How do VCs internalize startup risks?

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Decision making in venture capital often comes down to making data-informed, gut calls on business risks.

Even the very best opportunities present with significant risks. That’s the hallmark of early stage deal flow. You can always talk yourself out of a deal. The key to making smart decisions is knowing which risks are acceptable, and which are not, for a given situation.

I’ve adopted a short framework to map out and separate risks inherent in a venture deal. I present it on a classic 2x2 matrix. The first axis is a measure of how controllable the risk is. I call risks that are controllable “intrinsic” and those that are not “extrinsic.” The second axis is a measure of how comfortable you are with that category of risk, given your biases as an investor. The former axis is mostly static across different investors, while the latter is subjective and prone to change given an investor’s style and beliefs.

The below is a superset of the types of risks one might find in each quadrant:

Parsing risks into four quadrants makes it easier to drive due diligence and, ultimately, investment decisions.

As investors, we reveal our biases in quadrant I. Good execution and oversight can mitigate controllable, inherent risks. An investor with more marketing expertise might be more comfortable taking risk on go-to-market, while a product person might be more comfortable investing before product/market fit. Finding which controllable risks you’re comfortable with determines your style as an investor.

Similarly, figuring out which risks, even if controllable, you’re not willing to touch is important too. Those are in quadrant IV. For example, some investors may avoid situations where founders don’t get along. Others may avoid capital intensive businesses. Some investors avoid these risks as a rule, even if they are theoretically addressable by the company.

The extrinsic risks in quadrant II speak to situational awareness. They must be understood in the context of a deal, even though you can do little to mitigate them. Every e-commerce company, for instance, needs to think about how Amazon will react to its success, although it can do little to influence Amazon’s behavior. The quadrant III risks do not come into play as often, but are significant considerations when they do. Funding a business that, for example, depends on access to cheap debt or is highly correlated with disposable income has a level systemic risk that some investors will never be comfortable with.

In an attempt to make their businesses look as attractive as possible, some founders avoid discussing risks up front. I’ve found that the more successful fundraisers proudly display risks and quickly jump to mitigation. Some of my favorite presentations have a slide titled, “Here’s what you have to believe to invest in my company.” Displaying risks communicates confidence and insight and helps you pick investors who are comfortable with those risks.

I hope this framework is useful for both the investors and entrepreneurs. Let me know what you think!

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