Pick of the crop

Pick of the crop

Early-stage investors are faced with a plethora of options when it comes to backing start-ups. So what are their initial screening processes? New research takes a look at what is most important to these investors, and explores the differences between how experienced and inexperienced backers make investment decisions. By Gregory DL Morris.

How do early-stage investors choose which start-ups to support? There is little systematic evidence on the selection process of early-stage investors. This paucity stands in sharp contrast to the wealth of evidence on investment decisions in public equity markets by institutional and retail investors. 

However, recent research, Attracting Early Stage Investors: Evidence from a Randomized Field Experiment, by Shai Bernstein, Arthur Korteweg and Kevin Laws, attempts to fill this gap. “In teaching entrepreneurial finance, the question always comes up: how do venture capitalists make their decisions to proceed?” says Bernstein. “That is especially true at the early stage, which is characterised by large uncertainty, no track record and attempts to do untried things.”

The research, which uses companies in an online database (AngelList) to track which characteristics are of most interest to venture capital investors in early-stage investments, seeks to answer this question – at least partly (see “The research” for an explanation of the methodology and findings). 

The importance of teams

It finds that the characteristics and experience of the founding team are of most interest to early-stage investors, compared with the amount of traction the start-up already has (as measured by sales or number of users, for example) or its existing investor base. “One surprise is the importance of teams, versus the traction of the company or the behaviour of other investors,” says Bernstein. “Coming in, I thought that what other investors were doing would be important, especially for increasing awareness of one project over another. I also thought that traction would be important. But it was the quality of the leadership team that resonated most strongly with investors.” 

Execution is key

Bernstein suggests that there may be two drivers to the findings. One is that, at the earliest stages, what matters most is execution. “Whatever the idea is at the start, it will likely change, so you need high-quality people to execute,” he says. “The other driver could be that, whether the idea is sound or not, talented entrepreneurs, who have other options, chose this one, which could be a signal about the prospects of the project.”

The research also found that inexperienced investors (those that had not made an investment before) were more likely to look at all three – team, traction and other investors in the company – while the experienced investors looked only at the team. 

This finding chimes with some experienced investors. One of these is Robert Siegel, a partner with Xseed Capital, an early-stage VC firm based in Silicon Valley with $110m managed across two funds. “Bernstein may be on to something not obvious here,” Siegel says. “The smart money does not just follow
the smart money. It is also of great interest that, among early-stage investors like us, the cohorts, experienced versus inexperienced, behave differently.”

Jockey before horse

Siegel also echoes Bernstein’s point about execution. “Experienced investors know that the team is the big X,” he says. “In the early stages, experienced investors know that they are betting more on the jockey than on the horse. But that does not mean that hitting milestones is not important. A great idea with a mediocre team is not going to scale, but a great team with a mediocre idea can change and adapt. That is what creates the chance for success.”

Robert Johnston, executive director of the New York Venture Capital Association (NYVCA), entrepreneur and angel investor, sees the findings from a different angle. He lauds the researchers for their efforts to quantify the more elusive variables in the equation. 

Getting emotional

“The paper starts to get at the emotional aspect of early-stage investing,” Johnston says. “So much research in this field just looks at the unemotional, raw data but does not include the emotional component of this business.” 

He also suggests that VCs themselves are less inclined to acknowledge the emotional aspects of deal selection. “About 99% of VCs will tell you that they are very rational – that they look at the four corners of the spreadsheet and the investor deck, without emotion,” he says. “But the truth is that a lot of early-stage investing is based on emotion, time constraints and fear of missing out. When I read a lot of research – and I am a voracious reader – that emotional component is often missing.”

However, Siegel points to some of the study’s limitations. “There are some very subtle things in this paper that can easily lead to incorrect conclusions,” he cautions. 

Too early for results

“It could seem that investors should only look at the team and ignore milestones to get better results,” Siegel continues. “But that would be an over-simplification. In fact, the first thing that occurred to me upon reading the paper is that we don’t know the results of the investments. The research only looks at the selection and decision process.” Bernstein would agree, and he makes it clear that the paper only answers part of the question. He stresses, for example, that there is a wide variety of financial and behavioural factors in the VC decision-making process and that that complexity was not captured in the paper. 

The paper also makes clear that investment outcomes are not explored, “as participating companies are still at a very early stage and long-run outcomes such as acquisitions or IPOs are as yet unknown”. However, the paper does make the assertion that the team is important for fundraising, “which is a prerequisite for entrepreneurial success”.

Looking ahead, Bernstein believes that there is much more research to be done in this area. He would like to delve further into the decision-making process. “The limiting factor for investors is not money, especially at the early stage,” he says. “It is time and attention. Investors might see 1,000 business plans in a year,” Bernstein points out. “Of those, they might meet for coffee with just 50, but that is still one a week. How do they decide whom to meet?”


In Attracting Early Stage Investors: Evidence from a Randomized Field Experiment, Shai Bernstein from Stanford Graduate School of Business, Arthur Korteweg of the University of Southern California Marshall School of Business and Kevin Laws from AngelList sought to determine how VC investors decide which investment opportunities to pursue.

The authors sent 17,000 emails to nearly 4,500 investors on the AngelList online platform of investment opportunities, giving information about 21 different start-ups that revealed either the founding team’s background, the start-up’s traction (such as sales and user base) or the identity of existing investors – or a combination of two of the three characteristics. They then measured each investor’s level of interest in a given company by recording whether the investor chose to learn more about the company based on which characteristics were revealed in the email. Additional results show that this effect is not mediated by market transactions such as mobility of workers or patent trade. Overall, results suggest that VC brings about knowledge spillovers and affects the direction of aggregate innovative activity.

The research finds that the average investor responds strongly to information about the founding team (which received a 13% higher click rate than the other categories), but less to firm traction or existing lead investors. When the results were analysed according to the investors’ experience, the research found that the experienced investors respond only to team information, while inexperienced investors (18% of the sample) respond to all information categories. The results suggest that information about human assets is causally important for the funding of early-stage firms, and hence for entrepreneurial success.