Evaluation Uncertainty And Overconfidence

Published Date: 02 Nov 2017

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

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 predCommunication and Computer 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.

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 Gulkin (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 Gulkin (2010) considered a closely-related issues, namely the uncertainty associated with the evaluation of each single aspect 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. Gulkin (2010) use search, experience and credence qualities as a theoretical framework for their analysis.

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 quantity 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 (Gulkin, 2010). Gulkin (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.

Ruhnka (2001) examine another phenomenon related to the VC investment decision, namely the overconfidence involved in predCommunication and Computering 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, Ruhnka (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). Decision aids may also reduce overconfidence by increasing decision accuracy (Ruhnka , 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). This may mean creating a public fund or being directly involved in private or corporate funds.

Franke (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 Franke (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, Franke (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 Franke (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 (2007), direct public interventions play a stabilizing role for the overall VC industry. 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, 2003; Beuselinck, 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 quantity 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, Mullins 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 Franke (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. Artus 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. Cochrane (2005) 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.

Ruhnka (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 quantity 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 quantity 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. Chan (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. 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 Franke (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 quantity 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.

Open-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. Chan (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 Franke (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 (Cochrane, 2005). A "hurdle rate" makes sure that "general partners are only compensated for over-performance" (Cochrane, 2005). 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

2011 capitalization of all Russian private equity and venture capital funds increased and amounted to $20.1 billion (20% higher than in 2010 ($16.8 billion)). It’s consecutive growth to previous period too (10.5% in 2010). But, the relative growth rate was lower than the growth in pre crisis periods (in 2008 the gain was 40% to 2007 level, and in 2007 it was more than 60% comparing 2006).

The first time in Russia a fund destined specifically for investments in high-tech companies was launched. Particularly, in 2011: the only one existing in the Russia mezzanine fund made first investment. There were working 15 seed funds. With support of government the largest infrastructure fund (RPEF) was launched. The biotechnology and infrastructure funds of Russian Venture Company (RVC) start to work. Rusnano actively formed the nanotechnology funds which entered to market. The pharmaceutical, clean technologies, etc., funds expanded in 2011.

In total, in the Russia the size of newly attracted funds in 2011 ($3.8 billion approx.) was more than double higher than in 2010 ($1.74 billion).

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

The plans of management companies on fundraising are very wide. The volume of the funds amounts to $15 billion. Though the analysis of facts shows that the declared intentions on raising new funds often cannot be done for time and must be delayed for later. However, the market potential of attracting capital in short-term is high, with the funds which are only planned to launch. The biggest input in the Russian fundraising is made by Rusnano (the total funds quantity with participation of Rusnano will be 15).

The 2011 total Russian market capitalization growth was $3.8 billion with help 21 private equity and venture capital funds launch. The volume of capital attracted in 2011 connected with new funds.

The statistics included new funds in the form of closed-end mutual private equity and venture capital investment funds.

The newly created funds invested in various industries such as Communication and Computers to Clean Technologies and Agriculture. Capital outflow was due to liquidation of a quantity of funds’ work in 2011. Total volume of the funds liquidated amounted to approx. $523 M (17 funds). Half of capital accumulated in PE funds. 2/3 of the quantity of terminated funds belonged to the common investment market. The total quantity of the funds on the Russian private equity and venture capital market were on 2010 level and was equal to 174.

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

Quantity of management companies conducted work on attracting capital in new funds during 2011 would be equal in 2012.

In 2011, the growth of capitalization was lower than before crisis but growth was almost double than in 2010. The capital volume accumulated in the funds acting in the Russian market was $20.1 billion.

Figure Quantity of companies which obtained investment from PE&VC

Variety of management companies

We can state that in the end of 2011 the quantity of management companies (Companies) working in the private equity and venture capital industry in Russia reached 120 (compared to 110 in 2010).

