Are European VCs too Risk-Averse?

“VCs do not want to take risks” is an often-heard criticism expressed during start-up conferences or wherever VCs meet with entrepreneurs in more relaxed settings. There is however an inherent paradox in this statement since suggests that VCs have somehow managed to grow out of their risk-taking nature and found a magic formula on how to make a good living on risk-free investment decisions.

I believe that the topic merits a deeper look with the goal to eliminate potential misunderstandings between intrepid entrepreneurs and their brave financial backers. So, let’s untangle things by looking into the various aspects of risk in innovation financing, followed by a glimpse on the underlying constraints in dealing with risks imposed by European singularities in the VC business. This will help us to understand what really counts when it comes to risk management in technology start-ups.

Risk and Risk Assessment in Innovation Financing

One of the qualities of entrepreneurs is their ability to underestimate (if not ignore) business risks. In a way, this is a fundamental trait of most successful founders which in turn provides them with the adequate energy and audacity to navigate in unchartered terrain. Equipped with this mindset founders often dismiss VCs as being obsessed with KPIs when analyzing companies while they apparently tend to under-value other important aspects such as vision, technology or the general quality and energy of the founding team. Risk-averseness is (mis)understood here as the attempt to avoid uncertainty at all cost. From an entrepreneur’s perspective, a VC-investment process employing a metrics-driven approach is questionable in at least two ways. Firstly, it resembles a catch-22 situation where VCs demand a lot of proof before entrepreneurs have managed to raise the necessary funds to fuel their business model. Secondly, it supposedly demonstrates a rear-mirror attitude coming from investors who of all people should know, that future value creation requires confidence, time, effort and last but not least money.

Unfortunately, the reality of capitalism has it that all business-model uncertainties inherently translate into risks which can negatively impact future success. VCs will inevitably try to assess these risks in order to separate the ones that are less important from the ones that, once cleared out, help the company to overcome important inflection points on its growth path. The identification, evaluation and sober assessment of mitigation strategies for these major risks is one of the most fundamental tasks for any professional VC.

To illustrate this fact, the table below computes the odds for success of a virtual company. Obviously, the model being illustrative and rather simplistic, events are purely indicative and figures arbitrary. You should however note that if the probability of just one milestone to materialize decreases from 80% to 40%, then the combined probability of success will no longer be 17% but a meager 8%.

Source: “Probably of Company Success” by Harvard Business Review

Predicting future values for these probabilities is of course no strictly scientific task. However, breaking down major milestones into smaller entities, then taking an educated look at related KPIs and estimating their potential evolution during the company’s growth path does oftentimes provide an approximation of a company’s progress. Additionally, integrating the expected enterprise value at the time of the assumed exit will allow VCs to determine whether the derived risk/reward-ratio actually makes for a suitable investment case.

This being said, the founding team’s ability to mitigate future risks and to react to setbacks by generating alternative paths remains the most important success factor in any venture. While most VCs will immediately embrace this notion, a prediction about a management team’s future stability and their ability to operate wisely is once again coupled with risks that VCs will try to gauge. Common indicators here are entrepreneurial track record (hence the bonus for ‘serial’ entrepreneurs), a joint history between founders and their backing VCs plus further references collected during the due diligence process.

How European VC’s Are Handling Risk

VCs (at least the experienced bunch) are well aware of the fact that they are operating in a risky asset class. When climbing a mountain, the alpinist usually tries to reach the summit by taking the safest route, not necessarily the most dangerous one. Risk as such has no value, it simply comes at a price for the attached positive reward once you manage to eliminate it.

The VC business model is essentially about making money for their Limited Partners (LPs), typically large institutional investors who invest money into the VC’s fund with the expectation of an adequate return over a given time period. European LPs who provide the majority of money in European Venture Funds by and large flocked into the VC asset class at the tail end of the 2000 internet bubble. Most of them subsequently burned their fingers badly due to bad timing and– in contrast to their US-cousins — were undergoing that painful experience without having had a prior chance to build general confidence in this cyclical asset-class. As a result, many European LPs simply never came back to European VC and the few that did made it clear to their selected crop of VCs that they were not inclined to accept losses.

