Venture capital (VC) plays a huge role in supporting and scaling startups, often serving as the financial backbone in a company’s early days. It’s often a catalyst for transforming a new startup from a promising idea into a successful and established company. But it’s not easy to come by.
Behind every VC deal is a rigorous, complex decision-making process that involves assessing risks, analyzing opportunities, and, most importantly, placing strategic bets on the future. The process is far from straightforward, and it often feels like a black box. Perhaps less so these days, as VCs continue to open up. But, generally speaking, it can feel like everything is going on behind closed doors for founders.
We know that venture capitalists rely on a mixture of data-driven insights, intuition, and experience to evaluate potential investments. But no matter how detailed the analysis, uncertainty is always a factor. Much like trying to develop a biotech product. Even seasoned VCs face the challenge of balancing optimism with reality, all while navigating a sea of unpredictable market conditions and entrepreneurial ambition.
In this post, we’ll walk you through the critical steps VCs take when making investment decisions, from deal sourcing to managing portfolio companies and eventually exiting investments.*
We’ll also shed light on a significant flaw in the investment forecasting process—an insight that reshapes how we view the inherent risk in venture capital and startups.
Numbers and Percentages are credit of: Chris Tottman and the National Bureau of Economic Research.*
Before any investment can be made, venture capitalists need to fill their pipeline with potential deals. This is a key step because the quality of the deals they source often determines the quality of their investment portfolio. Deal sourcing is a mix of active searching, inbound opportunities, and relationship-building.
VCs generally rely on key sources like their networks and other investors for deal flow. The percentage breakdown is as follows:
According to Chris Tottman and the National Bureau of Economic Research, out of 100% of deals in a year, 31% are from professional networks. But remember that these are not total closed deals, mind you. These are total deals. In a particular year, there can be something like 200 deals considered by a VC, but maybe only one ends up closing.
A typical VC firm reviews hundreds of potential investments each year. For example, out of 200 companies considered annually, around 25 might be brought to management for further review. Of these, 8 might make it to a partner meeting, 4 to the due diligence phase, and just 1.7 investments close on average.
This selective process shows how important it is for VCs to maintain a robust pipeline of high-quality deal flow. Without a steady stream of opportunities, a firm risks missing out on the next big company.
Once a venture capitalist has sourced potential deals, the next step is evaluating which companies should be targeted as a worthwhile investment. This process goes beyond the surface-level attractiveness of a product or market.
VCs rely on sets of specific criteria to determine whether a startup has the potential to deliver substantial returns. These can include:
The most important takeaway here is that almost every startup a VC looks at, they will take a really close look at the startup’s management team. For investors, management is an incredibly important thing to get right, and a huge reason why you see deals move past the consideration phase.
VCs will also obviously conduct extensive due diligence, analyzing everything from financials and legal structures to the startup's competitive landscape. The goal here is to identify potential risks and understand the company’s ability to execute its business plan. But ultimately, investment selection is not just about betting on an idea, and the potential profitability of the idea—it’s about betting on the right people with the right strategy to turn that idea into a market success. This is why VCs often emphasize team strength as a major factor, in addition to financial metrics.
Determining the value of a startup is one of the most complex and critical aspects of venture capital investing. VCs must assign a valuation that balances the company’s potential for growth with the inherent risks of investing in an early-stage business. Valuation sets the stage for negotiations on ownership percentage, deal terms, and eventual returns.
Valuations typically rely on several key metrics, particularly for later-stage companies. The percentages here represent how much of the time you’ll VCs use each metric to help determine a company's worth, as well as the weight of importance:
VCs also evaluate several qualitative factors when determining a company’s worth:
VCs are looking for specific target returns. This is the return they expect on each investment. A commonly sought-after target is an average required cash-on-cash multiple of 5.5x. The anticipation of a significant return is why valuation is so important; it can set the foundation for future profitability.
But valuation is a delicate balancing act. If it’s set too high, the startup may struggle to raise follow-on funding without dilution. If it’s too low, the founders might feel undervalued and lose motivation. VCs have to carefully assess the numbers and, hopefully, negotiate terms that work for both sides.
Predicting the future is no easy feat. In venture capital, the ability to forecast revenue and growth is key to making sound investment decisions while also providing assurance to investors you are thoughtfully prepared for the financial impact on your strategic game plan. VCs generally rely on forecasts to gauge the potential success of a company and determine how it fits within their portfolio strategy. Yet, the reality of forecasting may be much more uncertain than many investors care to admit.
