For Startups, the First $1 Million Is the Easy Part

You coauthored a recent paper with Penn State’s Young Soo Jang, in which you find that it was a lot easier than you had anticipated for startups to raise funds early on. Does that mean venture capitalists aren’t as discerning as they should be?

The data in this paper came from a fund in the Midwest that invests at the seed stage, early in a startup’s life before there’s revenue. Between 2016 and 2020, it considered over 8,000 companies and only invested in a hundred or so. We looked at what happened to the ones it didn’t invest in, and found that roughly 30 percent received VC funding of some sort, according to PitchBook data. For a startup, this suggests that if you talk to enough VC funds, you have a reasonable chance of finding one that will invest. 

It could be true that VCs are not so discerning. A second and related explanation could be that there was an unusual amount of VC activity during the period we studied. Finally, this particular fund wasn’t looking at random deals, but at more promising startups, deals that came to them through their network or their own scouting efforts. My guess is that a bit of all three account for the high funding rate.

You were part of another research team that surveyed VCs to find out what they look for in an investment. What did that reveal?

This work is with Paul Gompers of Harvard, University of British Columbia’s Will Gornall, and Ilya Strebulaev of Stanford. We asked VCs to choose what was most important: sourcing a deal, selecting a deal, or adding value to the deal. If you generalize, the VCs felt the most important thing was selecting the right deal. Roughly half said that, while sourcing and adding value were most important for about a quarter each. 

This touches on a big debate: In that selection process, do VCs bet on the team or the business? There are a couple of papers that say it’s the team. I have other research, from 2009 (with Vanderbilt’s Berk Sensoy and the Stockholm School of Economics’ Per Stromberg), that said it’s the business. In the first survey that Paul, Will, Ilya, and I sent out, in 2015 and 2016, about 60 percent of respondents said the team mattered more in their investment decision. We also asked them what was most important for success after the investment, and they again said the team, by a similarly wide margin. However, when we redid the survey in 2020, team and business were roughly equal for both investment and success—half the VCs said it was the team; half said the business. 

Do you have a sense of whether the team matters more earlier on?

In the PitchBook data from our study of the Midwestern VC, Young Soo and I find that the team predicted which startups would raise the first $1 million, but when it came to raising at least $10 million, the product was the most predictive. The market helped a little bit, but the team didn’t predict anything. This suggests that a team may get you going, but without the right product and market, you can’t raise the big money.

Steve Kaplan is Neubauer Family Distinguished Service Professor of Entrepreneurship and Finance at Chicago Booth.