Risk management for venture capital firms

Venture capital (VC) firms are the launchpad for startups. Without substantial venture capital support, groundbreaking companies like Facebook, SpaceX, and Uber might never have taken off.

However, as any venture capitalist will tell you, VC firms are also synonymous with risk. In fact, risk is the defining characteristic of venture capital, and only a solid plan can transform it from a liability into a strategic advantage. But does your firm have a solid venture capital risk management plan in place?

In this post, we’ll delve into risk management for venture capital firms and break down how to manage these new risks while continuing to pursue successful investments.

Venture capital risk management explained

At its core, venture capital is about investing in risk to fuel and facilitate innovative and disruptive ideas to reach enterprise status. VC firms essentially trade the risk they take on for a share of ownership (equity) in these potentially high-reward companies.

What makes venture capital so risky?

VC firms fund startups and early-stage companies that often lack established revenue streams, proven business models, or even a stable market presence. This stage of a company’s life cycle is volatile, to say the least, with both the potential for exponential growth and sudden failure. Additionally, venture capital investments are generally illiquid, meaning it can be years before investors see any returns, if at all.

Considering that about 90% of startups fail, it’s pretty obvious that the odds of investing in a successful startup are slim. In some cases, VCs will inject millions of dollars into startups, only for the company to fail soon after. 

Take health technology startup, Theranos as an example: The company received hundreds of millions in venture capital from prominent investors, eventually receiving a $10 billion valuation in 2015.

However, it was later revealed that the startup’s core technology didn’t work as promised, and the company had misled investors and regulators about its capabilities. Theranos dissolved in 2018, and its VC backers lost millions of dollars.

That said, the startups that do 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 15% of the company — and a lot of ridicule from others around Silicon Valley for investing so much in a young startup.

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.”

Different types of risks 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 to develop an awareness of the different risks that could jeopardize their investments.

Since risk is inherent with venture capital investments, your firm will want a complete picture of what you are getting into before investing in a startup. 

Evaluating risk in VC investment is not a one-size-fits-all approach. Your risk management strategy will vary based on a number of factors, such as the type of startup seeking funding and the investment size. 

There are several different types of risks associated with VC investment that can be organized into four main categories: market risks, operational risks, technology risks, and financial risks.

Market risks

Even the most revolutionary idea can fail if there is no market for it. So, it’s easy to see why this is one of the most crucial types of risk for VC firms to address before investing. 

A prime example of this is Quibi, a short-form streaming platform that raised $1.75 billion in venture capital before crashing hard and selling to Roku for less than $100 million. There simply was not enough of a market for Quibi’s service, and the streaming platform proved to be a major failure.

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. 

Here are some questions we recommend asking yourself when analyzing the potential market risk of an investment.

• 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

Even if a company has a great idea with a solid market to sell to, the startup may run into issues if they aren’t able to operate efficiently. The honest truth is that some people are cut out for growing a business from the ground up, and some aren’t.

Operational risks involve everything related to a company’s operations. This could include the motivation of the founding team, the startup’s overall capabilities, supply chain management, the company’s business model, and everything else related to the people and systems involved in running the company. 

Unfortunately, there are many startups that have a great product but fail to capitalize on it due to operational struggles.

A real-world example of this is Jawbone, a wearable technology company that liquidated in 2017. The company faced continuous supply chain and manufacturing issues, causing major delays in shipping as well as defects in their products. Despite having a good idea for a product, Jawbone was unable to succeed due to irremediable kinks in its core processes.

For VCs, operational risks are a key indicator of whether an investment could see a profitable return. An incomplete management team or a startup with management that lacks focus and experience is a major red flag. In a nutshell, operational risks come down to assessing the startup’s management and whether the team has the ability to grow the business and make 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

A startup doesn’t have to be in Silicon Valley for technology risk to apply. In the modern business environment, technology is an integral part of essentially every industry. That said, the majority of the most successful startups are involved in tech in one way or another.

Technology risks address the possibility that a startup’s technology may not perform as expected or fail to meet market needs. For obvious reasons, this is a major concern for investments in tech-driven industries because if the core technology doesn’t work correctly, there may be delays in the company’s growth.

Juicero was a juice company that went out of business in 2017 due to issues with its primary product, a high-end juicer. The expensive, internet-connected juicing machine was designed to press pre-made juice packets. However, it quickly became apparent that the machine’s technology was unnecessary, as consumers could simply squeeze the packets by hand to get the same result. Juicero ultimately shut down in 2017 after burning through more than $118 million in venture capital funding.

Before investing in a startup, venture firms should evaluate the technology or product risk. This risk category has some overlap with market risk but, more specifically, focuses on the functionality of the technology rather than the market demand for the product.

Here are some questions to ask when calculating the technology risk of an investment:

• 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 biggest risk for VCs: financial risk.

There are a few different ways to examine financial risk when it comes to VC investments. Financial risk can pertain to a startup’s cash flow situation, but it may also refer to a VC’s risk of being unable to make a proper exit from an investment. 

