The anatomy of startup risks

From an investor point of view

Overview of Risks in Financial Markets
Financial institutions are notorious for taking risks across the spectrum: FX, country, politics, sector, execution, team, counterpart, concentration, market risks.
Risk is a multi-layer notion which can be sliced into dozens of independent, smaller elements. It is surprising that few investors could name the risks they are the most comfortable with.
In the financial markets, shrewd investors are taking specific types of risk while hedging the residual ones with derivative products. That is why sell-side financial institutions like investment banks are organized in desks, each solely responsible for a slice of the structure’s risks: debt, convertible, equity, arbitrage, commodity, prime brokerage, interest rates.
Buy-side organizations as well: Long/Short hedge funds for example are mainly taking on ‘company risk’, hedging unwanted hazards like market or currency-related risks and mitigating country or political-related risks through shrewd portfolio management techniques.

Every well-defined financial strategy has a risk perimeter which is circumscribed to a few areas of expertise. Hence the team. Hence the business model.

Overview of Risks in Early Stage Venture Capital Firms
Early stage Venture Capital firms are organizations investing in startups: new companies with scalable and repeatable business models.
Which risks do VCs have to be expert in? What are those they need to mitigate? And those they can’t do much about?

I will define 3 types of risks to answer the interrogations at hand:

• Business Risk: any risk intrinsic to the startup’s ecosystem.
• Financial Risk: any extrinsic risk depending on the financial markets.
• Non-Business Risk: any non-financial extrinsic risk which is outside of the startup’s area.

Non-business risks

Non-business risks stem from the geopolitical context.
Political risks, Country risks, Tax risks, Systemic risks belong to it. How do we deal with it? From a topdown perspective, IndigoBlue is based in continental Europe. We are aware that European Union has some challenges ahead (Currency, European Union…) but we think that Europe and particularly France is one of the most stable environment to operate financially and technologically over the long run.

Financial risks

Expertise in portfolio management allows to mitigate the main financial risks embedded in portfolios. How?

We mitigate Liquidity risk as we invest within different timelines in mind for startups that will become liquid at different exit times and, if successful, reduce the investors’ lockup period.
Market risk is hedged with market neutral companies, i.e. companies which are not correlated to market movements as is the case in the Healthcare sector for example.
To deal with Valuation risk, we invest 50%+ of our portfolio in province-headquartered startups where deals are just as good but less expensive.
We hedge against Concentration risk by investing in fundamentally different thematics which make them financially independent.

We also monitor a collection of residual risks (inflation, credit, FX…) without taking specific actions as they have a minor influence in startup-focused portfolios.

Mitigating financial risks is part of our fiduciary responsibility. We consider financial risks a cost center, but it is a robust mean to build an eclectic & balanced portfolio. The finesse of early-stage VC portfolio management is that it involves only a handful of decisions per startup each year, as the liquidity of startup positions reduces the windows of exit opportunities. We only take a few decisions but they are all the more fundamental since we must ask ourselves the following questions for every new investment:
Which sector? Which duration? Which correlation to the market? Which potential? Which level of risk should I add to the current portfolio?

Business risks

“We must make the best use that we can of the things which are in our power, and use the rest according to their nature.”
Epictetus

Understanding Business Risks is the core of VCs expertise.

Any startup belongs to an ecosystem from which derives the majority of business risks it faces. We call endogenous business risks all the risks which depend directly on the founders actions, processes and execution. On the other hand, exogenous business risks do not depend on management’s direct action.

Exogenous Business Risk
Competition, Technology, Legal, Demand, Timing risks belong inherently to the startup’s peripheral world. They wield a significant influence on the startup activities and motivations but are not under management’s direct control.
Exogenous risks are thoroughly analyzed during our screening process: we study those risks in the startup’s ecosystem. They help us contextualize the startup’s dynamics based on the present market situation and our expectations over the next 5 years. They are important to decipher as they qualify the competitive landscape, the startup’s potential and in fine, the appetence we will have to tackle problems alongside the founders.
Exogenous business risks tend to be static, sector-driven and not prone to iterations. They represent the backdrop of our investment. As VCs will have little leverage to mitigate them, they need to be favorable from inception.

Endogenous Business Risk
Execution, Team, Business Model, Complementarity risks are the main levers of founders as they are dynamic, metric-oriented, with short feedback loops. They are quantifiable, manageable, iterative and have a high short-term impact.
This is during the phases of creation, structuration and development of early stage startups, when they are the most vulnerable, that VCs will have the most influence. Our hands-on approach focus primarily on early endogenous business risks as progresses can be easily monitored and corrective actions quickly taken.

At IndigoBlue, we are comfortable with the Business Risks which are the most impactful. It is indeed our core competency: we put an emphasis in our operational support on Execution, Team, Complementarity and Business Model. For the remainder risks (Technology, Timing, Legal, etc…) we are getting help from experts and LPs.

Once you become a specialist in a few areas pertaining to risk, they become sheer investment opportunities. Transversal knowledge helps you increase the edge of founders & teams, and mitigates the weaknesses when spotted. Hands-on VCs tend to decrease startups’ fatality rate thanks to this transversal savoir-faire.

Taking on business risks we are expert in is the main reason we create value, the main reason we can be contrarians, the main reason we are able to de-risk companies from within. This is the epitome of VCs creation of value and one of the beauties of our activity.

If you’re an actual European startup looking to close a Seed/Series A stage, make sure to hit us at apply@indigoblue.vc