Companies separated by their capital depending on the total capital volume under management. The Companies were divided into three groups. The quantity of "large" management companies ($151 M to $2200 M under management) increased largely and amounted to 34 companies in 2011 (22 companies in 2010). The total capital $15.643 billion was under management of the companies in this group. The funds of this group invested in the portfolio of companies at the expansion and later stages of development. Investment volume changed from $10 M to hundreds of million dollars per one company. The companies in this group provided the main share of total capitalization growth (more than 60%). In 2010, this parameter was 85%, in 2009 – 53%, in 2008 – 85%.

The quantity of management companies in the second group that managed funds with "medium" capitalization (from $51 M to $150 M) did not change comparing 2010 and was 33 companies. A certain capital outflow in this group was due to by liquidation of work of a quantity of companies having one fund under management. The volume of funds under management of the companies of this group amounted to $3.068 billion. The deals’ volumes varied within the limits of $5–15 M.

The third group of companies with "small" sized funds (having $5-50 M under management) included the biggest part of companies – 53 (55 in 2010). Total capital volume under management in this category was equal to $1.381 billion in 2011.

Figure Quantity of fund management companies by capitalization of funds under management

Source: Russian venture capital association, 2012

Figure Capitalization of fund management companies

Source: Russian venture capital association, 2012

Investments by industries

The 2011 funds maintained high level of investment activity. Both the volumes and the quantity of investments exceeded the 2010 volumes. The funds made more than 135 investments in Russian companies in 2011. The total volume of the deals in 2011 was $3.1 billion.

The first took the consumer market with the $1.5 billion (approx. 50% of total volume of investments) comparing $300 M (near 12%) deals in 2010. The main input in this volume (near 3/4) made one deal in the retail trade.

The second place by investment volume took Communication and Computer related industries in aggregate. The companies in this sector received $560 M of investments (approx. 18% of total investment volume) in 2011. The communication and computer companies got 3 times smaller investment volume in comparison with the leading Consumer market branch. The communication and computer investment volume decreased almost 2 times (approx. $1 billion in 2010). Its share decrease (near 40% in 2010). Communication and computer sector in 2010 was provided by one large deal near $700 M by volume.

The Industrial equipment branch took the third position, with more than $490 M of investment volume (approx. 16% of total investment volume). The main input was provided by one large deal near $480 M by volume.

The most remarkable 2011 deals were with the Industrial equipment and with the Chemicals & Materials branches. The high-tech investments made by private equity funds, founded by west investors.

The unique investments in high-tech companies made by large and well-known PE funds were registered in 2011. The Financial services industry decreased comparing the previous period by investment – in absolute (more than 3 times) and relative (more than 4 times). This industry follows the three leaders with aggregate investment volume near $230 M (almost 7.6% of total investment volume in 2011).

The 5th and 6th positions were taken by Energy (near $140 M or 4.5% of total volume) and Chemicals & Materials ($64 M or 2%) industries. When the Energy had kept the investment level as compared to 2010 ($100 M and 4% of total volume), the Chemical branch noticeably raised its investment and exceeded the 2010 values ($3 M and 0.12%).

The others industry in decreasing investment order:

Electronics related (near $17.5 M or near 0.5%),

Medical/Health care ($14 M or 0.5% comparing $53 M or 2%, correspondingly, in 2010),

Other industries (near $7 M or 0.2% comparing $0.3 M or 0.01% in 2010),

Transportation ($8.5 M or 0.28% comparing $3.4 M or 0.13% in 2010),

Biotechnologies (near $2.33 M or near 0.08%),

Ecology (approx. $0.6 M or 0.02%).

Total share in the total 2011 investment volume of the industries mentioned doesn’t exceed 1.6%. There were registered no investment activities in the Light industry, Construction, and Agriculture industries.

The branch section of activities looks differently to the quantity of the companies – recipients of the investments. Here, the leader is communication and computer sector (near 50% of total quantity of investee companies). Among leaders were Medical/Health care (near 10%) and Industrial equipment (approx. 6.5%) branches.