It is crucial for VCs to have an exit strategy laid out before investing in a startup because it defines how they will realize returns on their investment, typically through IPOs or acquisitions. Without a clear exit plan, your VC firm may face an increased risk of illiquidity and struggle to recover invested capital if the startup underperforms.

We highly recommend having a thorough, upfront understanding of a startup’s financial situation before making an investment. This will provide your VC firm with insight into its ability to exit successfully down the road. After all, reaching an IPO or acquisition is the ultimate goal of both VCs and startups.

An example of financial risk impacting VCs is the coworking space startup WeWork. Initially valued at billions, WeWork faced significant cash flow issues due to high operating expenses and an unsustainable business model. As WeWork attempted to go public, concerns grew about its financial instability, causing its valuation to plummet, ultimately derailing the IPO.

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 does risk management work for venture capital firms?

As you can see, there is a significant amount of risk involved in VC investment, so it is incredibly important to manage risks appropriately and minimize the negative impacts.

Identify key risks

Your first step in managing risk as a venture capitalist is to identify the key risks of each investment. Identify what types of risks are associated with each investment (market, financial, competitive, and operational). 

Assess risks with the risk quantification process

Once you’ve identified the different types of risks, your VC firm should assess their severity using risk quantification. During this process, you’ll assign a numerical value to each risk measuring their individual likelihood and impact. 

There are a variety of different ways that VC firms calculate risk, but one of the most popular ways is to use a Monte Carlo simulation.

A Monte Carlo simulation helps venture capitalists determine different possible outcomes of uncertain events by running thousands of scenarios, each with different variables. For example, a Monte Carlo simulation can determine possible returns and the probability of extreme outcomes, such as bankruptcy. As there are obviously thousands upon thousands of different possible end results for venture capitalists, this process is a good way to better understand each investment’s potential risk.

Organize risks

After quantifying each risk and calculating the possible severity, your firm can categorize them based on their urgency, potential impact, and controllability. We recommend grouping risks into categories based on priority (high, medium, and low). This will allow you to streamline decision-making, address similar risks across multiple investments, and implement uniform mitigation strategies where it makes sense. For example, let’s say a company in your investment portfolio sells diabetes medication. There is a clearly defined and sizable market for the product, but as it is a pharmaceutical, it is at risk of legal and regulatory issues. Organizing the different risks associated with the investment, you could place the market risk as “low” and the legal/compliance risks as “high.”

Monitor risks

Don’t simply forget about the potential risks after calculating and organizing them. Risk management for VC firms is an ongoing process, and you’ll need to monitor each investment’s risk profile continuously. Doing so ensures that your firm is prepared to respond to changes and that your risk management strategy continues to be effective.

How venture capital firms mitigate risk

Risk mitigation is a sink-or-swim situation for venture capitalists. For VC firms, it should be a prerequisite to invest in a robust risk mitigation strategy. Choosing to forgo risk management will be, well, extremely risky. Undoubtedly, with so much potential risk at stake, mitigation strategies are vital for the survival of venture capital firms.

As mentioned, risk is an inevitable part of life as a VC, but there are plenty of ways to reduce the severity of risks your firm faces. Let’s take a look at some of the best ways to mitigate risks as a VC firm.

Portfolio diversification

Have you 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 your firm’s portfolio; it can be achieved through industry, stage, and geographical diversification. Having varied investments across multiple sectors reduces industry-specific risk, while stage development diversification reduces exposure to risks specific to different startup stages, such as the seed, growth, and late stage. Additionally, 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 who don’t commit to it will not survive in the investment world.

Every VC firm must undergo due diligence before finalizing an investment deal. Due diligence evaluates an investment opportunity by identifying and analyzing its potential risks. Understanding the potential issues and challenges associated with an investment reduces a VC firm’s risk. 

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.

Syndication

In venture capital, syndication is a strategy that involves having multiple investors come together and share an investment deal. Generally, venture capital syndicates choose a lead investor who negotiates the terms of the deal 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 better odds for success.

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

Purchasing insurance coverage tailored to venture capital firms is one of the most effective ways to mitigate and transfer many of the risks that these companies face. At the end of the day, insurance is the best protection against legal claims or financial losses.

Unforeseen risks such as data breaches, lawsuits, regulatory fines, and liability claims can be very costly, but with insurance coverage, VCs can safeguard themselves from otherwise destabilizing situations.

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 claims such as harassment and wrongful termination.

Important insurance policies for venture capital firms

• Directors and officers insurance: This policy covers a company’s executives and board members. VCs typically join the board of directors of companies in their investment portfolio, which can make your firm vulnerable to various claims, particularly those targeting management or investment failures. 
• Errors and omissions insurance: 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. For example, if a company suffers a substantial loss and sues the VC for bad advice, E&O insurance will come into effect.

• Employment practices liability insurance: An important policy for any VC firm or portfolio company with employees, EPLI shields against lawsuits related to employment practices, such as discrimination, wrongful termination, or harassment claims. 

• Cyber liability insurance: This policy covers risks associated with cyber threats. For VC firms, this protects portfolio companies from financial losses and reputational damage caused by security breaches.

Risk management is key for VCs

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? Visit Embroker’s digital platform to get an online quote in just a few minutes.