Assessing risk in venture capital transactions
Early-stage venture capital analysis is a many-layered thing, with equal parts art (judgment) and science (data and analytics). Analytics can be taught, while judgment is developed from experience — whether the hard lessons of failure or the nuggets gleaned from success.I’ve described a “meta” view of risk analysis in previous NHBR articles, but will offer a deeper dive into both the objective (data, analytics) and subjective (judgment) of the VC process.There are lots of venture capital analytics that go into a “yes” or “no” decision: market-product needs assessment; competitive positioning and differentiation; financial and financing analysis; and management analysis. Venture capital investors consider each analysis independently and then try to assess elements concurrently.Simply put, VCs assess the size and dynamics (growth-competitiveness) of a market for which an entrepreneur would like to pursue.The market side asks: how large is the market, how fast is it growing and what is the competitive environment — number of competitors, how competition occurs, etc.The product analysis asks: How unique is the product or service? How much does it solve a problem for customers willing to pay (or advertisers willing to subsidize)? The combination of product-market analysis translates to the potential profitability of a venture both in terms of its outlook for both high sales growth (volume) and high realized value — i.e., ability to sell at a price that delivers high product/service per unit profitability, most often expressed as its gross margin.A high gross margin business – such as software — generates more cash for each sale and so offers greater value than a commodity or low-gross margin business, such as food retailers and natural resource businesses.So the sweet spot is where the highest volume of high value products can be sold.This assumes, of course, that the company has the capital and management capacity to deliver said volumes. If a target market requires too great an investment within too short a time period, it may not be attractive to investors. For example, if — to realize volumes and value — a company needs to build a large manufacturing plant at a cost of tens or hundreds of millions of dollars, the venture economics may not work.Accordingly, a second perspective examines the capital requirement viewed against the time to market provides a more complete analysis.Operating 10-year limited partnerships, venture capitalists’ time constraint impels them to pick cash-efficient growth opportunities that can get big (sales) and valuable (good gross margins) within their target holding period of four to eight years — no mean feat. But such is the nature of this particular flavor of capital.
From objectivity to subjectivityData and analytics are very comforting for their relative certainty. Market sizing, identification of competitors and their relative position, mathematics of production scale and gross margin — all can be seen and massaged to deliver a fairly reliable conclusion. That is, different analysts would be likely to arrive at the same result.Judgment, by contrast, relates to assessment of a host of unknowns — seeing the present, assessing the cognitive, social and emotional intelligence of management, investors and directors, projecting the future based on opportunities, assets and human capital, powered by financial capital, managing change and assessing reasons for non-performance, whether management, company or both; gauging proper response to outsized performance.The tools and outcomes of judgment vary from individual to individual. My experience — peppered with successes, failures, situations I’ve seen, biases, etc. — will inform my particular sense of a host of subjective issues around management, the future and what to do in good and bad situations. If I’ve had a tough experience in a new media play with an entrepreneur who came out of Google, I may be slow and cautious to jump in bed with the Yahoo refugee offering me his big-company suite of experience and networks.Countless are the entrepreneurs who lead with the data (size and growth rate of target market, evidence of customer interest) and neglect the subjective elements that, more often than not, are the real drivers of success.These softer issues permeate the entire venture capital lifecycle from determining whether to bet on a team and opportunity, to dealing with the countless decisions that lack data during the course of a venture’s lifecycle, whether driven by positive or negative events.To aspiring and practicing entrepreneurs looking to lock in some capital from professional fund managers, think through the hard and soft aspects of your product, team and opportunity. I can tell you with some certainty that we’ll be doing that. The more you think like us, the better your odds of walking out of a VC meeting with more than some good advice.Michael Gurau, president of Clear Venture Management, a venture development organizations based in Portland, Maine, can be reached at firstname.lastname@example.org.