On risk taking in the venture world

Nick Britton wrote a great, well-researched piece on venture capital which I encourage you to read (A Crisis in Venture Capital).  We had a long chat on the topic and as you can see I provided him in the process with some fun quotes to lighten up the mood of this appropriately downbeat article.   I want to look at risk-return in more detail here.

Spurred by my combative quote at the end of article, Paul Fisher from Advent last night commented that I had to watch painting a black-and-white picture of "those who take risk" versus "those who don't".  Robert Loch chimed in with an interesting theory: for him the trouble with next-gen European venture capitalists is that we all got kids at the same time (Court, Destin, Fisher, Klein, De Rycker and so on) and changed our outlook on risk both at home and at work.  He has a point, but the capital crunch maybe more of a driving factor here :-).  Anyway we proceeded to mention CAPM and the like together and I think it's worth re-emphasizing a simple framework for risk in venture as you can't provide much subtlety through colourful one-liners in the press.

Venture is all about taking managed risk.  That means risk that can be handled appropriately both by management and investors and returns that are commensurate with the exposure taken.  There is endless strife between venture investors and entrepreneurs usually around the idea that "venture capitalists are dumb lemmings who are susceptible to irrational investments in bubble times and irrational capital preservation in tough times" whilst "entrepreneurs think cash grows on trees and that they should not suffer the consequences of their actions" or similar helpful lines of argument.  As an example, there is a well-argumented Vivek Wadhwa post on Techcrunch that is a really good read but perpetuates this fairly useless battle (Yes, VC's follow Entrepreneurs who are the real heroes of innovation, let's put that one to bed once and for all please).

My observations are as follows:

• You have to think of risk /return tradeoffs as a continuum from initial idea to $10bn business.  At different levels of developments investors will need to deploy different skills to analyse investments and help their companies.  Venture capital covers a broad variety of risk/return tradeoffs.
• A $20M revenue business is not a de-risked business.  Tough and risky decisions continue to be required and often require greater skill and analysis then at the early stage, particularly as these decisions tend to be "non-reversible".
• Each venture firm tends to have a "risk-return DNA" that determines the natural risk habitat in which they will feel comfortable investing.  Some folks are highly comfortable with taking on two technical co-founders in an unproven market whilst others like to help companies scale and like to use reliable KPI's and financial models as a guideline to decision making.  The best, most experienced investors and outstanding partnerships may be able to operate across the spectrum.
• Trouble arises when investors stray to far from their natural habitat.  A couple of years ago, a potential investor in Zoopla asked us to produce a 3-year budget that we could stick in the legal documentation as a roadmap for execution for the company.  Whilst this is a sound business practice for more mature businesses, it was a clear indication that this investor was not ready to take on a "quick iteration" team that was testing its market continuously and revising pricing and product mix on the fly.  Better not sour the relationship and keep the potential investor relationship alive for a time when the company would be ready (and need) this type of expertise.

So it is all about taking "the right type of risk".  To take a practical example, Peter Baines, a proven investor at Advent Venture Partners, provides myself and Philippe Collombel with a great complementary set of skills on the board of DailyMotion.  I don't think he would have been too happy with the kind of acrobatics that Phil and I had to do in the early days of the business, but by the same token I am extremely grateful for the added discipline and financial focus that he now brings as we progress to and beyond breakeven.

The current crisis of confidence in venture is driven by a long-overdue realisation that the assumptions on exit values and capital intensity were just plain wrong.  As Mike Chalfen, again of Advent, notes in the article:

The key to survival in a post-credit crunch world is to accept that businesses are going to sell for less. It follows that investors need to put smaller amounts of money into more “capital-efficient” companies in order to generate attractive returns.

What Mike is referring to is a late-stage portfolio build strategy that probably looks like this:

• Return profiles are 3-5X rather than 5-10X and over
• Very low default rate on the companies rather than the usual 30+ % ("don't drop the ball")
• Controlled capital intensity and hopefully shorter holding periods

I will come back to the relationship between capital intensity and risk taking in a separate post as it deserves more discussion, but I think Mike nicely captures:

• The current malaise in venture capital as companies and entrepreneurs continuously struggle to achieve the "right" risk-return tradeoffs for investors
• The need for venture capital firms to sharply focus on consistent portfolio build strategies that fit their natural DNA
• The absolute focus on capital efficiency that is currently permeating the market, driven both by outside events (liquidity crunch) and a return to the artisan roots of venture business building

The industry clearly needs to shrink and get back to its roots, with VC's being realistic about what they are good at and those who seek a quick buck exiting the industry.

For my side, I remain focused on early stage and high upside, risky deals with combative, scrappy entrepreneurs.  Once Segerstrale, Ek, Chesterman, Cohen and co have realized the substantial exits we're expecting of them, and provided we have the right metrics to woo our investors, we will have earned the right to continue doing what we do, with all the passion and determination that it takes to succeed.  And that, my son, is how the West was won :-)

Comments

[Michel de Guilhermier]

Fred,

Just one point : "Venture is all about taking managed risk"

It's not only venture which is about taking managed risk, it's the investment game in general. In that field, one always has to assess the level of risk vs the potential expected return.

And - for investment in general - I do agree that focus should be the efficiency of invested capital.

[Sean]

Good thoughts. But 'capital efficiency' - like all good truisms before it - has been misappropriated as a crutch for venture investors who actually don't want to take venture risk imho. Sure you need to watch your pennies and it goes without saying that a frugal executive team is an asset. But.

But there is a difference between lean and anorexic and I'm not sure the pendulum hasn't swung too far to the latter for many European investors...

[Fred Destin]

@Michel -- emphasis here is on managed in the active sense of the word -- you have a serious and direct (positive or negative) influence on the outcome / level of risk

@Sean: actually think it's a subtle point as in the early days money is almost never the answer to a startup's woes but when scaling undercapitalisation really hurts. Would be interest in your expanded view on this.