For early-stage companies, forecasting cash flows is particularly challenging due to limited historical data. VCs often look at market size, customer acquisition potential, and revenue projections over a 3- to 5-year period to determine whether the company can scale effectively. But even with all the data in the world, these predictions remain far from foolproof.
Most forecasts assume an overly optimistic growth trajectory, which can be misleading. In fact, 20% of revenue forecasts fall short for early-stage companies. Despite the best efforts of founders and investors, predicting market adoption, competition, and timing is fraught with uncertainties.
The statistic that only 30% of companies meet their projections reveals a fundamental oversight in how venture capitalists approach investment decisions. When rephrased, this means 70% of company forecasts do not materialize as expected. Instead of acknowledging the difficulty of forecasting, you may hear vague justifications like "complexity" or "uncertainty." Or worse, the blame might get shifted onto entrepreneurs for "failing to meet projections."
But the truth is, when you look at that statistic differently, it suggests that investors fail to forecast accurately 70% of the time. This shows the limitations of relying heavily on future predictions when making investment decisions. There are undoubtedly firms out there that are reassessing the weight they place on long-term forecasts and considering alternative ways to evaluate potential investments that acknowledge the unpredictability of early-stage ventures, without placing the blame on the founders and founding team entirely.
After a VC has decided to invest in a company, the next critical step is structuring the deal. The deal structure outlines the terms and conditions under which the investment will be made, defining the relationship between the VC and the startup as well as memorializing how both stakeholders will benefit in the short and long term. A well-structured deal aligns the interests of the VC with the founders, ensuring that both parties work toward a successful outcome.
VC deals often include several key provisions designed to protect the investor’s interests while giving the startup the necessary resources to grow:
Deal terms can vary significantly in their flexibility, depending on the stage of the company and the negotiating power of each party. The least flexible terms might include heavy liquidation preferences or high dividend rates, which protect the investor but place more burden on the cash flows of the company. On the other end, founder-friendly terms provide greater flexibility like no liquidation preference and minimal pro-rata rights.
The goal of any deal structure is to align the incentives of both the VC and the startup. Poorly structured deals can create friction between investors and founders, potentially damaging the relationship and reducing the likelihood of long-term success. VCs must strike a balance between protecting their investment and ensuring that the founders have the motivation and resources to drive the company forward.
An equitable deal structure strikes an alignment between the VC and the startup that takes into consideration the milestones the company intends to achieve without disrupting the decision making process solely on the basis of the terms set forth in an investor term sheet.
In many cases, venture capital deals are too large or too risky for a single VC firm to handle alone. That’s where syndication comes in. Syndication is the practice of co-investing in a startup with other venture capitalists, allowing firms to pool resources, share risks, and leverage different expertise. It’s a collaborative approach that benefits both the investors and the startups with the amount of capital required to achieve a startup’s strategic plan.
Sometimes it makes sense to find a partner to work with. 65% of VC deals are syndicated, according to Tottman’s data pulled from the NBER. Syndication offers several advantages for venture capitalists, including :
Not all syndication partners are created equal, and VCs carefully consider whom they team up with. Key factors in choosing syndication partners include:
For startups, syndication can be highly beneficial. It not only brings in more capital but also increases the breadth of strategic support, connections, and industry insights. Syndicated investors often work together to help the startup grow, providing introductions to key players, helping recruit top talent, and offering operational guidance.
Syndication allows VCs to manage risk and leverage the expertise of their peers, while also providing startups with greater resources and access to a broader network.
Once the investment is made, the relationship between the venture capitalist and the startup doesn’t end with a signed contract. In fact, many VCs pride themselves on offering more than just financial backing.
They provide ongoing support that helps guide the startup’s growth, steer it through challenges, and improve its chances of success. This "value-add" approach is what differentiates passive investors from those who take an active role in shaping a company’s trajectory.
Most VCs maintain regular contact with their portfolio companies. This can range from monthly check-ins,weekly informal meetings, and board of director reporting depending on the startup’s stage and needs. These interactions allow VCs to stay informed about the company’s progress, provide feedback, and address any challenges early on.
VCs often contribute in several key ways beyond providing capital:
Startups that receive consistent support from their investors often have a higher chance of success. A VC who actively engages with their portfolio company can help founders avoid common pitfalls, make strategic pivots, and connect with the right people. This hands-on involvement creates an ongoing partnership where both the investor and the company work toward mutual success.
