Chicago Booth Review Podcast What Investors Look for in a Startup Pitch

Steve Kaplan: The odds that a venture capitalist invests in it, it's something like 100 to 1. Depends on how you do it, but 100 or 200 deals for everyone that invests in. So you'd say, "Okay, 30% just means they're talking to a lot of people." Everyone's talking to each other, and at least in this time period, 30% of them got funded, which was surprisingly high.

Hal Weitzman: What do start-up founders need to do to get venture capitalists to invest? Do VCs invest in the right team, or the right idea? Do they invest where they can add value or do they try to pick new businesses that are going to be winners from the start? Welcome to the Chicago Booth Review Podcast, where we bring you ground-breaking academic research in a clear and straightforward way.

I'm Hal Weitzman, and today I'm talking with Chicago Booth's Steve Kaplan, Faculty Director of the University of Chicago's Polsky Center for Entrepreneurship and Innovation. For years, Kaplan has surveyed venture capitalists to find out what they look for in start-ups, and he has a framework he uses to advise both founders and funders on how to pick winning companies.

Steve Kaplan, welcome back to the Chicago Booth Review Podcast.

Steve Kaplan: Thank you, Hal. Great to be here.

Hal Weitzman: Now listen, you had a piece for us, a great piece that you wrote for Chicago Booth Review in 2019 when you talked about watching start-ups pitching to venture capitalists in the 1990s, way back in the dark ages. You wrote, "The entrepreneurs would spend 40 minutes of the 45 minutes they had describing their product, solution, or team, and it wasn't until the last five minutes they got round to talking about customers. Sometimes by that point became clear they'd left that to the end, because they didn't have any customers."

So then you came up with this framework known by the acronym OUTSIDE-IMPACTS. We'll talk a little bit about that, but I'm interested to know, were you trying to help entrepreneurs or were you trying to help investors? Were you trying to help entrepreneurs think like venture capitalists so they could pitch to them better?

Steve Kaplan: I mean, it's clearly both, and I've had students who've done both. The framework is very useful for investors because it is basically the framework that venture capitalists use when they make investment decisions. And based on reading a number, I think it was 69 investment memoranda from different venture capitalists and also observing them and surveying them, what do venture capitalists do? What do they look for? And if you're trying to teach students who want to be venture capitalists, that's a very useful thing to be able to do. So it's very useful for venture capitalists. And on the flip side, if you're an entrepreneur, it's also extremely useful for a couple of reasons.

First, it's useful because you want to know how you're going to be evaluated. If you're looking to raise money from venture capitalists, you want to know, okay, here are the things I'm going to have to convey in order to get them interested, number one. Number two, and this may be more important, is if I'm doing a startup, the framework basically is telling you, is the startup going to be successful? And so if you go through this framework and it tells you this is not going to be successful, just stop. Stop, don't do it. Go do something else, or fix it.

Only if the framework tells you this is great, it's going to get funded, then you say, "Okay, let's full speed ahead and let's make sure I nail down some of these particular criteria."

Hal Weitzman: And the framework is all about the business model basically, isn't it? Is the business going to succeed, like you say, just get-

Steve Kaplan: The framework includes the team.

Hal Weitzman: And the team.

Steve Kaplan: The team is a big, so you need both the-

Hal Weitzman: Absolutely.

Steve Kaplan: As you said earlier, the team and the idea.

Hal Weitzman: I guess the question I was going to ask is have things improved since the 1990s? Are the entrepreneurs better at pitching now than they were then?

Steve Kaplan: For sure. The entrepreneurs who go through the new Venture Challenge-

Hal Weitzman: Of course.

Steve Kaplan: ... at Chicago Booth are much better because we do a better job of preparing them and teaching them. And the new Venture Challenge process every year gets better. Short answer is at Chicago Booth, absolutely, yes.

Hal Weitzman: Okay, great.

Steve Kaplan: And in the real world, I would guess yes.

Hal Weitzman: I mean, there's a more infrastructure, isn't there?

Steve Kaplan: There's a lot more. There's more infrastructure, there's more information. You can go on the web and you can listen to me on the web. You can listen to other people who are very knowledgeable. So I think the answer is, yeah, the pitching is better.