Moreover, total exuberance on Europe’s public markets during the internet bubble led to an overly depressed exit environment for European start-ups in the 2002–2008 period. VCs, forced to deliver on their promises simply could not bet anymore on ‘fund-makers’ that would allow them to return an entire fund with just one or two portfolio companies. The few surviving VC-firms in those days meticulously honed their investment strategies towards low portfolio’s loss rates while benefiting from a broader winner base featuring more moderate individual returns. This is one of the reasons why European VCs are sometimes blamed for taking “small calculated bets” rather than targeting moonshots, unintentionally validating Peter Thiel’s famous motto “We wanted flying cars, we got 140 characters”.

In hindsight, it can be argued that the pendulum for European VCs has swung too much from irrational exuberance during the 2000 internet frenzy towards an obsession for risk-minimization. Over the six or seven years following the popping of the bubble European VCs have sometimes behaved like micro-buy-out firms while trading-in chances of realizing over-performance on a fund level.

Creating Risk-Symbiosis between Founders and their VC-Backers

Over the past years, we have all seen great companies emerge in Europe with quite a number of them making it to ‘Unicorn-status’. This comes as the long awaited positive news for the entire ecosystem and clearly does not go unnoticed by European LPs who on the basis of renewed interest have cautiously started to refuel VC-funds.

I believe that it is now the right time for Europe’s VCs to fuse useful lessons learned during the post-bubble ‘nuclear-winter’-years with the tremendous opportunities induced by an ever accelerating digitalization of the entire economy. Experienced VCs and savvy founders should go ahead valiantly and form symbiotic alliances to deal with the inevitable success risks tied to any new and innovative business. I am convinced that the very symbiosis of intrepid founders and ‘professionally paranoid’ investors makes up for a perfect match on the bumpy road to create international tech champions such as Spotify, Zendesk, Neolane, Criteo, Withings, StickyAds and the likes.

To do so, VCs and entrepreneurs will have to (re)build the necessary mutual trust through a joint understanding of the risks on the road ahead. Building new companies in the digital economy generally translates into navigating foggy terrain. It is however possible at every moment to look ahead and identify major inflection points, then jointly assess the related risks and define adequate mitigation strategies. The initial due diligence process preceding any financing round is an ideal opportunity to establish the necessary level of joint understanding for anticipated risks on the way.

Here is an illustrative yet non-exhaustive list of tasks that founder and investors should accomplish before going on the journey together:
· list the anticipated risks associated with the next company phase and identify those which have the most impact
· think about alternative routes well in advance to mitigate risks
· determine the right amount of money needed to eliminate fundamental risks in any chosen business model
· if possible, ‘serialize’ major risk elimination instead of overlaying too many concurrent business milestones
· rapidly create the famous MVP while burning through the least amount of cash
· understand whether an investment in a company fits the current fund lifecycle & strategy of a respective VC to save time and energy during fund-raising

To some extent, the “lean start-up” best practices are a risk-minimization scheme that helps to progressively eliminate uncertainties about product-market fit. It is also a great tool to optimize capital-efficiency and hence minimize dilution for founders. The development of a shared understanding for the principal risks between entrepreneurs and their financial backers helps to deal with critical situations and keeps everybody in the same boat during stormy weather periods.

Experienced VCs are used to jointly manage risks with the entrepreneurs they have invested in. And since it is mandatory to keep an eye on potential risks, the question whether VCs are risk-averse becomes quite frankly irrelevant.

Founders should rather question a particular VC’s capability to cope with inherent business risks. It might appear counter-intuitive, but a VC’s capability to rapidly dissect major risks in a company’s growth plan definitely is a positive sign. The capability to further act as an experienced sparring partner in assessing these risks and discussing potential mitigation strategies are further indicators for a value adding financial backer. Finally, a quick enquiry about past VC-fund performances and references taken with other portfolio entrepreneurs will prove to be much more valuable in selecting the right VC-partner than to enjoy unfiltered applause from self-acclaimed financial ‘risk-takers’ (i.e. gamblers) who are likely to be the first to leave ship when the going gets tough.

Christian Claussen
Partner Ventech

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