Figure Quantity of investee companies

Source: Russian venture capital association, 2012

Figure Average annual investment volumes

Source: Russian venture capital association, 2012

Figure Distribution of investment for economic sectors

Source: Russian venture capital association, 2012

Within the Consumer market, Energy, Electronics related, Chemicals & Materials, and 0ther industries, the quantity of financed companies ranged from 6% to 4.5% of total deals quantity. The smallest quantity of investee companies was registered (in descending order) in Financial services, Transportation, Biotechnologies, and Ecology industries (approx. from 3% to 0.7% of total deals quantity).

Average investment volume per one company increased and reached $23 M in 2011 ($20 M in 2010). The crisis year 2009 deal size decreased (to $7.4 M), within the previous periods ($12.3 M in 2008, $12 M in 2007, $10 M in 2006, $7.5 M in 2005, and $5.1 M in 2004).

In 2011, the volume of investments increased to $3 billion. Next figure shows that, for Russia, quantity and value for all private equity activities decreased, fundraising, investment and divestment, trough in the beginning of 2009.

Investment activities by stages

In 2011 distribution of investments by the stages of companies development was traditional： expansion, restructuring, and later stages took the biggest part of the deals volume. But the quantity of investee companies was larger on venture stage deals (seed, start-up and early stage).

Thus, at the expansion, restructuring, and later stages were investments to total $2.8 billion (30 investee companies) comparing $270 M at venture stages (105 companies). Proportion of investments at venture stages in the total investment volume remained at the 10% level. In 2010, the investment volumes in the expansion, restructuring, and later stage companies amounted to $2.3 billion (47 companies) and in the venture stage companies – $150 M (81 company).

The major share of investment volume corresponded to the later stage companies. Total volume of investment at expansion and restructuring stages was $980 M (near 30% of total deal volume) comparing almost $1800 M at later stages (near 60%). The same time, the quantity of investee companies at the expansion and restructuring stages was 2 times bigger than for later stages.

Venture stage deals has sufficient growth of investment volumes at seed and start-up stages. Aggregate volume at the seed and start-up stages was near $130 M in 2011 (near $20 M in 2010), and at the early stage – approx. $140 M (approx. $130 M in 2010).

The last Figure Exitsshows us the same declining of activities in venture capital investment. We can see decrease of exits in the industry after economic turmoil in 2008-2009.

Figure Relative fraction of investment of different stages in the total investment volume (%)

Source: Russian venture capital association, 2012

The quantity of seed and start-up deals (85 companies) exceeded the quantity of early stage deals (20) 4 times in 2011 (32 comparing 49, correspondingly, in 2010).

Figure Investment activity in early and later stages of projects

Source: Russian venture capital association, 2012

With the 2011 results the main industry preferences of venture investors were communication and computer sector (near 64% of total venture deals). The same time, in 2010, the main point was on the Medical/Health care branch (near 34%). At the second place, Financial services sector was positioned in 2011 (near 10% of total volume of investments at venture stages), unlike the 2010, when the same place was occupied by communication and computer sector (approx. 33% of total venture stage investments volume).

The third place by the investors’ industry preferences belonged to Chemicals & Materials (near 5% of total venture stage investments volume) in 2011. In 2010, the third place was occupied by Industrial equipment branch (approx. 19% of total venture stage investments volume).

Also in 2011, some venture investors’ activity comparing 2010 was noted in Transportation, Biotechnologies, and Ecology industries.

In 2011, the volume of investments at venture stages increased (approx. by 1/8) comparing the 2010 level and amounted to near $270 M.

Divestments

In the 2011 the funds’ divestment activity was keeping at the level of the post-crisis 2010 year. Exits from 25 investee companies registered.

As regards the exit ways, investors preferred the trade sale of portfolio companies – sale of a company to strategic buyer (9 exits or 36% of total exit quantity).

Due to economic crisis the "write-off" exit way took the second place (5 exits or 20%). 0n the other hand, big "weight" of this parameter is an indicator of market transparency growth.

