Risk Management for Venture Capital Firms
Venture capital is synonymous with startups. It’s the reason we have some of the most innovative and successful companies of the last few decades – like Facebook, Uber, and SpaceX.
But venture capital is also synonymous with risk. In fact, if you look up venture capital in the dictionary, you’ll likely see risk included as part of the definition. But does your firm have a solid venture capital risk management plan?
At its core, venture capital (VC) is about investing in risk to fuel and facilitate innovative and disruptive ideas to reach enterprise status.
Despite the global pandemic, 2021 was a record-breaking year for venture capital activity. In 2021, venture capital-backed US companies raised an impressive $329.9 billion, up from the previous record of $166.6 billion raised in 2020.
However, as of 2022, the VC investment world has come back to Earth, with money pulling out of funds, less companies being invested in, and some of the smallest rounds we’ve seen in over a decade.
The volatility of this market, especially in 2022, has given startup founders and investors something to think about when considering where their funding is going and coming from.
So how can VC firms manage these new risks while continuing to pursue successful investments? It all comes down to risk management.
Venture Capital Risk Management
So what makes venture capital so risky? Consider that about 90% of startups fail. Sure, those odds may not sound good, but the startups that succeed can be immensely profitable for VCs.
Look no further than Facebook as a prime example of a VC investment gamble that paid off (and then some). In 2005, VC firm Accel Partners invested $12.7 million in Facebook. In return, they received around 10% of the company — and a lot of ridicule from others around Silicon Valley for investing so much in a young startup.
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But it turned out that the joke was on everyone else. When Facebook went public in 2012, Accel made $9 billion off its investment, with Bloomberg declaring the VC firm’s initial wager to be the “most profitable ever for a venture firm.”
A report from CB Insights summed up the high-stakes gamble and payoff of VC investments with:
“VC investors are long-term players. They spend years funding startups through several rounds, hoping to eventually achieve market-beating returns. Many of these investments fail, but good VC firms know and expect it will take a lot of losses to find the rare, huge successes. These bets will generate the majority of a firm’s returns and cover for all the inevitable losses.”
Assessing Risk for Venture Capital Firms
It’s impossible to manage risk without first knowing what to look for. That’s why, for VC firms, the first step in risk management is an awareness of risks that could jeopardize investments.
Since risk is inherent with venture capital investments, firms will want a complete picture of what they are getting into before investing in a startup.
While the way that VCs evaluate risk doesn’t follow a one-size-fits-all approach and will vary based on factors like the type of startup seeking funding and the investment size, there are certain risks that all VC investments face.
Market Risks
Even the best idea can fail if there is no market for it. (There’s a reason none of us have a WebTV box in our homes these days.) So it’s easy to see why this is one of the most crucial types of risk for VC firms to address before any investment.
Market risk comes into play when looking at the relevance of new services or products, a company’s potential competition, and changes in the market.
Questions that VCs often ask when gauging market risk include:
What market does your product or service address?
How big is the available market?
Does a market currently exist for this?
Who are the targeted customers?
Are the targeted customers known to buy from startups?
Operational Risks
You can take the concept about not every great idea succeeding and apply it to founders. Some people are cut out for growing a business from the ground up, and some aren’t.
Operational risks involve everything about how a company operates. This risk category has to do with the motivation of the founding team, the startup’s overall capabilities, the company’s business model, and everything else that has to do with the people running the company.
For VCs, these operational risks are a key indicator of whether an investment could see a profitable return. For example, an incomplete management team or a startup with management that lacks focus and experience can be a major red flag. In a nutshell, operational risks come down to assessing the management of the startup and whether the team has the capability of growing the business and making it profitable.
Examples of questions that VCs often ask when assessing a startup’s operational risk include:
Is the business model appropriate for the intended market?
Are the financials of the business model realistic?
Are there any legal issues that need to be addressed?
Is the management team transparent about the state of the business?
Is the team receptive to feedback?
Technology Risks
Startups don’t have to be in Silicon Valley for this risk to apply. Since technology is an integral part of our everyday lives, most VC investments will be with companies with an innovative tech focus or component.
Before investing in any startup, venture firms will want to evaluate the technology or product risk. This category has considerations that overlap with market risks since the technology has to have market fit to have any hope of success.
Questions for VCs to ask to assess technology risks associated with a startup include:
Is this product/service solving an existing problem?
If the problem it solves already exists, how does this product/service differ from what is already available?
Are there any technical dependencies to consider?
How long will the technology take to develop?
Financial Risks
And, of course, we can’t leave out the quintessential risk for VCs: financial risk.
There are a few different ways to examine financial risk regarding VC investments. Financial risk can pertain to a startup’s cash flow situation and can also reference the risk of a VC not being able to make a proper exit from an investment. So, you could look at it this way: Having a thorough, upfront understanding of a startup’s financial situation provides a VC with insight into the ability for a successful exit down the road.
When it comes to financial risk, the primary considerations for VCs are 1) How much profit can be made with this investment, and 2) How long will that take?