Hal Weitzman: Okay, so I know our listeners will want to revisit that essay from 2019, but just remind us about the framework, OUTSIDE-IMPACTS. What does it stand for? What are the key points?

Steve Kaplan: So the key points, O is about the opportunity, which is basically the business, and IMPACTS are the pieces of the opportunity. So I is the idea, you want to be able to explain what you're doing succinctly. M is the market, and you want to understand what is the market I'm attacking? Is it a big market? Because the bigger the market you have, the more mistakes you can make and still make money. P, I'll come back to. A is acceptance, A is basically will you get customers, and can you make money getting those customers?

Hal Weitzman: Will you get customers or have you got customers?

Steve Kaplan: Ideally, you have customers. If you're a raw startup before you have, when it's just an idea, you want to convince yourself you'll get customers. So really that's stage dependent, is understanding will you get customers or do you have them and can you make money once you get them? C is competition, so anytime you start something and it succeeds, you're going to get competition. T is timing, and this is something I always ask. If it's such a great idea, why hasn't someone done it already? And so that's a very University of Chicago type question.

Hal Weitzman: The economist's question.

Steve Kaplan: But the answer, and the answer is usually, yeah, that's why it's technology, right?

Hal Weitzman: Right.

Steve Kaplan: Technology changes, and that's why startups usually come with technological change because that's why it hasn't been done before, you couldn't. S is speed, right? You want to be able to do something in two, five years, not 50. And so that's impacts, or that's impacts without the P. And the P is thinking about what's proprietary or what's really positive about this that creates value. It may be that there's, you have a technology no one else has. That would be a big P. It might be a business where you're the first mover, and once you get in, there are network effects or switching costs or both, and it gives you a real advantage if you get there first. You always want to think about P, because if you don't have P, then you're going to be vulnerable to C, which is the competition and so those go together.

Hal Weitzman: Right, it's like your moat.

Steve Kaplan: It's a moat.

Hal Weitzman: Okay, so that-

Steve Kaplan: But that would not be IMPACTS, that would be IMACTS so it didn't work, so I had to make a P.

Hal Weitzman: Right.

Steve Kaplan: So that's O, then you have U, which is uncertainty or risk. The investors are always going to say, "What's uncertain? What am I worried about? What's risky?"

And actually, most of the investment memos are very funny. They would say, they would always have positives, "Here's what we like." And they would always have negatives, "Here's what we're worried about."

And so you want to understand as an investor, okay, what are you worried about? And that's where you focus your due diligence. And if you are the entrepreneur, the things you don't know, try to resolve them and get information. So you reduce the risk for investors, but as importantly, for yourself.

T is the team. Can this team do it? And if it can't, can you get pieces or people to join your team who are going to be able to do it? S is the strategy, so that's, I'm going through OUTSIDE now. S is strategy, because in many startups, the strategy is not clear from the start, what exactly are you going to do? And so it's really figuring out what's the strategy, how do you get product market fit. I is investment, and that's really how much money do I need and do I make money? Do my investors make money? D is the deal, which you may or may not, if you're an investor, then you're looking at a deal. The entrepreneur, you may not have that yet. So that's really about once you're negotiating a deal, and E is exit, can I get my money back? Is there someone who can buy it? Can I take it public? What's my exit? And so that's OUTSIDE-IMPACTS.

Hal Weitzman: Okay. This is all good advice. Tell us, you looked at real data. Have you refined your approach, your framework using the real data?

Steve Kaplan: The framework came from real data, and so that framework had a first version of it probably 25 years ago, and it's still right. The details changed, right? AI didn't exist 25 years ago. The internet did, mobile, then mobile came. The framework really hasn't changed. I think I've done research to look at the different pieces of that. And there's always a question, it was question 25 years ago, it's still a question today, what matters more? The idea or the opportunity or the team? So is it O or the T? And I've looked at data on that. I have a particular opinion there, although there's a lot of difference of opinion on that.

Hal Weitzman: Okay. Well, I want to get into that, but before that, there's a more recent paper that you wrote looking at VC funding. This is fascinating because it seems to suggest that it was easier than you had anticipated for startups to raise funds early on. Tell us what you found out and what was surprising about that.

