Playing the investor

The Deloitte Institute supports a stack of competitions and challenges for students

Find out what happened when teams of MBA students posed as venture capital investors for a day

This article is provided by the Deloitte Institute of Innovation and Entrepreneurship.

DIIE Newsletter3Jeffs article

Setting the stage

The Deloitte Institute supports a stack of competitions and challenges for students who want to test their entrepreneurial mettle. Most are a variation of the traditional, ‘business plan competition’ format where students pitch opportunities to investors. But once a year we turn the tables by challenging students to take the role of that investor. Hundreds apply for the ordeal (it’s the most popular competition in the calendar) but just one team wins to fight another day.

This is the ‘Venture Capital Investment Competition’ and it works like this.  We recruit five external entrepreneurs who are on the verge of seeking ‘Series A’ investment and six venture capital investors with loads of experience of investing in such businesses. The entrepreneurs are our ‘subjects’ and the investors the judges.   We then select our contestants - six teams of students (five per team) who - under the watchful gaze of the real investor judges - must select, negotiate and ultimately ‘invest’ in one of those businesses on terms that impress. The entire event takes place over the course of one intensive day.

The first act

The day starts off gently enough. Each entrepreneur delivers a free-form ten-minute pitch to the assemblage of student teams. Each polished pitch promises the usual stellar returns and has gullible investors reaching for their purses.

But the student teams are made of sterner stuff. They’ve all received the business plans in advance and have spent two days and nights potholing. It’s time for a spot of due diligence.

The entrepreneurs establish themselves in rooms around campus and are ‘visited’ by each of the student teams in turn. Under the watchful gaze of one of the professional investors each team has 15 minutes to conduct their due diligence.  A fairly analytical exercise you would think – simply a case of probing every spreadsheet assumption and emerging with a quantified assessment of ‘risk’ that can be used to dial in the right discount factor – and out pops a reasonable valuation.  

It isn’t like that. Even at this early stage human factors begin to emerge and relationships crumble before they’ve even begun:

  • Teams learn that going straight for the jugular puts the entrepreneur on the defensive and signals mistrust and lack of respect. The entrepreneur disengages and the shutters go down. On the other hand, if a team tries to ‘make friends’ with the entrepreneur they can’t subsequently appear critical of his or her business in case they destroy that superficial friendship. This leads to limp and sycophantic due diligence. The best teams somehow manage to establish a likeable rapport in minutes, praise all that is genuinely good (without false flattery) then pinpoint and probe areas of weakness. The entrepreneur emerges drained but wiser and impressed by his or her interlocutor’s ability to zero in on the weaknesses.  Respect. 

  • The student teams can implode. This normally happens when one of the team has possession of the ‘script’ of pre-prepared questions and – irrespective of who came up with the concern - asks all the questions.  When this happens the entrepreneur has a very easy time of it since any answer will do, especially when the list is long. The rest of the ‘team’ becomes visibly frustrated, first interrupting then lapsing into resignation as time ticks by.   The best teams prioritise their concerns, decide who will lead on each and for how long, then prepare their questions and lead on that part of the diligence. 

Great analysis turns out to be a necessary but insufficient condition for effective due diligence. And to their credit, teams are pretty good at pinpointing the weak points in businesses. The problem is that – being a risk-aware bunch - they tend to find rather a lot of them, each converting into a question.  An agenda of burning issues becomes a sterile script that enervates the atmosphere. Everyone becomes bored. Time drags.

The best teams manage to inject energy and humour into the discussion. Team members still orchestrate roles but this time questions appear to reflect genuine intrigue. The entrepreneurs feel the pressure as one team member after the next – driven by curiosity and genuine interest – rhythmically pummels and probes one assumption after another, mercilessly but empathetically drilling down until the fundamentals out. And when this happens the entrepreneur feels nothing but respect and a desire to continue the conversation. Result.

The best teams also find time to probe the parameters of a possible deal. They ask whether the entrepreneur would consider (say) convertible debt. This helps the team discover whether the term is understood (if not then maybe keep the Term Sheet simple) and whether they’re up for a bit of financial engineering.

Judges agree that it’s an inherently human process. The teams are selling money. Entrepreneurs buy (that money) from people they like and respect.  

Act two – the term sheet

Once the due diligence phase is done teams caucus to consider which of the five businesses they’d most like to invest in. That done they set about constructing an agreeable Term Sheet. 

A curious ‘groupthink’ can invade their discussions. It happens like this. Students are well-versed in the panoply of financial instruments – convertible debt, liquidation preferences, ratchets, tranched investment, anti-dilution and the like. Taken together these instruments can mitigate investor risk and reconcile differences in opinion over valuation. Teams incorporate these terms with gusto and without regard to mounting complexity. Moreover, believing that their cash (rather than the investee venture) are most scarce they persuade themselves of their power to dictate terms and an implied duty to appropriate as much value as they can from the deal. And even if an entrepreneur won’t accept a term surely it’s best to ask for it anyway so that can harmlessly be dropped as a ‘concession’. The logic is powerful and naysayers within the team are made to feel ‘soft’ and then marginalised. Groupthink.