Other questions that VC firms should ask to assess financial risk include:
Does the company have enough capital to realize its objectives?
Is the financial risk reasonable with the current market and company business plan?
How Venture Capital Firms Mitigate Risk
Risk mitigation comes down to a sink or swim premise. Investing in a robust risk mitigation strategy will be immensely beneficial, but choosing to forgo risk management will, well, you can probably guess the outcome. Undoubtedly, with so much potential risk at stake, mitigation strategies are vital for venture capital firms.
Before we dive into tactics, it’s worth noting that while most risks can be mitigated, not all risks will be mitigated. The reason? Mitigation strategies have costs, or even additional risks, associated with them. The cost could be in cash, such as purchasing additional insurance for your firm, or it could be in the form of resources and time, such as creating a strategic partnership.
Once the risks have been identified, the next step is determining which ones must be mitigated by prioritizing them based on severity. For example, a risk with a high likelihood of occurring with significant consequences should quickly go to the top of your mitigation to-do list. But a risk that has a low chance of occurring and only minor repercussions can be put on the back burner for the time being.
Here are some of the ways that venture capital firms mitigate risk.
Portfolio Diversification
You’ve heard the phrase “Don’t put all your eggs in one basket”? That’s the premise of portfolio diversification for VC firms. Diversifying investments is one of the most effective ways for VC firms to mitigate risk.
Diversification doesn’t just refer to increasing the number of companies in a firm’s portfolio and can be achieved through industry, stage, and geographical diversification. Having diversified investments across multiple sectors reduces industry-specific risk, while stage development diversification reduces exposure to risks specific to different startup stages, like seed, growth, and late stage. And geographical diversification helps reduce regional-specific risks (think extreme weather).
What’s more, portfolio diversification can be beneficial for sourcing new investment opportunities rather than solely focusing on one industry, stage, or region.
Due Diligence
You could call due diligence the backbone of risk mitigation for VC firms because those that don’t commit to it won’t be in the venture capital world for long.
A process that every VC firm must go through before finalizing an investment deal, due diligence is used to evaluate an investment opportunity by identifying and analyzing its potential risks. Due diligence reduces a VC firm’s risk by understanding the potential issues and challenges associated with an investment.
Any effective due diligence strategy, which should be a company-wide approach that outlines criteria for evaluating investment opportunities, increases a VC firm’s likelihood of detecting successful investments and avoiding ones that won’t produce high returns.
In venture capital, syndication is a strategy that involves having multiple investors come together and share an investment deal. Often, venture capital syndicates have a lead investor who negotiates the deal’s terms on behalf of the entire partnership.
Not only does syndication mean sharing risk with other investors, but it can also help diversify investments. Plus, having more than one VC screening a deal can be beneficial for bringing different perspectives to the table.
Not to mention that having syndication partners can enhance the due diligence process, leading to reduced risk and that means better odds for success.
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Staged Financing
Staged financing is widely used in the venture capital world – and for good reason. With staged financing, rather than providing all of the capital upfront, a VC invests in stages. Often, a startup must meet predetermined milestones before receiving more funding. But the real advantage of staged financing is that a VC firm can abandon the project without penalty if a deal doesn’t meet expectations.
Risk Transfer
You may have been wondering when insurance would come into the picture. This is it.
Purchasing insurance coverage tailored to venture capital firms is a way to mitigate and transfer many of the risks that these companies face. After all, there’s no shortage of sources for claims against VCs: employees, partners, limited partners, portfolio companies, and regulators, just to name a few. And in the venture capital industry, litigation is often complex, which also means expensive.
Keep in mind that VCs join the board of directors of a company they invest in to serve as an advisor. However, this can make firms vulnerable to various claims, particularly those about management or investment failures. These portfolio risks can expose venture capital firms to legal challenges ranging from regulatory fines to misrepresentation lawsuits. Plus, VCs that join the board of a startup can also face operating risks as a participant in a startup’s team and could face employment practices liability claims such as harassment and wrongful termination.
On top of that, being a limited partner can lead to fiduciary claims related to managing funds. And since VC firms provide professional services to other companies and investors, they are susceptible to errors and omissions (E&O) claims. Here’s a scenario: A VC firm provides guidance and advice to the companies in its portfolio. One of those companies suffers a substantial loss and blames the VC for bad advice, leading to an E&O claim.
Having appropriate insurance to cover the unique risks that VCs face will help protect assets and the firm in general.
The Bottom Line
Risk often gets a bad name. But it’s worth pointing out that not all risks are bad. In fact, some risks can create opportunities for growth and success.
The key to sorting the good risks from the bad? A robust risk management process.
That means having risk management processes and procedures in place before you need them. And making sure you have the right strategies in place to meet the needs of your venture capital firm.
Interested in learning more about insurance policies that can help protect your VC firm from potential risks? Contact one of our experienced brokers or visit Embroker’s digital platform to get an online quote.
