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Though the industry is called venture capital, the goal of a VC isn’t to maximize every risk. Instead, we try to understand all the risks a business might face and weigh those risks with the reward – the exit. Here are the major risks that I typically review when a startup pitches. In response, I’d love to see the entrepreneurs’ list of VC risks.

Market timing risk – Is now the right time for the business? It’s often hard to evaluate this risk, but nevertheless, it’s an important consideration. There are many stories of people saying I invented Facebook before Facebook, which may very well be true. But the market just wasn’t yet ready for it.

Business model risk – Is there a clear business model? Do the unit economics seem to work? If not, what are the assumptions required to achieve profitability?

Market adoption risk – Are there strong competitive players in the market? What are the major barriers to entry?

Market size risk – If the company is successful, is the exit scenario large enough to provide the types of returns our fund needs?

Execution risk – Does the team have the right skills and passion to reach their goals? If not, are they amenable to finding others to complement their skills?

Technology risk – Does the company have to develop a new technology that may not reach fruition, or may take much longer than expected? This is typically more prevalent in cleantech and hardware companies.

Capitalization structure risk – does the company have enough room in the cap table to take more investment necessary to grow while still ensuring employees and executives are well compensated?

Platform risk – Is the startup building atop YouTube, Twitter or Facebook? How strong is their relationship? Are their product plans in the direct path of the platform or complementary?

Venture management risk – Is the company receptive to feedback? Is the team candid about the state of the business?

Financial risk – How much money does the company require to achieve its goals? Is the financing risk manageable given the current environment and company trajectory?

Legal risk – Does the company have a high likelihood of lawsuit for patent or copyright infringement? Does the company have any outstanding complaints with early employees or founders? Are there regulatory challenges involved in this sector?

The list of these risks applies differently to each startup, but for me, it serves as a great checklist.

NB: Hat tip to Francois Berube who inspired this post

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30 thoughts on “The 11 risks VCs evaluate

  1. That is a really great list. I would like to see that list weight tabled. That would be a really cool slide seeing all the intersections and overlaps that would happen

    • You invite the Entrepreneur to reciprocate and list VC risk – her is my two cents:

      Team and Chemistry – We have spent a long time in mutually trusting relationships building networks, know how, initial traction. Some formalization comes with growth, but culture is important. Inevitably VC involves money to buy a place at the table (and other significant contributions). Money until this point has been out of the question and a side effect of success – because you need to find a market, find what clients want, build with no resources until you don’t need money and only then is money available at a sensible price. This may be hard for VC money to understand.

      Agility – Refining and repositioning to map onto opportunity or respond to a client, implies that the most sophisticated business planning is a big guess. Yes, we need a vision, but no a “plan” that is an any way rigid would be fatal.

      Appetite for risk – We have built a safe business model, but one that can scale hugely. To do this there will come a point where huge cash injection is necessary (to lead the market as competition catches on and responds).

      Multi-culturalism – We are a small team (growing very fast) we are geographically distributed Germany, Switzerland, UK and have languages and cultural flexibility in a complex heterogenous marketplace where regulatory structure (Energy Business) are diverse. Our physical and cultural diversity is a huge advantage, but means that a VC will not be able to track us closely given the time they have to denote to our stage. So it will need a very mature investment philosophy to fit our needs.

      Team 2 – There are gaps in any growing team, we have found that we are very good at assessing what we need to plug these holes, without breaking our culture – A VC will often try to “contribute” by foisting generic managers on an investment taht can do more harm that good.

      Signalling – What signalling can we expect for successive rounds – We don’t understand VC, but we understand there are subtleties. We intend to do uprounds only but know that any SaaS service faces funding issues as metrics stabilize, this can force fundraising during volatile finance periods. We could wait to fund organically, but that is sub optimal for value creation. Therefore we want a VC that will go all the way, or at least hand us on – fundraising time sucks the marrow out of our resources – we want to abstract it very largely – we cannot do that unless we know our investors are there for us with cash when necessary – and though it starts small it may need a lot.

      Exit – Our team have worked together a long time and two have exited previously (trade sales) – One of the older members of the team will want to start taking some money off the table relatively early because of discounting future value differently.

      Finally – Time – We would want our VC to understand our business – it is B2B and not a traditional model, it does disrupt traditional ways of doing things. A superficial “yes we get what you are doing” we have heard before – it is almost a guarantee of the opposite. Richard Feynman said, “if you think you understand quantum mechanics, you do not understand quantum mechanics.” … Our technology is not so rarified – but you get the picture. There is no hobby version of involvement!

      So long post and hope you found it interesting

      • Thanks, James. This is a great response and I think these are insightful points about the risks of taking investment from VCs. A lot of the risks come down to really understanding the business and the team well.

    • I agree in theory, but ratio implies some mathematical relationship. Each company’s risks will be different and so the weightings of these risks will vary. I’m not sure you can distill to an equation.

      • I fully agree. There is no formula and very opportunity is analyzed separately (the word ‘ratio’ might have been misused here). It was merely conveying that went entrepreneurs take the first steps in their journey, they should analyze the risks and question marks, identify the key ones and focus on validating them. Mitigating some of these risks, in my view, is another indication as to the team’s understanding of the business and their ability to execute.

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  3. This is an awesome post Tom. Having worked with a VC fund earlier, I sure to say you couldn’t have captured this better. We were in advance stages of negotiations when the deal dint go thru because of the previous legal case of one of the founders. I think this is a must read for both entrepreneurs & aspiring VCs

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  6. Tom – Have you looked at Disqus.com for commenting it is local to you guys (It has a much cleaner interface for commenting) and plays very nicely with engag.io). It supports simple functionalities like nested view of comments and so much more – In any case thanks for responding and I will keep you “in my book” for A round – which I imagine coming around Spring / Summer 2013 when we will be needing a foothold in CA – Europe will be getting too small 🙂

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  8. Great post, as usual!
    I would only point out not to underestimate what I would call the “do nothing risk”, since even though the statu quo may not lead to any of the risks listed above, it may still prove to be extremely risky.

    And finally, I woud say that knowing the risks a startup is/could be facing is undoubtedly crucial in my mind, but of equal importance is making sure everybody (from the VC to the founder, but also including management and employees as well) understand their role and make sure they pay attention to these risks and do the necessary follow up as well so it does not just become a yearly exercise to list them.

    I’m not saying that risks should be the crucial elements of all decisions, but a company will be much better equipped to face them if they are prepared or at least aware of what might come up.

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