The Categories of Risk in the VC Brain
Venture capitalists often talk about different kinds of risk. It’s worth asking the VC’s you meet with what types of risk they feel most comfortable or uncomfortable taking. All VC’s have their preferences and it’s a good way to assess whether your company is a good fit for that particular VC. Here are some of the big categories of risk in the VC brain:
- Product risk. Will the product actually work? This is a risk that is inherent in early stage companies, especially those that are pioneering novel science or technologies. Any early investor in A123 Systems for example was clearly willing to take product risk.
- Market adoption risk. Will the dogs eat the dog food? Is this the right product/market fit? This generally refers to all the risks related to getting your first sets of customers, starting to get momentum in the market and whether the value proposition, pricing, etc. will resonate with your target customer.
- Market size risk. Lots of companies get to $15M-$20M, but can’t go from $20M to $100M+. That ultimately becomes a market size question. We’ve seen many an enterprise software company run into this trap where they hit the wall at $15M-$25M in revenue and flatten out. That’s a market size issue.
- Market timing risk. Is this the right product for today or 10 years from now? Back in the late 90’s, wireless applications, electronic medical records, etc. were all hot. Fast forward to 2009, and their time has finally come. Market timing is the difference between the lack of success of Six Degrees of Separation and LinkedIn.
- Competitive risk. Are there dominant players that you have to contend with or are there 25 other start-ups doing the same thing that create too much noise? This was always an issue in the IT security space where there would always be a dozen “heel nippers” in each segment. The robust capital markets in 2000 exacerbated this issue for all dot coms.
- Financing risk. How much capital will it take to get to the finish line? This was a risk inherent in many of the communications services companies back in the bubble days and is also a risk inherent in many clean tech and biotech companies. It’s hard for an average size fund to manage through a company that requires hundreds of millions in capital.
- Execution risk. Does this business rely on a specific execution approach that is uniquely complex and difficult? For example, a roll-up strategy requires a specific expertise. Running a young global business also requires expertise.
- Management team risk. At the end of the day, VC’s invest in entrepreneurs and managers. Who is the A player on this team that you are “backing”? If there aren’t any, often VCs have to decide whether they want to go through the process of helping to build that team which brings with it different challenges.
- Exit risk. So you build an interesting company, get some great customers, generate healthy revenue and margins – but will anyone care? This is often a concern with companies building good businesses in niche markets which may not be strategic to anyone and also may not quite be large enough for the public markets.
Looking through this list, the types of risk I dislike the most are: management team risk, financing risk, and competitive risk. I’m pretty comfortable with the other risks now that I think about it. At the end of the day, any young company will be fraught with risks, that’s why venture capital is “risk capital”. But, hopefully the potential rewards justify those risks. A good VC partner should help an entrepreneur not only expand the potential upside of their company, but also de-risk their downside as well. The partnership should make a high value outcome more probable.