Risk Management for Early Stage Venture Investing

Andreessen Horowitz recently revealed that its investment of $250K in Instagram became $78 million. Thats a multiple of 312. Investing in early stage ventures is indeed very rewarding yet inherently risky. It thrives on multiple high risk bets out of which one or more would achieve high rewards. But that certainly does not mean putting blind bets on anything that comes your way. Those who believe in "Spray and Pray" kind of investing are often losers in the long term. Most VCs through their experience would have developed some sort of an internal braincloud (mental) checklist which gets ticked during the pitching sessions. Relying on mental checklists again is risky. Some or more of those check points might get sidelined if the idea falls into one of the soft spots of the more influential team members. So how can venture capital funds systematically mitigate undue risks?

Here is a list of risks inherent in Venture investing along with practical risk mitigation strategies and if needed a Jugaad. Jugaad colloquially means a creative idea, or a quick workaround to get through commercial, logistic or law issues.

1.     Risk of the Unknowns : Most people think a business is after all a business whether it is hi-tech or low-tech. If it makes money, why shouldnt one be part of it. Some argue that if one understands the need of such a product/service, one qualifies to invest. But most would forget that it takes a lot more for a venture to succeed than just a great idea. Devil is always in the detail and execution. If you come from an e-commerce background and are offered an opportunity to invest in an orthopedic surgical device, think twice. How would you figure out what is the right amount of field trials you need to carry out before pitching it to potential acquirers? What makes more sense - licensing the technology to an existing player or go solo?
Mitigation: Invest ONLY in areas where Fund Managers have some domain knowledge.
Jugaad:  If you are excited to support an idea where the investment team does not have relevant expertise, the fund management should think about appointing an advisor who knows that domain and is willing to work closely with one of the investment team members.

2.     Risk of loss of visibility: This is something I have learnt from my own and my partner's experience. I am a firm believer in technology and remote working when it comes to Shared Service Environments in large multinational companies where job descriptions are clearly laid out and roles are well defined. However, it just doesn't work in startup environment with founding team sitting in a different time zone. Having a development centre alone in a different time zone can create headaches and delays.
Mitigation: Invest LOCAL.
Jugaad: Appoint local advisors as representatives and enhance corporate governance measures by inviting -local independent directors to the board.

3.     Risk of Founder's fatigue : Starting up is hard enough. Doing it alone makes it even harder. What would you do if the key founder throws in the towel? It is indeed very difficult for a startup to find a CEO material to pick up and run.
Mitigation: Invest in TEAMs not Individuals. Also, test individuals in the team by offering them less salaries than their expectations. This would be a small test for them to prove that salary is not their motivation and they understand the big common goal.
Jugaad: If the founder has prior track record, that can be viewed favorably.

4.     Risk of running out of cash: Most startups before getting proper funding are in boot strapping mode. Spending is conservative and revenue prediction is optimistic. Who hasn't seen those hockey sticks and the great magic of excel? But as soon as they get investor funding, startups tend to shift modes. They think more like a real company with real overheads.There is nothing wrong with that except the fact that monthly burns suddenly shoot up to such an extent that there is not enough time left to pivot. If the idea spreads virally, it works. Otherwise, founders are happy to treat this as a learning opportunity on the scholarship provided by VCs.
Mitigation: Assess how much cash is required as per the most reasonable forecast. Multiply outflows by 1.5 and inflows by 0.5. Scott Anthony says: "It always takes longer and it always costs more." Fund the company with at least 20% more than the number you arrive at. An early stage company needs at least 18 months runway.
Jugaad: Syndicate with someone who can do follow on investments. You are going to need that money whether the company does well or not.

5.     Risk of post marital blues : It is very common to have disagreements whether it is among co-founders or between founders and investors. Being humans conflicts are inevitable. Most of the time people manage to settle these issues by a little give and take. But there are instances where there are gridlocks and relationships become so sour that the parties can't even stand each other.
Mitigation: Investment lead should be identified and allocated to the investment opportunity even before the first pitch. This person, through the course of due diligence, must pose some difficult questions in front of the team and observe the team's reaction. If the team shows any signs of arrogance or denial, this must be looked into greater detail.
Jugaad: None. Stay away if you see such early signs.

I sincerely believe that there really is a science to nurturing successful startups, and that it has to do with methodically knocking down risks to get to the rewards.

Happy Investing,
Piyush