IP0 entered in the leading three exit ways in 2011 (4 exits and 16%). E.g. flotation of the Yandex company’s shares at a foreign stock exchange took place. The history of this flotation represents a classic example of successful development – from a small company to a giant which finally became a public company. Some PE funds which were investing in the company within several recent years have made material contribution in this development. The one from the bottom place was shared among management buyout and sale to financial investor (correspondingly, 3 exits or 12% of total exit quantity).

Total or partial sale of assets was at the last place in 2011 with the 4% result (one "distressed sale").

Figure Exits

2003

2004

2005

2006

2007

2008

2009

2010

Sold to strategic investor

9

10

7

16

17

20

9

16

Management buyout

11

7

4

1

5

1

1

1

IP0

1

2

0

1

2

0

0

2

Sale

n/a

n/a

n/a

n/a

n/a

n/a

n/a

3

Write-off

n/a

n/a

n/a

n/a

n/a

n/a

n/a

2

Total

21

19

11

18

24

21

10

24

Source: Russian venture capital association, 2012

These overall tendencies observed in Russia may not be equally distributed across the various countries, but they still indicate a negative impact of the crisis in general.

The more specific question of "How do VCs evaluate start-up teams?" – which could provide more detailed insights – has received only little attention to date, leading scholars to call for focused research on VCs’ evaluations of start-up teams (Timmons and Sapienza, 1992; Siegel et al., 1993). Table provides an overview of prior research into the criteria VCs employ when assessing venture proposals.

Table

Author

Sample

Method

Evaluation criteria

Wells (1974)

8 VC

Personal interviews

Management commitment

Product

Market

Poindexter (1976)

97 VC

Mail survey

Quality of management

Expected rate of return

Expected risk

Johnson (1979)

49 VC

Mail survey

Management

Policy/strategy

Financial criteria

Chan (1981)

46 VC

Phone interviews

Management skills and history

Market size and growth

Rate of return

Artus (1985)

102 VC`

Mail survey

Capability for sustained intense effort

Familiarity with target market

Expected rate of return

Goslin/Barge (1986)

30 VC

Mail survey

Management experience

Marketing experience

Complementary skills in team

Robinson (1987)

53 VC

Mail survey

Personal motivation

0rganization/managerial skills

Executive/managerial experience

Rea (1989)

18 VC

Mail survey

Market

Product

Team credibility

Dixon (1991)

30 VC

Personal interviews

Managerial experience in the sector

Market sector

Marketing skills of management

Mullins (2005)

73 VC

Personal interviews

Leadership potential of lead entrepreneur

Leadership potential of management team

Recognized industry expertise in team

Bachher/Guild (1996)

40 VC

Personal interviews

General characteristic of the entrepreneurs

Target market

0ffering (poduct/service)

Shrader/Steier/McDougall/0viatt (1997)

214 new ventures with IP0

Interviews, publicly available documents

Technical education

New venture experience

Focus strategy

Shepherd (1999)

66 VC

Conjoint, experiment (personal/mail)

