“VC is about extracting enormous signal out of very little data.” — Nigel Morris

QED Investors’ co-Founder Nigel Morris had the rare privilege of entering Venture Capital after managing a $20 billion public company, Capital One. Comparing these two experiences, Morris confided that running a public company was more straightforward than investing in startups—there’s much more data to analyze. Morris insisted that early-stage investing is about making decisions based on few signals, generally centered around the Founders’ competence and character.

In this post, I explore the fascinating mystery of VC decision-making. After re-examining explicit and implicit criteria Investors use to make a go/no-go decision about an investment opportunity, I go behind the curtain to investigate mental shortcuts they unconsciously mobilize to arrive at such conclusions. These heuristics explain many of the industry’s faults, including the lack of diversity, reputation-crushing mistakes like FTX and Theranos, and VC herd mentality.

Explicit Criteria Venture Capitalists Use To Make Investment Decisions

Interviewed on the 20VC podcast, Nigel Morris explained the main difference between leading a large public company and investing in startups. The former relies on abounding data to make reasonable projections, while the latter is mired in uncertainty and ambiguity. Very little in the startup’s past will help make educated guesses about the future. Anything can go wrong.

Yet, VC Partners make investment decisions about hundreds of opportunities every year. How do they do it?

Morris’s VC firm, QED Investors, put a process in place to manage the uncertainty. Partners operate with hypotheses and constantly gauge how accurate they are. The central questions that QED tries to answer on every investment opportunity are:

• Can you build the team?
• Is the market big enough?
• Are there regulatory hurdles?
• Can you get to Series A?

As I outlined in my webinar “The 3 Investment Criteria Venture Capitalists Use to Screen Deal Flow“, VCs use a rigid list of criteria to make go/no-go decisions at each stage of the funding process. The team’s quality and the market’s size consistently rank high on that list. Watch the webinar to dig deeper into these criteria and learn more about others, such as fit with the fund, exit routes, and scalability.

I then went further and regrouped the top 28 questions VCs ask Founders they meet for investment opportunities into five categories probing the following aspects:

• Fit with the fund: questions on the startup’s activity, traction, and fundraising
• Potential returns: questions around the market, business model, and exit plans
• Execution risk: VCs ask Founders about the team, the competition, and what needs to happen to execute the vision
• Appropriate round size: questions about the roadmap and uses of funds
• Red flags and deal breakers: the Founders’ drivers, the deal’s structure, the cap table

However, these explicit criteria do not give the whole picture—far from it.

Implicit Decision-Making Criteria Play A Bigger Influence

Venture Capitalists operate with abundant deal flow, of which only a few gems will emerge. Contrary to what entrepreneurs believe, most fundraising journeys don’t end well. Overconfidence is a trait necessary to venture creation, but it undeniably is a double-edged sword.

VCs are well-placed to observe this phenomenon. They spend more time turning opportunities down than deciding to allocate more resources for a deeper analysis. This high deal flow context generates room for more subjective judgments than in other asset classes.

I analyzed in another post the 7 Untold VC Evaluation Criteria that Investors use when investing in a startup. Some of these are unconscious cognitive biases (about the Founders and their business ideas, or what others think) that have far-reaching consequences, including subpar performance and discrimination. The seven implicit, sometimes secret, criteria are:

• Not moving the needle: VCs will turn down startups they believe won’t significantly impact their investment portfolio’s overall performance or value. Experienced Investors play the power law to allocate resources (time and money) to potential “home runs”
• Internal standing: Venture Capital is a people business, and people are open to political shenanigans, especially during Investment Committee meetings
• Founder-related biases: Guy Kawasaki used to say that “Venture Capital is a dating game”, where judgments about Founders are made in less than 30 seconds. I explore the causes of this phenomenon below
• Being primed: One of the most influencing criteria on the list. Investors make decisions based on past successes or failures with similar ideas or situations.
• What others say: groupthink and VC herd mentality lead Investors to outsource the decision to others, a process I call “proxy due diligence”. Consider reading my post on due diligence failures to avoid these mistakes
• Narrow mental models: successful VCs break their decisions grids to avoid errors of omission, the Venture Capital’s “capital sin”
• Too much work: in an industry characterized by high deal flow and time pressure to close, non-obvious projects requiring deeper analysis are often overlooked

However, in the webinar, I didn’t discuss the psychological and neuronal mechanisms underlying the Venture Capital investment decision-making process. We discuss some of them now.

Interpreting Signals Opens Venture Capitalists To Dangerous Cognitive Biases

The context of venture capital investing makes VCs susceptible to cognitive biases, as the high uncertainty, time constraints, and fear of loss can influence their decision-making processes. Recognizing and mitigating these biases is essential for successful investments and fostering innovation.

In a recent interview, a successful VC said all he needed was a lunch or dinner meeting with a Founder to determine if they think strategically enough (start from 16’25).

To make these fast-paced decisions, many VCs rely on mental patterns to select the individuals they will engage with. The closer the Founders they meet fit this mental pattern, the more susceptible they are to go on to the next stage.

Pioneering research by Daniel Kahneman and Amos Tversky has demonstrated how human decision-making can be influenced by various cognitive biases, leading to suboptimal outcomes. In Venture Capital, these biases play a significant role in decision-making.

Firstly, the sheer volume of deal flow and the limited time to evaluate each opportunity lead to the reliance on heuristics—mental shortcuts that can sometimes result in cognitive biases like representativeness and availability. VCs may be more inclined to invest in startups that resemble previous success stories or are quickly brought to mind, potentially overlooking innovative ideas that don’t fit established patterns.

People rely on a limited number of heuristic principles [i.e., mental shortcuts] by which they reduce the complex tasks of assessing likelihoods and predicting values to simpler jugmental operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors.

Tversky & Kahneman, 1974

Secondly, the high failure rate of startups and the pressure to identify the few that will succeed create a fertile ground for confirmation bias. VCs may seek information supporting their initial beliefs about a startup’s potential while dismissing contradictory evidence. This can lead to overconfidence in their investment decisions and poor performance.

Moreover, loss aversion, a phenomenon also identified by Kahneman and Tversky, can play a crucial role in VC investing. The disproportionate weight VCs assign to potential losses may make them overly cautious, passing on promising opportunities for fear of losing their investment.

You can read the following posts for a deeper dive into these biases:

• This post goes deep into the representativeness heuristic, which I believe is the root of the lack of diversity in Venture Capital. I also make suggestions on how to address it.
• I’ve analyzed confirmation bias at length in other posts—this one on Theranos is a good place to start, and this webinar demonstrates how confirmation bias is at the root of due diligence failure
• Finally, I address the fear of failure through the lens of the promotion- and prevention-focus framework I’m currently researching. Let me know in the comments below if you want a dedicated post on VCs’ loss aversion

Conclusion: tl;dr

Venture Capitalists’ investment decisions are influenced by a combination of explicit and implicit criteria, where cognitive biases often come into play. Due to the high uncertainty and time constraints inherent to the industry, VCs rely on mental shortcuts such as the representativeness heuristic, confirmation bias, and loss aversion to navigate the complex decision-making landscape. These cognitive biases can lead to suboptimal outcomes and hinder the identification of genuinely innovative and diverse ideas.

Aram Founder

Aram is a veteran investment professional with 20 years of experience. He’s realized over 45 transactions across Project Finance, LBO Financings, Growth Equity, Venture Capital, and M&A in half a dozen countries on three continents.

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