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Venture Capital investment framework

Joe D asked on Jun 24, 2019 - 2 answers

Team,

What is the best framework to answer VC investment question? For example: VC fund is considering a Series A investment in a pre-profit company X that produces kid-friendly smartphones. Should they invest?

Thank you.

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Sidi
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replied on Jun 24, 2019
McKinsey Engagement Manager & BCG Consultant | Interviewer at McK & BCG for 7 years | Coached 100+ candidates secure MBB offers
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Hi!

From your question, I believe you still need to understand how to think about strategic business issues. VC cases (or PE cases, or any other investment scenarios) are completely identical to all other strategic issues, and hence I believe it is completely senseless to ask for specific "frameworks" (the same is true for "market entry frameworks", "product launch frameworks" and all the other nonsense stuff that is floating around). As an MBB consultant, you also would not use a "framework" in real life! You just need to understand the core of the problem.

If the question is whether a VC fund should invest in a target, then, in essence, you need to check whether the return on your investment exceeds the minimum ROI required by the client (the fund). This return depends on how the fund actually intends to makes money - does it extract operational profits, does it intend to exit after a certain time frame, or both?

So you need to check whether the money inflow created in the future will be enough to justify the investment that has to be made today (most probably via the future resell price, since this is how VC firms usually make money). The resell price depends on the future valuation of the target, and this valuation in turn depends on a certain base metric (most probably "expected profit generation"). So this is what you need to analyze and quantify in the case. This is best done via a rigorous driver logic, visualized by means of a driver tree.

The interesting thing is that this principle thinking frame is not only true for VC or PE or M&A situations, but for 90% of all strategic decision cases that you will ever encounter (market entry, new product, capacity expansion, licence purchase, etc. etc.). It is always about value creation! If you learn to rigorously start your thinking from the principles of value creation, the typical case frameworks from well-known books like Case in Point etc. become practically obsolete, while at the same time your thinking becomes way more rigorous and mature.

Then for the structuring, there are a couple of simple notions that you need to adhere to in order to effectively set up and navigate strategic cases (for example, contrary to what is taught in the popular books, NEVER start with qualitative questions like "first I would like to understand the market context..." - this is exactly how you should NOT work as a consultan! This would be the definition of "boiling the ocean" ;-))

Cheers, Sidi

Sidi, with all the respect, what you are saying is not applicable for early stage investment and it's not how the early stage VCs make their decisions — Vlad on Jun 25, 2019

See my reply below. :) — Sidi on Jun 25, 2019

Vlad
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replied on Jun 25, 2019
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Hi,

Can't agree with Sidi here. At the early stages, VC funds are not looking for ROI of the particular investment but rather ROI of the whole portfolio. In most of the cases, it's 1-2 companies out of 10-15 that generate ROI. The key things to look at the early stages:

  1. Team (Industry expertise, Previous exits, insights)
  2. Problem / solution (Timing, Insight, defensibility, etc)
  3. Traction (MRR, LTV, CAC, etc) or early signs of traction (MOUs, etc)
  4. Market size (ideally >1B), TAM, SAM, SOM. Competition

Best!

Not sure I can follow on the disagreement. You are right on how VC funds mostly generate their return. It doesn't change the principle though! It would just mean that the logic I described has to be applied to the entire portfolio - but if you look at the starting question, this is not the scenario described above. In fact, looking at the 4 areas that you outline, they all make perfect sense, but at the same time they are all corollaries of the logic I described above. — Sidi on Jun 25, 2019

I put there exactly the 4 points ser A investors are looking at. Early stage investors are making the decision based on the framework they internally develop. They are not trying to assess the exact "expected profit generation" at this stage in most cases. In other words - you'll fail interview with any VC if you start assessing the company by doing the valuation and trying to estimate the cash flows — Vlad on Jun 25, 2019 (edited)

If we are talking about a VC interview then I agree. If we are talking about a consulting interview with a VC setting, then not. — Sidi on Jun 25, 2019

That's why consulting digital ventures are such a failure:) But I would always recommend answering the correct way - and not in a way consultants expect to hear. You never know how experienced is a person on the other side of a table. One of my candidates started with ROI and failed because the interviewer wanted him to look at the team first. And that's right. Most of the investment decisions at this stage are made by reading the presentation from your phone, not calculating ROIs — Vlad on Jun 29, 2019 (edited)

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