illustration by Peter Arkle

When Professor Paul Gompers began studying the venture capital industry in the late 1980s, colleagues often wondered why. “They’d say that it’s such a backwater and unimportant industry,” he recalls. With more than $127 billion invested worldwide in 2016, venture capital and its place in the business ecosystem has changed significantly in the intervening decades. Two recent working papers explore those changes—Gompers’s survey of decision-making at hundreds of VC firms and Professor Ramana Nanda’s study of the modern era of venture capital—and put hard data to a sector that thrives on anecdotal evidence. Here, the professors discuss what their findings mean for entrepreneurs, venture capitalists, and innovation.

Today, the VC industry is still small in absolute terms: Less than one quarter of 1 percent of companies receive venture capital funding. Why is the VC industry so influential?

Paul Gompers: From the early 20th century to the mid- to late-20th century, most innovation happened in large firms. Then because of both managerial and organizational changes, innovation in large companies started to decline. It’s no longer the case that you can rely on the IBMs or the RCAs of the world to continue to create innovations and job opportunities. Think about the number of firms that wouldn’t be here and the number of technologies that wouldn’t be here without venture capital. The innovation that affects consumers and enterprise today happens in the context of venture-backed companies.

Professor Nanda, you’ve identified 2006 as a turning point in venture capital investing. What happened then, and how did it change the decision-making process among venture capitalists?

Ramana Nanda: In the mid-2000s, the early-stage investing landscape changed quite centrally and rapidly: The number of early-stage ventures that people were backing had exploded. Young, inexperienced teams were getting a chance to try their ideas in a way that hadn’t happened as much in the past. Why?

Reading the literature and speaking to practitioners, we came upon the introduction of Amazon Web Services in early 2006. This was the defining moment when the cost of starting consumer internet businesses really plummeted.

That fact was very useful in rationalizing other things we saw happening: VC investing across stages is effectively a series of real options. When the cost of starting firms falls, this lowers the cost of the option, so you will take on higher option value projects. You will potentially take on more of them and focus less on governance in the early stages. It’s what is known as a “spray and pray” investing style, and it has been embraced by a number of VCs: We’re going to take a lot of bets early on, and most of those aren’t going to pan out, but the ones that do will be very successful. That was new.

More than 10 years later, how has this continued to shape the VC sector?

PG: Twenty-five years ago, the venture industry was pretty homogeneous in size, scale, and scope. Today, we see a specialization in activity: There are those who are really good at supporting large numbers of relatively inexperienced entrepreneurs, and then there are those that specialize in scaling businesses and are willing to write big checks.

RN: And some of the changes we’ve seen with the consumer internet sector are now beginning to happen in other industries. If you look at hardware, rapid prototyping has really revolutionized the way hardware startups are built. The burgeoning space sector, for instance, is being propelled by a massive fall in the cost of building and launching satellites.

But one thing I’ve been interested in is, have VCs gotten too caught up in chasing the cheap experiment sectors? Who will fund the big, expensive, life-changing, pathbreaking technologies?

Professor Gompers, your survey asked about something that is conventional wisdom: VCs are investing in the management team, not the business idea.

PG: This debate has been going on in academic circles for a long time: How much is the jockey, the team, versus how much is the horse, the business opportunity? What’s interesting is that, except for health care—health care venture capitalists are more likely to put far more weight on the horse—it is clear that the primary determinant in investing is the jockey. It’s all about the people. There are lots of opportunities out there, but it’s those people who can execute on those opportunities that are absolutely central to the ultimate success of those ventures.

As the cost of starting a company has gone down, and so many first-timers and much younger entrepreneurs are starting companies, how do you identify, in a 25-year-old without much experience, whether she or he is a skilled, competent entrepreneur? That’s the next question: What is it that VCs are actually looking for?

You also address another commonly held idea about the VC world: Investments are not always made based on the numbers.

PG: In first-year Finance and second-year Private Equity Finance, and lots of other finance-related courses, I’ve spent so much time teaching the tools that are based on theory. What is really interesting is that professionals in lots of industries, in particular the VC industry, totally disregard them. Using derived cost of capital and discounted cash flows, perpetuity growth rate, terminal value just doesn’t happen.

It’s often the case that hot venture sectors get too much money, that too much money chases too few deals and drives up prices. It’s being driven by the fact that the markets don’t exactly follow the way our theories say they should. So the real question is, not do VCs take financial theory explicitly into account, but rather, do their actions intuitively take it into account?

What practical guidance can entrepreneurs and venture capitalists glean from this research?

RN: Because of the bifurcation in fund size and fund strategy, it has become even more important for entrepreneurs to think about those dynamics as they build their board. Sequoia and Andreessen Horowitz, for instance, have a very different incentive for exit than some of the more traditional VC firms. They would be much more willing to go for a huge return—or zero—than take a sure $100 million exit. Other VCs have a reputation for being quicker on the trigger. Think about what aligns with your interests.

PG: There’s a greater menu of choices today than there would have been 15 or 20 years ago. Be informed. Twenty-five years ago it was harder to get information. Now, there are all sorts of places where entrepreneurs can go to learn that this particular VC has a penchant for doing something. Entrepreneurs need to become better consumers of capital.

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