Venture Capital Firms
Venture Capital firms employ unique mixtures of risk evaluation techniques to determine who they will include in their portfolio and which companies they will pass on. Risks that VC firms evaluate include market timing risk, business model risk, market size risk, execution risk, technology risk, capitalization structure risk, platform risk, venture management risk, financial risk, and legal risk. Each firm has its own methodology when it comes to selecting which risks to take. Here are the two different methods that long-standing VC firm Kleiner Perkins and newcomer Andreessen Horowitz use when evaluating their portfolios' risk.
Kleiner Perkins, formerly Kleiner Perkins Caufield & Byers, is one of the most widely and well-known VC firms in the world. It was founded in 1972 on storied Sandhill Road in Menlo Park, California and is known for investing in such heavy hitters as Amazon, AOL, and Google. With three decades of experience and proof that their methodology of risk evaluation works, Kleiner Perkins is a good place to start looking at how some VC firms evaluate portfolio risk.
- Kleiner Perkins uses their investment managers' backgrounds and experience to evaluate new ventures, as partner Wen H. Hsieh describes. "My deep background in engineering and sciences has been indispensable in helping me more accurately assess that delta of opportunity on a timely basis."
- The value of investment managers having external knowledge and experience to evaluate risk is backed up by a German scientific study on mitigating risk. "The construct investment manager´s experience and skills as a risk management measure in VC-backed ventures are significant, which was rarely discussed in literature before."
- Kleiner Perkins partners Randy Komisar and Eric Feng say that business model risk is not as big a factor for early stage investments because business models can change and that instead evaluating the existing customer base, how an entrepreneur thinks about his/her business, and whether a startup has momentum are key indicators.
- Co-founder Tom Perkins said the most important element in evaluating risk is timing — making sure you don't get in on a deal too early or too late. "When an idea comes to you, it's always a mix of people, technology, marketing, even legal issues. You have to identify the most important risk element and structure the deal so your initial dollars get rid of it."
Andreessen Horowitz is a relatively newer VC firm, founded in 2009, and also located in Menlo Park, California. In 2019, a Forbes article stated "Andreessen Horowitz Is Blowing Up The Venture Capital Model (Again)". A different type of VC than the long-standing institution of Kleiner Perkins, Andreessen Horowitz was started by the co-founder of Netscape and was openly in search of “megalomaniacal” founders who would shake things up in a big way. So how does this very different type of VC evaluate the risk in their portfolio?
- According to co-founder Ben Horowitz, Andreessen Horowitz typically follows the following model of risk evaluation and mitigation when pursuing VC investments:
- "Raise a large amount of capital from institutional investors."
- "Assemble a set of experienced partners who can provide hands-on expertise in building the product and then the company."
- "Evaluate each deal very carefully with extensive due diligence and broad partner consensus."
- "Employ strong governance to protect the large amount of capital deployed in each deal. This includes requisite board seats and complex deal terms including the ability to control subsequent financings."
- "Manage own resources effectively by calculating the amount of capital/number of partners/maximum number of board seats per partner to derive the minimum amount of capital that must be invested in each deal."
- However, Horowitz says this model of risk mitigation is sometimes not the best way to go as it requires too much capital, a long due diligence process, and selecting a board seat. So, Andreessen Horowitz also invests in some opportunities like an angel investor, who only puts in a small amount of capital, with simple terms, and can help in the early stages "to bridge the gap between building the initial product and building the company."
- This portfolio diversification of big VC investments and smaller angel investments allow Andreessen Horowitz more opportunities for "unicorns" or outlier companies that make it really big, unexpectedly.
- Co-founder Marc Andreessen said that for each different stage of start-ups, there is a different risk factor that is most important to look at.
- For seed stage startups, the entrepreneurs and people are the most important factor, including their experience, skills, and track record, Andreessen said.
- For venture stage startups, the people and the product/market fit are the most important factors, and whether the product will take off in this market at this time, according to Andreessen.
- And for growth stage startups, the financial state of the business is most important, particularly as Andreessen said, "can the startup profitably sell its product to each customer?"