The endgame for any venture capitalist is the exit—the moment they can cash in on their investment. Exits represent the culmination of years of work, risk, and guidance, and they come in various forms. A successful liquidity event can lead to significant returns, while an unsuccessful one can result in minimal or negative returns. Understanding exit strategies is critical to the VC model, as the entire venture cycle revolves around eventually realizing profits from investments.
There are three main types of exits that VCs aim for:
So out of 100% of VC deals that happen in a year, 24% lead to an IPO. More often, however, a VC-backed company will end up being acquired by another company. And sadly, companies do fail. Yes, a 32% failure rate does seem high, but VC investment can be quite valuable. It’s a bit of a “look on the bright side” notion, but having an almost 80% chance of IPO’ing or being acquired sounds like a pretty good bet, despite the risks.
The goal for VCs is to achieve high return multiples from successful exits. A return multiple of 3x to 5x the original investment is generally considered good, but many VCs aim for 10x returns or more, especially in high-growth sectors. In some rare cases, VCs can achieve "home run" investments with 100x or greater returns, but these are rare outliers.
The timing and type of exit can significantly impact a VC’s overall portfolio performance. A well-timed exit during a market high can maximize returns, while a delayed or poorly executed exit can erode potential gains. For VCs, managing the exit process effectively—whether through negotiating acquisition terms or preparing for an IPO—is just as important as the initial investment decision.
Exits are where VCs reap the rewards for years of effort and risk. The right exit strategy can lead to transformative financial outcomes, while the wrong one can result in losses.
Creating value is the essence of venture capital. It’s not just about providing capital; it’s about helping startups grow and increase their potential for a successful exit.
For VCs, the process of value creation involves making the right choices throughout the investment lifecycle, from picking the right deals to helping companies overcome challenges along the way. Understanding the key elements that drive value is critical to achieving strong returns.
Several factors play into how VCs create value in their portfolio companies:
The hands-on approach many VCs take after making an investment is a key driver of value. Startups that receive ongoing support tend to be more agile and better equipped to navigate the challenges of scaling. Whether it’s advising on a pivot, helping close a crucial hire, or introducing a new client, these value-add activities often make the difference between a company thriving or stagnating.
Value creation doesn’t stop once the company reaches a steady growth stage. VCs continue to work with their portfolio companies to sustain momentum, preparing them for future fundraising rounds or an eventual exit. The ultimate goal is to create long-term value that benefits both the startup and the VC at the time of exit.
Creating value is what separates successful venture capital firms from the rest. By focusing on strategic deal selection, active engagement, and leveraging their networks, VCs can significantly increase the likelihood of strong returns.
In venture capital, not every investment is a winner. In fact, failure is an inevitable part of the game, with many startups either falling short of expectations or shutting down entirely. VCs are keenly aware of this risk and factor it into their overall investment strategy. Understanding what leads to success or failure is essential for both VCs and entrepreneurs.
A startup’s success or failure often hinges on the strength of its founding team. VCs invest heavily in teams they believe have the vision, resilience, and leadership skills necessary to navigate the complex journey of building a business.
The team’s ability to pivot, adapt to challenges, and make critical decisions often determines whether the startup thrives or fails. Startups with great products but weak leadership can struggle, while strong teams may pivot from initial failures to eventual success.
Beyond the team, several business factors play a crucial role in a startup’s success:
While every failure is unique, certain patterns emerge when it comes to why startups don’t succeed. Many startups fail due to:
For VCs, learning from failed investments is just as important as celebrating successful ones. Failure offers valuable lessons about what to look for in future deals and how to better support portfolio companies through tough times. Moreover, failure in one startup doesn’t always mean the end for the founders—many VCs are willing to invest in entrepreneurs who have learned from their mistakes and are ready to try again.
VCs understand that the path to success is paved with both wins and losses. The ability to identify and nurture successful ventures while learning from failures is what makes a great investor.
Behind every successful venture capital firm is a well-organized deal team working diligently to manage investments, foster relationships, and identify the next big opportunity. Understanding the internal workings of a VC firm sheds light on how decisions are made, how time is allocated, and what drives a firm’s success.
The typical VC firm is composed of several roles, each playing a distinct part in the investment process:
VCs spend their time across several key activities and organize their team member’s responsibilities appropriately across the following primary categories:
The structure and hierarchy of a VC firm are designed to streamline decision-making and ensure that every investment is carefully considered. Senior partners hold the ultimate responsibility for making final decisions, but they rely on input and supporting analysis from associates and principals throughout the evaluation process. The result is a collaborative approach that balances risk and opportunity while leveraging the strengths of the entire team.
