Wharton@Work

February 2022 | Finance

Venture Capital: Succeeding in a Founders’ Market

A record number of venture-funded start-ups are poised to go public this year, including social media platform Reddit and the grocery delivery platform Instacart, according to a new study by Pitchbook. That’s very good news for the venture capital investors who provided early-stage funding and are about win big on their investments. “It’s not just the original investment that matters — it’s a successful exit that ultimately drives returns,” says Wharton finance professor David Wessels.

He’s right, of course. Creating an exit strategy that benefits both founders and investors is essential to successful venture capital deals. But finding promising entrepreneurs, doing due diligence, and structuring deals matter too, and Wessels and other Wharton finance faculty explore these topics in Venture Capital. Since its launch in 2018, the program — renowned for its rigor and faculty-designed models and tools — has offered an in-depth, up-to-the-minute understanding of what is often referred to as the least transparent area in finance.

It’s a Hot Market

While venture capital has been around since the mid-20th century, it has been in the last few years that “we have seen the industry’s hard work come to fruition,” says Wessels. “In the 1990s, venture capital provided healthy returns. Then the dot com boom and bust made investors gun shy. Most of the early internet companies never lived up to their hype. But in the last two years, the number of VC-backed companies going public, especially in the business-to-business space, has exploded. Their multi-billion-dollar valuations are justified — we’re seeing best-in-class operating margins, capital-light business models, and scalability.”

Wessels says the combination of incredible potential and available capital from investors eager to cash in has fueled the intense interest in venture capital. Founders, entrepreneurs with promising ideas, family offices, and investment advisors have created a hot market. Record numbers of investment dollars are pouring into start-ups (global venture funding nearly doubled from 2020 to 2021), and the democratization of venture capital means the rewards and risks are available to both institutional and individual, less-affluent investors alike.

But that doesn’t mean it’s easy to cash in. Companies like streaming platform Quibi, which raised $1.75 billion from investors before launching and then quickly dissolving in 2021, serve as cautionary tales. For entrepreneurs, the lessons include the fact that infusions of cash can’t make up for flaws in business models, timing, or leadership. For investors, due diligence can detect weaknesses, and it has never been more important — or harder to do.

Due Diligence Under Pressure

Another reason for the hot VC market is the worldwide transition to digital that was accelerated by COVID-19. “Tech is driving returns in the broader stock market,” Wessels says, “and investors, who have consistently underestimated the financial potential of tech, are now taking much bigger bets on unproven companies. I believe we are still in the nascent stages of the tech revolution. There are a new generation of entrepreneurs no one has heard of yet — and smart investors are looking for them. Whoever is asking ‘How could anyone invent anything else?’ is clearly not paying attention.”

“But investors need to be extra diligent in this frothy market. Right now, the check sizes are getting larger and the pressure to move fast is growing too,” says Wessels. “It’s very similar to what happens in real estate: in a seller’s market, the buyer is willing to forgo basic due diligence like inspections. Today’s VC deals are very founder friendly, giving entrepreneurs more flexibility with less oversight.”

But how can VC investors today balance the need to be founder friendly without forgoing appropriate due diligence? Wessels says, “There is a certain fervor associated with a hot space, and that means you don’t always have the time required to get fully up to speed. That’s especially true for fintech and other complicated businesses. When only the founder and their team have the expertise needed to run the business, you are investing in something you don’t fully understand. It’s more important than ever to have the right skills and best tools to determine whether the business has the key ingredients to be successful.”

Those skills are what participants come to the Venture Capital program for. “We are heavily application oriented,” says Wessels. “We show you how to become a better investor by using faculty-designed frameworks and models. They help you discover the hidden truth that you might not see on your own. It’s so easy to misinterpret information and find yourself in situations that can lead to a bad outcome. At Wharton, you get access to the cutting-edge science that shows where the potential pitfalls lie and how to avoid them. It’s an intense, rigorous week of learning.”

Immersion in the VC Ecosystem

The VC ecosystem goes well beyond entrepreneurs and investors — and Wharton’s program attracts and provides guidance to all of them. “Expect to be in the room with attorneys, investment advisors, bankers, institutional investors, and family offices. The complete ecosystem actually strengthens in the classroom, and it is industry-agnostic by design,” says Wessels. “In the last running, we had a family office, a venture capitalist, and a serial entrepreneur in discussion about a health care opportunity. They were all there to hone their skills, but also realized the people they needed to partner with were already in the room. Most participants leave not just with faculty resources and academic knowledge but with an extensive network throughout the investing ecosystem.”

A Final Word for Investors

When asked for advice for new investors in this founder-friendly, fast-paced market, Wessels zeroes in on the makeup of the venture capital firm. “If I were a new investor or family office investing through a venture capital firm, I would look at the makeup of the investing team,” he says. “If the firm is relatively small, assess the group not only for its skill set, but also the potential for turnover. Does the team have the chemistry to work together, and do they respect one another? A few key departures over the 10 years of your investment window can make a really big difference.”

Wessels notes that some of the best venture capitalists are the youngest on the team, in part because they “have no baggage when it comes to evaluating an industry. They see things others can’t, but they also have little to no political power in their firm. If you are selecting the team because of those managers, make sure they are happy and are compensated appropriately. When you are betting on people to manage your money, due diligence can’t stop with the investment. You have to vet the managers as well. This is one of the more subtle aspects of VC that can’t be neglected.”