Industry related competence

Education capability

Competitive rivalry

In this context, two observations seem to be noteworthy. First, the table shows that a wide variety of evaluation criteria have been suggested by the literature. In essence, however, it seems that they can be collated into four major groups, namely evaluation criteria related to (1) the product / service offering, (2) the market / industry, (3) the start-up team, and (4) the financial returns to be expected from the new firm. This observation is mirrored in the findings of Chan (1984), one of the most widely cited works in this area, which identified five basic evaluation criteria used by VCs: market attractiveness, product differentiation, managerial capabilities, environmental threat resistance and cash-out potential. Second, although the existing results are somewhat heterogeneous – VCs consistently rank criteria related to the start-up team among the top three evaluation criteria. This result is already evident in the pioneering study by Wells (1974), who found that management commitment, products and markets were the key evaluation criteria in the VC decision-making process. The results from the large quantity of studies that followed show that at least one, but often two or even all three of the top-ranked criteria pertained to characteristics of the start-up team. For example, Mullins et al. (1996) find that (1) the leadership potential of the lead entrepreneur, (2) the leadership potential of the management team, and (3) the recognized industry expertise in the team were most important in VCs’ evaluations of venture proposals. Artus et al. (1985) also investigated criteria, which would disqualify a venture proposal. Again, the quality of the start-up team was key, as five of the ten most frequently rated criteria were related to the human capital base of the venture. The most recent findings stem from a field study by Silva (2004) which did not provide an explicit ranking of criteria, yet highlighted the fact that the attention of VCs is heavily focused on assessing the quality of the start-up team. The available evidence thus indicates that evaluation criteria related to the start-up team are of major importance in VCs’ decision making. More specifically, characteristics which are frequently mentioned by VCs as desirable features of start-up teams are industry experience, leadership experience, managerial skills, and engineering/technological skills. However, a consideration of existing findings also shows that current knowledge on VCs’ evaluations is still rather general, a critique that has also been voiced by other scholars (Sandberg et al., 1988; Mullins et al., 1996; Ruhnka , 1999). First, we still lack knowledge on the importance of different parameter values of particular team characteristics. For instance, relevant parameter values for the characteristic "educational background" might be (1) all team members have management education, (2) some have management education/some have engineering education, and (3) all have engineering education. Similarly, relevant parameter values for "industry experience" might be (1) all team members have industry experience, (2) some have industry experience, and (3) none have industry experience. However, the available results do not reveal the relative preference VCs attach to these parameter values. Second, the existing results cannot reveal utility trade-offs between different team characteristics. For example, if a team lacks leadership experience, which potential strengths might compensate for such a shortcoming?

In summary, as knowledge on the parameter values of particular team characteristics and on trade-offs between different team characteristics is key to understanding VCs’ evaluations of start-up teams but still lacking, the first goal of this paper is to provide a focused exploration of team evaluation criteria.

A recent study by Shepherd et al. (2003) suggests a second important extension to research on VCs’ evaluations of venture proposals in general and the evaluation of start-up teams in particular. Drawing on cognitive theory, Shepherd et al. find that the experience of VCs has a significant impact on their decision making. Human capital is one of the most important but difficult areas to assess in venture proposals (Kozmetsky et al., 1985), novice and experienced VCs may differ in their evaluation of start-up teams.

Cognition research provides valuable insights into the development of expertise in decision making. To arrive at a judgment, decision makers select, combine, and evaluate information cues (Spence and Brucks, 1997). The way in which information cues are processed is influenced by an individual’s cognitive structures (schemata). A schema is an organized network of knowledge that includes concepts, facts, skills, and action sequences (Gagné and Glaser, 1987). Schemata thus play an elemental role in all cognitive activities, such as predCommunication and Computering, explaining, and developing opinions.

Prior research shows that individuals refine their schemata in various ways as they acquire experience in a particular domain. For example, Lurigio and Carroll (1985) suggest that experienced individuals possess more complete and detailed schemata than inexperienced individuals. Experienced individuals also group domain-specific knowledge in more meaningful ways than those with little experience, will draw on clearer concepts, create richer connections between concepts, and will be able to apply domain-specific problem-solving procedures they have developed over time (Adelson, 1981). For instance, they will learn about the importance of different dimensions of a decision problem (Shepherd et al., 2003). With respect to the evaluation of start-up teams, this suggests that VCs will become increasingly knowledgeable about the question of which team characteristics are required for successful new firm creation.

Research on VCs’ decision making has not yet explored whether differences exist between the evaluation of start-up teams in general case and in case of specific industry as medical or pharmaceutical projects. However, knowledge on the existence and direction of such experience effects would be key for theory development on VC decision making and also for VC practice and start-up teams. In particular, if it turns out that experience effects play a considerable role in VCs’ evaluations, future studies would need to control for that variable.