Act three – the face to face negotiation


The stage is thus set for a wonderfully entertaining ‘rubber hits the road’ negotiation. The entrepreneur receives ‘their’ term-sheet and has time to ponder before meeting their putative investors. That meeting will last fifteen minutes and maybe a deal will be agreed. An artificially short period but you’d be amazed how little time it takes for the die to be cast. 

The investor team enters the amphitheatre. Pleasantries exchange and then one or other party suggests that it would be, ‘quite a good idea’, to run through the Term Sheet. And so the would-be investment team dives in. Helmut von Moltke (or was it Mike Tyson) once said that no plan survives first contact with the enemy.

The first part is usually the happy news. Yes, the team loves the business and is willing to invest. And at a valuation that usually isn’t too far from that sought by the entrepreneur. Sometimes there is divergence but both sides recognise that this will be settled later with a bit of ‘meet you somewhere in the middle’, horse-trading. 

Then comes the potentially toxic terms – ones that seemed perfectly reasonable to the team just a few moments beforehand. 

Let’s look at a few:

  • Directors and observers – the team usually asks for several, just in case

  • Liquidation preferences – so that investor multiples are assured even without a stellar exit

  • Investment in tranches – so that investors can rethink should targets be missed

  • Anti-dilution – to prevent investors being washed out should there be a next-round hiccup

  • Equity vesting – asking the entrepreneur to return shares should they quit

From the back of the room the VC professionals sit back and wait for the entrepreneur’s retort – and the team’s response. 

So predictably human is the reaction that at this point I always feel that the teams should have played out the scenario. Maybe they could banish their biggest naysayer after the due diligence session and then invite them in to ‘play’ the entrepreneur and see how they react to the terms. Let’s think it through the five ‘asks’ from the perspective of the entrepreneur.

This is what they hear:  

  • Directors: Clearly you don’t trust me or you want to take control of my company

  • Liquidation preference: You think your money is more valuable than my business

  • Tranches: You don’t believe my strategy - or else you want the option to renegotiate later

  • Anti-dilution: I thought we were in for this ride together

  • Equity Vesting: Hold on a minute – it’s my company already

One entrepreneur listened silently then said, ‘This is a very mistrustful Term Sheet’. And the negotiation was over.

There are often good reasons for including ‘cute’ terms but they need to be sold to the entrepreneur.  The words and body language that the teams use belie two different attitudes towards money and venture:

“We need to make a good return on our investment and ensure that we limit losses for our investors in the event that the business flops”

“It’s your business and we want to do everything we can to help you to realise your vision and valuation –our terms only impact if things go seriously awry”

The best teams know how to ‘sell’ their deal to the entrepreneur. But even then – at the debrief with teams - investor judges plead simplicity. Here’s a selection of the best investor quotes of the day:

  • "There are only two outcomes – zero or zillions. In either case, 90% of your terms become meaningless” 

  • "Your terms build in conflict between investors and entrepreneurs from day one”

  • "Entrepreneurs want investors who will build the business – not protect their money"

  • "Every new term restricts the flexibility of the firm to do what’s sensible"

  • "This was ‘death through termicide"

  • "Anyone can pick holes in an entrepreneur’s plan – your job is about selling your terms"

  • "Why go in with a bunch of terms that you’re ready to drop – just go in with a fair deal from the outset"

  • "Your proposed ‘cap table’ will make it impossible for the company to raise further funds"

  • "It would be amazing if he couldn’t get a better deal elsewhere"

A judge provides silent feedback to one of the teams

Jeff quote

After the curtain falls

As everyone mingles at the ‘after show party’ there is much laughter as students relive excruciating encounters with entrepreneurs and everyone spills what they were really thinking, feeling and doing in the heat of those moments.

It’s been a traumatic day for the student teams. Most come out licking wounds and wishing that they’d done things differently. As an educator I could wish for nothing better – learning has happened in the most direct, experiential and brutal of ways. Student participants invariably say that this was one of the most formative and memorable days they had at the School.

Students from the winning team reflect on the value of the competition and what they’d do differently next time

The entrepreneurs love it too. They’ve been able to have some practice negotiation and had the chance to try out a few ‘personas’ as they face different hoards of students.

Even the investors find the experience immensely entertaining and keep coming back for more.

The winning team is announced (they’ll represent the School at the next round somewhere in Europe). But everyone emerges wiser. A very happy day. 

The Venture Capital Investment Competition was conceived many years ago by Patrick Vernon at UNC Kenan-Flagler Business School. London Business School has been an eager participant since the beginning and hosted the European Finals for many years. In common with so many initiatives, the VCIC is organised by the Students for fellow students. This year’s organisers were Haley Murphy, Matt Wichrowski, Rory McCormick and Pierre Le Fillatre. Well done. 

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