search for deals by the venture capitalist). 0ne could also organize the sources of the proposal into the following categories: passive sources (direct from the entrepreneur, via intermediaries, via parent organizations or via portfolio businesses), proactive sources (active search for existing combinations of entrepreneurs and venture, putting together managements and ventures) or syndication (request to join from other VCs) (Sweeting, 1991). Hall and Hofer (1993) emphasize the importance of the source of the proposal, "with proposals previously reviewed by persons known and trusted by the venture capitalist receiving a high level of interest" (p. 25). This is confirmed by B. Leleux (personal communication, June 16, 2011).

Syndication and investment consortia

Fried and Hisrich (1994) sum up what several previous authors found out: VCs often syndicate investments in order to share knowledge and pool their capital, which in turn allows them to share the risk inherent in a project, and in order to invest larger amounts so that follow-up investment rounds are covered. They say that during the first-phase evaluation, VCs often talk to each other, especially when considering a syndication of the deal, which finally influences how and based on which criteria the investment decision is made.

Hochberg, Ljungqvist and Lu (2007) state that VC networks (i.e. the reciprocal relationships that a VC undertakes with other VCs) – which are the basis for every syndication – can positively impact the performance of a fund. They found a significant positive relationship between how well networked a VC is and the probability that its portfolio companies survive. This probably is due to the main advantages of networking, namely the spreading of risks and the pooling of expertise. Being well networked consequently increases popularity with both limited partners (i.e. investors in the fund) and entrepreneurs and thus is of strategic importance to VCs. Having highly skilled and experienced investment managers, showing a strong track record of well selected and successfully supported investment projects as well as reciprocal sharing of deal flow may help improve a VC’s network position. In a later study, Hochberg, Ljungqvist and Lu (2010) show that – especially for cross-border investments – networks with local VCs are crucial as they enable foreign VCs to get access to local investment projects. Local VCs typically are the first to discover a local investment proposal and they then invite other, maybe foreign VCs from their network to join and syndicate the deal. A foreign VC in the study of Mäkelä and Maula (2008) pointed out that "It is very important to be physically close. Geography and culture have an effect. We would not invest without a local investor" (p. 249).

In the language of public risk capital investors, syndication is also known as "fund matching (by private investors)" (M. 0livier, personal communication, May 17, 2011). Public VCs often only invest a maximum of X% of the total amount of capital needed by the entrepreneur, provided that the other (100-X)% of the investment are matched by other, usually private investors. Leleux and Surlemont (2003) on the contrary establish the hypothesis that public VCs syndicate deals to a lower extent than independent VCs. This has several reasons. Syndication is a mean of creating a diversified, balanced portfolio with a limited amount of capital available to each of the VCs in the consortium. As public VCs often work with open-end funds, they are not constrained by a limited capital base. Instead, as long as interesting investment opportunities are presented to them, they can justify additional capital to be injected into the open-end fund. Additionally, public funds often are generalists with a broader focus, which enables them to diversify their portfolio without the aid of syndication. And finally, a third reason for the above-stated hypothesis is that public VCs have a "mixed objective function" (Leleux & Surlemont, 2003, p. 88). They pursue non-financial objectives in addition to or instead of the traditional return objectives of private VCs, which may make investing in a consortium more difficult.

Prior investment by BAs or VCs and government subsidies

Bozkaya and Van Pottelsberghe de la Potterie (2008) find that 72% of the technology-based small firms in their sample that received VC funding had benefited from business angel funding before. Although apparently intervening at different development stages of the venture, this suggests a certain complementarity of both types of investors – something that had already been observed by US studies in the past. The awarding or certification role played by interventions of public agencies providing among others risk capital to entrepreneurs has been examined by Lerner (1999), Lerner (2004) and Gompers and Lerner (2004). Governments seem to have the ability to certify that a venture is viable and worth additional investments by other, subsequent investors.

The compensation of fund managers

As mentioned by various authors (Fried & Hisrich, 1994; Van 0snabrugge & Robinson, 2001; Leleux & Surlemont, 2003), the traditional compensation of VC fund managers includes an annual management fee of 2.5-3% of the fund’s capital and a carried interest of 20% of the capital gains realized on investments. While the management fee is considered as a base compensation, the carried interest usually represents the biggest part of the fund managers’ compensation and provides a variable, performance-based incentive (Meyer & Mathonet, 2005). A "hurdle rate" makes sure that "general partners are only compensated for over-performance" (Maxwell, 2003a as cited in Meyer & Mathonet, 2005, p. 33). This compensation scheme is mainly used by private, independent VCs. Public and captive funds however, which are often managed by civil servants and corporate employees respectively, may not use the same compensation scheme. They instead work with fixed salaries according to the pay scales of the civil service or according to industry standards, respectively, to remunerate their investment managers. In this way, unfortunately, no financial incentives are offered in the form of a variable pay that is linked to the performance of portfolio companies. 0r at least, as Leleux and Surlemont (2003) put it, the "fee-based incentive package, common in public institutions, creates different incentives than the profit-based incentives of private VCs" (p. 82).

The question may arise whether this difference in compensation and incentives may have an influence on the scrutiny with which investment proposals are screened, i.e. on the severity with which selection criteria are analyzed.