Steve Kaplan: This is a paper that I wrote with Young Soo Jang, where we got all of the deal flow of a Midwest venture capitalist who tried to invest in very early stage deals in the Midwest, and tried to see every deal they could possibly see or every deal in the Midwest. We ended up in that sample, there were about 5,000 deals that they looked at over, I think it was a five or six year period. They only invested in a hundred of those 5,000 so it was very small number, but with PitchBook, which is a database, probably the best database of private companies now, you can actually follow what happened to these companies.

And what was surprising is of those 5,000 companies, roughly 30% actually raised some venture capital, which was, I think we used a million dollars or more. And that was surprising because when a company looks to get venture capital, the odds that a venture capitalist invests in it, it's something like 100 to 1 that a venture capitalist will look at. Depends on how you do it, but 100 or 200 deals for everyone it invests in. You'd say, "Okay, 30% just means they're talking to a lot of people." Everyone's talking to each other, and at least in this time period, 30% of them got funded, which was surprisingly high.

Hal Weitzman: So does that mean if you're persistent enough, you keep shopping the idea around eventually you'll get funding or you've got a good chance of getting funding?

Steve Kaplan: It's not clear. It may mean that they were looking at firms that they thought were serious, and the ones that were not at all serious, they didn't look at, so you don't know exactly where that comes from. It does suggest that if you are persistent that there's money out there, so it's not hopeless, even though it's hard. It's hard, but it's not hopeless.

Hal Weitzman: Well, that's good if you've got a one in three chance of getting a million dollars, I would've thought that's a pretty good deal for most outfits.

Steve Kaplan: Yeah, that's why it surprised us.

Hal Weitzman: Okay. But as you say, that may be slightly-

Steve Kaplan: There's some selection there, but it was a bigger number than I would've expected.

Hal Weitzman: That proportion you talked about, they looked at 5,000 deals and they invested in 100, is that typical?

Steve Kaplan: Yep. So that would be, what is that?

Hal Weitzman: When you say looked at-

Steve Kaplan: That'd be 1 out of 50.

Hal Weitzman: When you say looked at 5,000 deals.

Steve Kaplan: 5,000 deals came into their system, which means somebody either they, and there were three ways that they got deals. Number one, they got deals from co-investors, so someone who they work with sent them deals. That may be part of the reason the numbers are high. These are deals that other investors have validated, second, deals that they went and found. So this would be things like they come to the new Venture Challenge and look at deals there, and the ones they were interested in, they'd log in. And then the third was deals that were referred to them by their network. So these are all going back to the 30%, these are of the 5,000, they're getting there with some, some.

Hal Weitzman: And the new Venture Challenge, the Booth Entrepreneurship Composition being a good example, because to get to the final there, you have already-

Steve Kaplan: There's certainly some screening, exactly.

Hal Weitzman: You've already been screened several times, right?

Steve Kaplan: Exactly. That's why the 30% is hard to interpret other than if you're in that group that's been screened or has a relationship or whatever, it's actually higher than I would've thought.

Hal Weitzman: I was just wondering if we were to conclude that VCs are not screening startups appropriately, but maybe they've been pre-screened.

Steve Kaplan: Those 5,000 have been somewhat, there's certainly some pre-screening there.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago Podcast Network show that you should check out. It's called The Pie. Economists are always talking about the pie, how it grows and shrinks, how it's sliced, and who gets the biggest share. Join host Tess Vigeland as she talks with leading economists about their cutting edge research and key events of the day. Hear how the economic pie is at the heart of issues like the aftermath of a global pandemic jobs, energy policy, and much more.

Steve, in the first half we talked about your framework, OUTSIDE-IMPACTS, for measuring whether startups are likely to succeed or have a chance of succeeding. And then we talked a bit about venture capitalists and the fact that actually it may be easier than we think to get funding for startups depending on how you think about it. So another question, fundamental question that we posed in the introduction is about whether venture capitalists succeed because they add value or whether they succeed because they're just good at choosing really good promising ideas. Well, what does your research say about that?

Steve Kaplan: I'd say the evidence is it's, there are three things that venture capitalists do that are all important. One is sourcing deals. So which deals do they source? And we saw in this case, the firm saw 5,000 and there were some selection probably in who they saw, so they weren't just seeing a bunch of dry cleaners and restaurants, they were seeing legitimate companies or companies that were potentially interesting. So number one is sourcing, what do you get to look at?

