Taking Risk and Mitigating Risk
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.
Comments (Archived):
“risk and return are highly correlated over the long haul”To a point! It’s not very different than betting on sports events: you bet on the favourite and you have a low risk/low return. You bet on the underdog and you have a high risk/high return. HOWEVER, you bet on a team that is eliminated from the playoffs and your return is guaranteed to be zero!The point is: there is a point where the risk is enourmous and the return is guaranteed to be zero.IS there a similar deviation at the other end? That is, can you get a slam dunk (low risk) on the cheap (high return)? Seems to me that you guys have some unwritten rules, where, in a certain era a first-round deal cannot be priced above $X. So, no matter how good the deal is nobody bids it up. The question is, who gets the deal then? Are those the type of deals that go to Kleiner and Seqoia by default? I don’t know the answer…
no first round deal is a slam dunk.there are some late stage deals that at times get priced like early stage deals and that’s where you can get a “slam dunk” on the cheap.it happened a bunch in 2002 and 2003 and maybe it will happen again some dayfred
“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.”meaning if the price seems to be irrationally low in future rounds of financing you invest enough to increase your interest in the company by approx. the same percent of ownership that you purchased in the first round?
there’s no formula, but if we think the price is irrationally low, we absolutely will look to increase our ownership
Hey Fred,Interesting post.If you get inspired sometime, I (and I’m sure many others) would love hear your take on b-school and the early part of your career pre/post MBA. Maybe it’s a self-indulgent topic but to those of us just starting out, the stories are extremely valuable!
chris, you inspired me to post this todayhttp://avc.blogs.com/a_vc/2…
This is great stuff. Can you do a video which we can use as an educational tool for budding entrepreneurs? Not all see the importance of building value and staying with their dream. Great post
Great post.Thank you.
i wanted to get some greater perspective on “dry powder”, found a great post over at VC Confidential that goes into it in more depth: http://www.vcconfidential.c…
Wow, this is a really interesting article. Thanks!Here’s why you should never give control to VCs:”There are two scenarios that are sub-optimal:1) Big winner, not enough capital in: your company does really well, really quickly and you only get a fraction of your allocation in. So, you targeted $5m per deal, invested your 30% ($1.5m) and then the company never raised additional capital. If it does really well (say 10x), then you pull down $15m. This, unfortunately, will only pay for 3 complete losers which you may have had ample opportunity (unfortunately) to get your full $5m into”There is an inherent incentive for the VCs that you don’t do well too quickly, or else they can’t put enough capital in. So if you give them control, they will impede your progress to a pace that they are comfortable with. What many of them don’t realize is how competetive and “winner-takes-all” some markets are. In some cases there is no middle ground: you either have to go full steam ahead or you are toast. The VCs are too preoccupied with their spreadsheets and how to optimize allocation with respect to their own ROI to notice these things… At the end everyone loses.I had always suspected this, but never seen it written explicitly. Most VCs pay lip service to your comittment to success, but sometimes their actions are different and have completely different motivations. The commenter under the article seems to be in a similar state of “a-ha!” as I am now.
I also found the article very interesting (obviously). My sense is, however, when it it comes down to it, want to ensure a successful return on every investment. I can’t imagine a time when a VC would want to take a bath on any ‘money-in’. ROI is always the measuring stick for the LPs. So good VCs will always put the success of the company first.That being said, I did find it to be a very interesting two articles that really sheds more transparent light on the actual “motivations” of all interested parties. The challenge for the entrepreneur is when they are executing well early, and both they and their VC does not see an impending threat in the market where moving a bit slower will not hurt, what is the right strategic play versus slowing down simply so the VC and board can get more money in. Great stuff.
Well, of course, nobody wants to fail on purpose… However, what it comes down is conflicting incentives for VCs.1. They want as big a fund as they can get. The bigger the fund, the more fees they collect, and that’s money-in-the-bank.2. Now you have a fund that is too big for your dealflow. Obviously, it makes no sense to invest it in crap.3. That makes it imperative to plow more into your winners.4. The winners, by rule, become self-sufficient early, so they don’t need that much cash.How do you navigate this?
Guess there is only one way to navigate it. What is funny is after all the complicated math, investment scenarios etc, the simple answer is where the art of the VC comes in: Detect your “winners” before anyone else does (i.e. in the seed round) and make as big a bet as possible.Even if you have a bigger fund, the rule of percentages still hold but it allows you to put a higher nominal value into your detected “winners” early. That is of course if you’ve have LPs that sign-off on the number of deals you plan on doing in the fund. I would assume the bigger the fund, the higher the number of deals you need to do. But if you do the same number of deals as with a smaller fund, I would assume you could plow more dollars in the seed round for a great stake. (sure there are rules of thumb for the good and bad of doing this as well).
that’s just not right. i have never met a VC who roots for a company to do poorly so they can put more money in.
I foung this post and response both really interesting. There are only 15 comments in two days. It was a pretty innocuous post to me, but attracted some odd responses of ‘VC’s hang out with Darth Vader” comments.I”m not a VC, but I’d think the issue is that anyone is going to put their money where they think the best opportunity is at that time. From the entrepreneurs point of view, you don’t know who you are up against. The relative difference of the ‘good’ and the ‘bad’ in the pool very well may be a more significant driver I’d think than the absolute measure of ‘good’ and ‘bad’. I’d think if the externalities dirve the outcome, managing risk is really difficult, as in, was there too much external pressure to chase bad deals in 1999? Perhaps, independent thinking is a better compass, though it seems the industry doesn’t follow that pattern.There also is a parallel as an entrepreneur to ‘try many alley’s’ to figure out what is not the dead end as a company vs a portfolio.At the end of the day it seams like, entrepreneur or VC, those who can be persistent in a sensible objective over a long period of time and a low burn rate…wins.re: “No investment plays out the way you think it is going to play out”. The Black Swan by Nassim Taleb is 400 pages of you don’t know what you don’t know, and that will frequently turn out to the most significant factor in the out come of things. It’s a facinating book that I think could truly inform decision making in business. He mentions VC’s too as being too risk averse.At the end of this day, the only thing I can figure is that the number one element in success is just trying. Right there you eliminate nearly everyone just because they don’t pull the trigger.
My limited experience (two funded companies) has been that venture capitalists want to invest in the risk that created a successful product or model, but once the money is in they want to reduce risk, and it stifles innovation. That’s too broad a statement, but it feels that way.
Fred: Your views and insights are priceless for those seeking to learn more about risk and the venture capitalist. Not everyone gets to experience the process first-hand and your musings allow a vicarious peek into some of the mechanisms at work when a startup is funded, or not. Thank you for sharing!
“Markets are never rational in the short term. And almost always rational in the long run.”Or as Benjamin Graham would have put it: in the shortrun, markets are a voting machine; in the long run, a weighing machine.I do not believe that risk and return need be correlated. Return is a function of your information and ability to process it better than the others in the market. Risk is a function of your ability to accurately assess your ability to correctly price return. The two need not be (and are not often) correlated.
true, but the two are related. most opportunity comes with significant risk