When I think about the venture capital business, I think about risk. It's one of the riskiest investment types there is. But as they teach you in business school, risk and return are highly correlated over the long haul.
What we want to do in the venture capital business is take a lot of risk (which should be rewarded with a low entry valuation) and then actively mitigate the risk we took as much as we can (thereby reducing the risk for future investors and increasing the valuation).
It's the same thing that entrepreneurs want to do. When they leave their safe job and go out on their own, they are taking a lot of risk. Their entry valuation should be zero, meaning they (collectively if they have partners) own 100% of the business for whatever startup capital they invest.
By the time they offer equity to new investors, they should have reduced some of the risk. By developing a product, or by developing a technical and operating plan, by attracting other talented people to the team, or by getting customers and revenues (and sometimes even profits).
However markets are not rational. Investors will price risk (and therefore value a business) differently at different times.
I think a good example is comScore, a company I helped provide the first venture capital to in 1999. Along with Bruce Golden of Accel Partners, we invested something like $6mm into comScore in August 1999. It was a typical early stage venture round where the investors purchased approximately 1/3 of the business for the invested capital.
A year late, in the summer of 2000, investors valued comScore at something like $140mm. The company had mitigated a lot of risk in the year that had passed. The technology was built, the service was launching, the team was hired, and the future was bright. But investors missed the fact that the Internet market (ie the customers), at least version 1.0 of the Internet market, was a mess and getting worse. And the next twelve months were ugly, really ugly.
The next round was completed at a fraction of that $140mm valuation and it took something like five or six years for the company to get back to that $140mm valuation. Today, comScore is a public company with a market cap of $670mm.
comScore's founders Magid Abraham and Gian Fulgoni did a great job of mitigating the risk in the deal year after year and they and their shareholders, including me, have been rewarded. But it wasn't a straight line up. Partially because markets are irrational and partly because new risks showed up that we had no idea were coming.
Both of those things are always going to be true. Markets are never rational in the short term. And almost always rational in the long run. So my approach to that fact is to keep a lot of "dry powder" and invest in every round at our pro-rata share or less if the price seems truly irrational. Early stage venture capital is often less susceptible to market gyrations because we get our ownership at a low valuation and keep it but generally don't increase it much as the valuations increase. And you have to be patient and ride the gyrations out, as long as the company is doing its job of mitigating risk.
And new risks will always show up. No investment plays out the way you think it is going to play out when you make the investment. So you can never price the risks you are taking correctly. My approach to that is to two fold. Don't freak out too badly when the risks you never saw show up. And have a lot of "dry powder" to insure that you and the company can face the risks, deal with them, and mitigate them as well.
Risk and return are correlated in the long run. Taking risks is the key to making big returns. But you must learn to live with risk, mitigate risk, and price risk as best you can.