Then number two is of the ones you get to look at, who do you select? And the third thing is once you select them and you've invested, do you help them? And so when we did a survey of this, it was 10 years ago now, we surveyed hundreds of venture capital firms and we asked them, "Were these three things important?" And basically all of them said all three of those were important.

And then we asked them which was most important. And what was interesting was 25% said sourcing was most important. 25% said adding value afterward was more important, but 50% said that selection was most important. When people ask me what's most important, I'll say they're all important, but if you survey enough venture capitalists, they're saying that selection is the most important, and actually, the better venture capitalists actually put a higher weight on selection than the average venture capitalists.

Hal Weitzman: What is it that they're selecting? Are they selecting the ideal, or the people?

Steve Kaplan: This is where, again, there's a difference of opinion. We asked in this survey, and then again, in a subsequent survey in 2021, do you select more on the team or more on the business? And in the first survey it was 60/40 selecting on the team. So 40% were selecting most on the business, and I should say they're looking at both. So all of them, they want a good team and a good business. But then again, we said, which is most important? In that first survey, it was 60/40 in favor of the team. The second survey was about 50/50. Again, you have different VCs have different strategies, so you would have, some are saying selection is the most important, and then some of them are selecting on teams, some of them are selecting on the business.

Hal Weitzman: But it's interesting, I mean I think the folk wisdom is you invest in people. And so when you're investing, you back a person. And what you're saying is that is somewhat true, but the 50% are based of investing based on the, or principally based on the idea. Does that mean they-

Steve Kaplan: Or not principally, but if you had to choose-

Hal Weitzman: Not the most important, right.

Steve Kaplan: On the margin, do you pay more attention to the idea or the people?

Hal Weitzman: Does that mean that-

Steve Kaplan: It's 50/50.

Hal Weitzman: ... if you're investing in terms of the team, does that mean that you are accepting that the idea may change, they may pivot into a slightly different idea?

Steve Kaplan: The idea may change, I'm not sure I love the idea, but I love this person and he or she's going to figure it out. I think that's, one, he or she's going to figure it out. I don't quite know what they're doing or I don't know whether I love what they're doing, but I trust that they will either, number one, they'll change if they have to. And number two, that they are really good so this idea that I'm not so sure of because they're so good, this is a good idea.

Hal Weitzman: And then conversely, if I invest principally, or if I had to choose, I would choose the idea, does that mean that I think, well, if it doesn't work out with these people, I still love the idea it could work out with a different team.

Steve Kaplan: It's two things. It's first of all, this idea is terrible. I don't care how great this person is. The idea is terrible, right? It's hopeless. That's my view. If I see an idea I don't like, it's like, "I don't care how great you are. I don't like the idea."

I think the other thing is too, and you see this occasionally, is it's a great idea. The original founder is not the right person. He or she takes it a little bit of the way, and then you bring someone else in who can run it.

Hal Weitzman: I think there's research about that, right? About whether this whole thing about the jockey or the horse, the person, the team, or the idea that depends on when you're investing, right? In the early stages, the person could be more important than the idea. And then that swaps over later on. Is that right?

Steve Kaplan: Can be. I mean, the early paper I wrote, which was a 2009 paper, so this is going to be transactions before 2009. For companies that went public, they were almost always doing the same thing they were doing when they got their venture funding, meaning the business rarely changed. Sometimes it expanded, meaning they started in one thing, they stayed there, but then they expanded around it. Sometimes it was exactly the same, but you did see founders, sometimes the person running it was a founder, sometimes not. So there was much more movement of the founders than there was of the business. And I think you can think about it, look at Apple still doing what it was doing 50 years ago or 45 years ago. Microsoft, it's expanded, but it's still, core business didn't change. Starbucks' core business didn't change and they've had different people running it. That's what I saw on the data. I still actually believe that.

Hal Weitzman: Fascinating. All right, one other nugget I wanted to ask you about. In your study of the company that looked at 5,000 deals and passed on 4,900 of them, they passed on deals they deemed uninteresting, and then it turned out those startups weren't successful. What makes a startup uninteresting?

Steve Kaplan: I'm trying to think if I know exactly what they did, but as I recall, uninteresting means it's not doing very well on OUTSIDE-IMPACTS.