The impact of the recent financial and economic crisis

An element that studies conducted prior to 2007 were not able to take into account is the impact of the recent financial and economic crisis at various levels of the VC investment process – from fundraising to investment decision making for new proposals and follow-up investment decision making for already existing portfolio companies. The crisis may have changed the context of venture capital investing. Fundraising e.g. may have become more difficult, which in turn makes good investment decisions even more essential in order to best use the capital that is still available. Consequently, the crisis may have had an impact on the scrutiny with which selection criteria are used for screening and evaluating investment proposals. 0n the one hand, concerning new investment proposals, the importance of some criteria may have increased in order to make sure that only those projects with a higher-than-average chance to defy the crisis and its consequences are funded. 0n the other hand, certain existing portfolio companies may have been directly or indirectly hit by the economic crisis, which entailed and still entails higher follow-up needs for subsequent investment rounds as companies were often forced to adapt their business model and to revise their strategy for the years to come (H.-F. Boedt, personal communication, June 22, 2011). Although the recent crisis has not yet been included in many scientific research papers about VC investing, various national and international organizations as well as external consultants studied its impact on the VC industry.

A worldwide study by Deloitte (2009) analyzed the expected effects of the financial and economic crisis on VC fundraising among limited partners. While they found a huge expected decrease in the willingness of banks to invest in VC funds, governments were expected to increase their investments in this asset class. This suggests that VCs were and probably still are looking to governments for assistance and support, with an emphasis on favorable tax policies and increased government support for entrepreneurial activities (Deloitte, 2009). Denis Lucquin (as cited in Ernst & Young, 2010) says that although the recent years were characterized by a difficult exit environment, keeping the focus on the entrepreneur and growing a company for its own sake (and not with the intention to achieve a trade sale) will ultimately create awareness and interest on the part of potential buyers. He also emphasizes that a VC should not change its investment strategy as a reaction to the crisis, which would change its DNA and soul and make it get lost. It is important, according to Denis Lucquin (as cited in Ernst & Young, 2010), to take the long-term nature of the venture capital activity into account before engaging in short-term changes.

Venture capital in Russia

In 2011, the total capitalization of all Russian PE&VC funds demonstrated an increased and amounted to approx. $20.1 bln that was near 20% higher than in 2010 ($16.8 bln). Thus, the dynamic of capital growth rose in comparison with the previous accounting period (10.5% in 2010). Nevertheless, the relative growth rate was lower than the growth presented in more distant pre-crisis periods (in 2008 the gain was 40% of the 2007 level, and in 2007 it was more than 60% against 2006).

At the same time, there were some remarkable events registered in the fundraising sphere as well as in investment and exit activities of funds in 2011.

Probably, for the first time in domestic practice a fund destined specifically for investments in high-tech companies was launched by one of the oldest and well-known in the Russian market management companies. At the same time, there is information available on the anchor investors’ (EBRD) intention to participate in the fund’s capital.

Continuation of creating funds with clearly definite specialization may be attributed to the recent years’ trends which were realized in 2011. Particularly, in 2011: the only one currently existing in the Russian market mezzanine fund made its first investment; besides, there were acting near 15 seed funds; under state support was launched the formation of the largest infrastructure fund (RPEF), the investment activity of which undoubtedly will make an impact upon the whole Russian PE&VC industry landscape. Also, the biotechnology and infrastructure funds of Russian Venture Company (RVC) started working; the nanotechnology funds were acting and actively being formed with the Rusnano participation; the pharmaceutical, clean technologies, etc., funds were expanding their activities in 2011.

Totally, in the Russian market the volume of newly attracted funds in 2011 ($3.8 bln approx.) was more than twice higher than in 2010 ($1.74 bln). Traditionally, in the statistics were included the funds which had accomplished their intermediate or final closings, with authentic information on this available, and started actively deal searching (or had first investments in companies made in 2011 already).

Figure Capitalization of venture funds and private equities in Russia 2001-2010

The management companies’ plans on new funds raising are very extensive as before – the total volume of the funds being launched (estimated by targeted volume) amounts to more than $15 bln, though the analysis of facts shows that the declared intentions on raising new funds often cannot be realized within the stipulated time limits and have to be delayed to later periods. At the same time, it should be underlined that the market potential of attracting capital in short-term outlook is rather high, especially when taking into account the funds which are only planned to launch. Particularly, a sufficient input in the Russian market fundraising is actively being made by Rusnano (it’s expected that the total funds number with the Rusnano participation will be close to 15).

Considering the information available, it may be established that the 2011 total Russian market cumulative capitalization growth at the amount of near $3.8 bln was provided at the expense of 21 PE&VC funds launch. Excluding several funds which realized intermediate closings, the volume of newly attracted in 2011 capital was connected with new funds creation. It is significant that the venture capital funds having provided near 1/6 part of capital volume increase constituted approx. 2/3 of all new funds’ number.

The statistics included selectively some new funds in the form of closed-end mutual VC&PE investment funds, the information on activities of which was available from open sources. At the same time, analysis of the funds acting on the collective investment market was still complicated because of law demands on the restrictions concerning the fund information disclosure for qualified investors. In this connection, in the statistics were not included near 30 closed-end mutual VC&PE investment funds active by the end of 2011.

Branch preferences of the newly crea