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Thursday, February 14, 2008

Venture Capital and Investment Risk Assessment

from Marc Averitt, Okapi Venture Capital





Marc Averitt, a venture capitalist at Orange County-based Okapi Venture Capital, and a frequent blogger about the business of venture capital and entrepeneurship. This is a slightly edited and condensed version of his original post entitled Arbiters of Risk.

I thought I could at least share a bit of the formalistic “science” (ie questions posed) behind VC risk analysis so that you have a better idea of the type of questions VCs ask entrepreneurs (and themselves) when making investment decisions.

Most VCs generally categorize risk into one of several buckets — the most common buckets being, in no particular order: market, technical, operational, and financial. Each VC weighs the risk associated with any potential deal across these buckets relative to the stage of investments that his or her fund intends on doing, the stage of the company in question, and what it will take to eliminate/mitigate any such risks — and whether doing so is worth his or her time. You see, we VCs are simply risk arbiters when you really break it down. The tools we use to assess, eliminate, and mitigate investment risks may vary by stage of funds and our own personal backgrounds and abilities but, in the end, we are simply “risk masters” that have been both glorified and vilified by the public in the past decade or two.

Market Risks - There are a number of risks associated with this bucket. Some are mutually-dependent and some could arguably be potential single points of failure for a company. The types of questions VCs ask here are along the following lines. What specific market will/does your product or service address? Or does one even exist (ie, do you intend to create a “new” market)? How big is the total available market? How big is the total addressable market (as a subset of the total available market)? Is the market expanding or contracting…and at what speed? Do the targeted customers routinely buy from start-ups? How long are the sales cycles?In summary, you could have the best ____, but it doesn’t matter if there isn’t a market for it.  Answers to these questions will help VCs determine whether the company can become of great value (at least as a function of revenue multiples).

Technical Risks - As most VCs invest in “technology / innovation” types of companies, we will inevitably need to understand the underlying technology / innovation for your product. The types of questions we will be asking you and/or ourselves here are as follows. What is the technology (ie what is its intended function)? Is it theoretical or proven? How is it better than what currently exists? What problem is it solving (or is it simply a “nice to have” rather than a “need to have”)? If it is still just theoretical, how will you prove it (we will need definitive data and lots of it). Is the technology in question part of a system or is it a “stand alone” type of thing? Is the technology defensible from an IP perspective? Any technical dependencies that need to be accounted for? The basis PLC considerations (e.g., design, development, QA, distribution, support, etc.) all come into play here as well depending on what it is your product (or service) is.  Answers to these questions will help VCs determine a number of other risks (eg financial) as well as what the value of the company may become based on its innovation (IP).

Operational Risks - From my perspective, this is the biggest/broadest category as it has to do with everything from the people involved in the endeavor to the business model, legal mechanics, logistical considerations and everything in between. While this category merits its own post, I’ll just leave you with a few questions to think about for now. Are the people involved the “right” people to get the company up and running? Alright, let’s stop here. If you’re like most entrepreneurs, you’re probably asking yourself “what the hell does ‘right’ mean???” Good question and one that you’ll rarely get a straight answer from a VC on but I’ll give it a shot here. By right, I mean to say what is it about you and your back ground that will give me the confidence needed to invest in your company and that you will be successful in building a very valuable company. Put another way, what we are really asking is whether you possess the relevant knowledge to do what needs to be done or will you/we need to bring in someone who does. In the essence of time, I’ll post more later on what it means to be “right” vs. “wrong” in a separate post and move on here. Does the company have the right business model for the targeted market? Is the model efficient from a financial and time perspective? Are there any legal considerations with respect to the start-up (e.g., IP, labor, contracts, securities, regulatory matters, litigation, etc.)? As you can see, operational risks are broad and mutually-dependent with many other risks.

Financial Risks - The financial risk analysis starts with the simple question:  how much money can we realistically expect to make if we did the deal and in what amount of time?  The next question here, based on the answer to the first question, is also simple: is it worth it?  As I’ve explained before,  VC funds are typically limited partnerships with a definitive end-date by which they must “liquidate by” so any investment must give the fund a degree of confidence that they can invest XXX number of dollars into the company and sell the corresponding stock for ___x (fill in the blank here) their total investment within the term of their fund.  The second question is, therefore, the most important one as it may be possible to make money by investing in a company but the expected return may be too small or take too much time relative to other investments that the fund might do.  Remember, just because VCs don’t invest, doesn’t mean that the company can’t be a going concern and make money for its founders.  It may simply be too little or take too long for VCs given the dynamics under which they operate.  Or, the company may simply require more capital than the VC in question is comfortable with from a dilution perspective.

Marc Averitt is a Co-Founder and Managing Director of Okapi Venture Capital (www.okapivc.com) and is responsible for Okapi Ventures' information technology investments. Marc also maintains a personal blog about venture capital in and around Orange County at http://ocvcblog.com.


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