Hal Weitzman: I see.

Steve Kaplan: Uninteresting would be the product's not interesting, the market's not interesting, the team's not interesting. It would just be uninteresting.

Hal Weitzman: Basically, I'm not interested.

Steve Kaplan: I'm not interested, exactly.

Hal Weitzman: It turned out that those startups weren't successful, so that proved to be correct.

Steve Kaplan: Well, so what you see in this data set is there are three different categories. First of all, the ones they looked at in didn't really evaluate. Then they evaluated close to 400. Of the 5,000, they actually evaluated 400 of them and they rated them, they rated the team, they rated the product, they rated the market. And of those 400, they invested in, I think 115 and then they passed on the rest. So you have these three buckets. You have uninteresting, you have evaluated, but didn't invest and evaluated and invested. And what's-

Hal Weitzman: So all the 4,500 were uninteresting, is that right?

Steve Kaplan: Or they didn't invest or they didn't evaluate, right? So they didn't go to do an evaluation.

Hal Weitzman: The due diligence, right.

Steve Kaplan: And so what is nice about the, I don't know if it's nice, the venture capital firm was happy when we told them the results is that the ones that they didn't evaluate did the worst. The ones that they evaluated but didn't invest in did better, and the ones they evaluated and invested in did the best. Now, it's still the case that many of the ones they evaluated and invested in didn't succeed, but their success rate was higher than the success rate of the group they evaluated and didn't invest in, which was greater than the success rate.

Hal Weitzman: When you say success, you're talking about getting more funding, or you're talking about launching as an independent business, or how do we define the success?

Steve Kaplan: The success rate is also, is maybe a work in progress. We just, we've updated it through the end of 2024. The original version was through I think the end of '22. And so these investments were made largely between 2016 and 2020 so many of them have not been exited. There've been a few that have been exited, but many have not. The ultimate outcome is unknown. And so what we do in terms of measuring success is did the company fail? That was not successful. And then did the company raise, we have 1 million, 10 million, 25 million, 50 million. Our view is that the ones that are going to be the big successes raise $10 million or more because if you're scaling, you're going to raise more money, and it's certainly the case that the ones that raised 10 million or more have at least been written up as being valued much more than when they were invested in. Going back to what we discussed in another podcast about how investments are marked, the investments that have raised more than 10 million have been marked up quite a bit.

Hal Weitzman: Steve, you've been studying this topic for decades and you've been advising startup entrepreneurs for decades as well. Give us three pieces of advice you would give to someone thinking of pitching their own venture.

Steve Kaplan: Three pieces of advice. I would say number one, convince people that you are solving a problem that is going to get customers. So that is number one. If you have customers use them. So I've had students present their business and say nothing about their customers, and then I ask them after, "Do you have any customers now?"

"Yeah, we have some customers." You didn't tell us about them.

So if you have customers, just start with that. "I have customers and here's why I have customers."

If you can't say that, and if you're a raw startup, you maybe can't say that, tell me why you think you're going to get customers. And that's where you say, "Here's what people use now it's broken, here's what I'm building and here's why they're going to love it."

Or, "I actually went and talked to people and they said they're going to use it." So number one, convince people you are going to get customers.

I would say number two if you, there's probably four. I'd say number two, convince me that it's a big market so it can get big because that's going to be very attractive, but that's what's going to attract the best investors. There's a big idea, it's going to get big.

Three, convince me that you're the right person. And that involves being somewhat enthusiastic, being able to convince an investor that you're going to be able to build this thing. And again, for the investors who care about the team, so you figure half the investors are going to care about the business, half are going to care about the team. You want to convince them you're the right team member. So don't go in like this, but go in like... Have some enthusiasm, and convince them you'll be able to build a team.

And then the fourth thing is P, why are you going to succeed when there's going to be competition? There may be something existing out there. Why will you win versus everybody else?

Hal Weitzman: All right, Steve. Well, great advice for all people wanting to start up a company, pitch it, get funding, go big, and we'll remember OUTSIDE-IMPACTS. I encourage our listeners to go and check out that piece you wrote for us back in 2019. Thanks again, Steve for coming on the Chicago Booth Review Podcast.

Steve Kaplan: Great, thanks for having me.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis, and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research.

This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe, and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.