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LITERATURE REVIEW

Since they are asked to consider a large number of deals, venture capitalists begin by quickly screening out deals that require larger or smaller investments than they typically make, or that require investments in areas in which the venture capital firm is unfamiliar, particularly in terms of technology, product, market, or geography (Hall & Hofer, 1993; Tyebjee & Bruno, 1984; Wells, 1974). It is common practice for venture capitalists to specify minimum investment, preferred investment, preferred industries, and preferred geographic locations. After this initial screening, venture capitalists then evaluate remaining possibilities by subjectively assessing business plans presented by the venture's managers (Tyebjee & Bruno, 1984; Wells, 1974). Venture capitalists use a variety of criteria in the process of selecting ventures in which to invest. For example, Tyebjee & Bruno (1984) found that decisions were based on market attractiveness, product differentiation, and managerial capabilities. Sandberg and Hofer (1987) found that decisions were based on industry structure and firm strategy. Four categories that have received the most attention will be discussed in detail below. These categories include management team, strategic, financial, and industry characteristics.

Management Team Characteristics

Prior research indicates that one of the most important areas venture capitalists evaluate is quality of management, which is indicated by the collective skills and experience of the management team (Bruno & Tyebjee, 1985; Hisrich & Jankowicz, 1990; MacMillan et al. 1987; Poindexter, 1987; Tyebjee & Bruno, 1984; Wells, 1974). Relevant skills include marketing, technical, and financial skills (Bruno & Tyebjee, 1985; Tyebjee & Bruno, 1984; Wells, 1974), as well as proven leadership ability (MacMillan et al. 1985; 1987). Perhaps because skills are developed through experience, prior studies show that new ventures are more likely to receive venture capital when their management teams have more experience in new ventures (Stuart & Abetti, 1990), in the same or similar industries or markets (MacMillan et al. 1985; 1987; Tyebjee & Bruno, 1984), or in general business (Bruno & Tyebjee, 1985; Hustedde & Pulver, 1992). Furthermore, demographic characteristics such as education and age have been found to influence access to venture capital (Hustedde & Pulver, 1992). Other less tangible management characteristics that venture capitalists have indicated are important include management commitment and staying power (Wells, 1974; Hall & Hofer, 1993; MacMillan et al. 1985; 1987) plus the ability to evaluate and react well to risk (MacMillan et al. 1985; 1987). Like skills, these characteristics can be developed through prior experience that is relevant to the new venture. In general, venture capitalists attribute failure of new businesses to deficiencies in their management teams (Gorman & Sahlman, 1986), and scholars have argued that competent management is necessary but not sufficient for new venture success (MacMillan et al. 1987). Therefore, venture capitalists are expected to consider additional criteria when evaluating potential investments.

Firm Strategy

In addition to management teams, venture capitalists evaluate strategic issues related to the ventures' products and target markets. Research indicates venture capitalists are more likely to invest in firms pursuing niche markets (Tyebjee & Bruno, 1984), differentiation strategies, (Rosman & O'Neill, 1993; Tyebjee & Bruno, 1984) and/or offering proprietary products in the early stages of development (Hustedde & Pulver, 1992; MacMillan et al. 1985, 1987; Wells, 1974). Because growth and expected return on their investments are primary concerns of venture capitalists (Tyebjee & Bruno, 1984; Hustedde & Pulver, 1992; Poindexter, 1976), they are more likely to invest in firms with aggressive market entry objectives. In fact, Rea (1989) concluded that entrepreneurs need not even approach venture capitalists if they are not in a growing market or if they do not have the ability to create a new market with high growth potential.

Financial Characteristics

While Rosman & O'Neill (1993) found that venture capitalists were far more concerned with strategic and market issues than financial characteristics, Tyebjee & Bruno (1984) found that financial history was mentioned by venture capitalists as frequently as growth potential when discussing investment decision criteria. One primary financial consideration among venture capitalists is the cash out potential or liquidity of their investments (MacMillan et al. 1985; Poindexter, 1976; Tyebjee & Bruno, 1984). Venture capitalists appear to view investments as too risky when cash out potential is low (MacMillan et al, 1985). In addition, because venture capitalists are particularly interested in maintaining a strong position of influence within firms in which they invest (Poindexter, 1976) and maximizing their own returns (Tyebjee & Bruno, 1984; Hustedde & Pulver, 1992; Poindexter, 1976) venture capitalists may favor ventures with lower levels of debt relative to equity in order to maintain a favorable balance of power with lenders and to reduce debt service expenses.

Industry Characteristics

Because of the influence of industry on firm performance, another important concern of venture capitalists is industry attractiveness, which is indicated by the industry's performance, size and growth (Bruno & Tyebjee, 1984; MacMillan et al. 1985; Rosman & O'Neill, 1993; Tyebjee & Bruno, 1984; Wells, 1974). Hall and Hofer (1993) found that long–term growth and profitability of the industry were overwhelmingly important when venture capitalists screened investments and that other criteria were relatively unimportant. Likewise, Rea (1989) found that markets offering unconstrained opportunities for rapid growth were far more important than any other criterion. Furthermore, venture capitalists tend to invest mostly in high technology industries (Hustedde & Pulver, 1992; Wells, 1974) in which the strategies discussed earlier can provide significant strategic advantages and can lead to rapid firm growth.

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