Venture capital firms are highly collaborative environments, with each team member playing a vital role in the firm’s success. By organizing their structure and time effectively, VCs are able to maximize their impact across a diverse portfolio of investments.
While venture capital firms focus on helping startups succeed, on the back end they also have to manage the expectations of their own investors, known as Limited Partners (LPs). LPs provide the capital that VCs use to invest in startups, and maintaining a strong relationship with their LPs is crucial for a VC firm’s long-term success. Keeping LPs happy involves regular communication, transparency, and, most importantly, delivering strong returns.
In order to keep investors (Limited Partners, or LPs, in this case), VCs have to hit certain benchmarks. There are a few metrics, amongst many (if someone wants to get granular), that can be used as key performance indicators. The most important benchmarks include:
At the end of the day, investors are looking to make their money back. Cash-on-cash multiples are the clearest way to measure the success of an investment.
LPs typically expect their VC investments to outperform public market benchmarks. Depending on the fund’s focus, LPs might look for an IRR between 20-30%, or cash-on-cash multiples in the range of 3x-5x. However, VCs know that not every deal will yield large returns, so they aim for an overall portfolio strategy that produces the desired results. That said, one or two home-run deals can significantly boost a VC firm’s overall performance, making up for the losses from other investments.
Keeping LPs happy isn’t just about delivering returns; it’s also about maintaining open lines of communication. LPs expect regular updates on the status of the portfolio, insights into market trends, and transparency about challenges the VC firm is facing. Regular investor updates, quarterly reports, and annual meetings are typical touchpoints where VCs ensure their LPs are in the loop and confident in the firm’s strategy.
VC firms that consistently perform and maintain strong relationships with their LPs are in a better position to raise new funds. LPs are more likely to reinvest in future funds if they trust the firm’s judgment, believe in its strategy, and have demonstrated the performance results originally promised at the onset of investment. For VCs, cultivating these long-term relationships is just as important as finding the next big startup to invest in.
Maintaining solid LP relations is a key aspect of running a successful venture capital firm. Balancing strong financial performance with clear communication and transparency ensures that LPs continue to support the firm, providing the capital needed for future investments.
Venture capital is not a one-size-fits-all industry. Different VC firms focus on various stages of investment, sectors, and geographic regions, each with unique strategies and approaches. Understanding the key differences across VC segments can help entrepreneurs better target the right investors for their specific needs.
One of the primary distinctions between VC firms is whether they focus on early-stage or late-stage investments:
Some VCs specialize in specific sectors, with early stage investor focus most popular in:
VC strategies can also vary by region:
For founders, understanding these distinctions is crucial when approaching investors. A startup developing a biotech product might find more success with healthcare-focused VCs, while a tech company with high-growth potential should target early-stage VCs in Silicon Valley. Matching your company’s stage, sector, and location to the right VC segment can dramatically improve your chances of securing funding.
The diversity across VC segments reflects the different needs and opportunities in the startup ecosystem. By tailoring their investment strategies, VCs are able to specialize in what they know best, offering entrepreneurs the most relevant support.
Venture capital plays a huge role in the growth of startups, enabling bold ideas to take shape and scale into successful businesses.
However, the decision-making process behind VC investments is intricate and involves a mix of art and science. From deal sourcing to exits, VCs must evaluate a range of factors, including the strength of the team, market opportunity, and the scalability of the business.
One of the most significant takeaways from this guide is that forecasting in venture capital is far from perfect. With only 30% of companies meeting their projections, it’s clear that a fundamental flaw exists in the forecasting paradigm. Investors often rely on projections that don’t materialize, which means 70% of forecasts are inaccurate.
Rather than attributing these failures solely to market complexity or blaming entrepreneurs for missing targets, it's essential to recognize the limitations of prediction models. This insight challenges VCs to rethink how they evaluate future growth and to account for unpredictability as part of their risk strategy.
At every stage—from deal structure to post-investment involvement and eventual exits—VCs strive to balance risk and reward. Successful firms are those that not only choose the right deals but also add value beyond capital, helping their portfolio companies grow and adapt to changing conditions.
For entrepreneurs, understanding the nuances of venture capital decision-making can make the difference in securing the right investment partner. By aligning with the appropriate VC segment and presenting a clear, scalable business model, startups can improve their chances of building a fruitful partnership with investors.
Venture capital is not just about funding—it’s about forging relationships, creating value, and, ultimately, sharing in the success of innovative ventures.
