How To Objectively Gauge Risk in Your Venture Investing Decisions

By Vlad Tropko 

To be successful in venture capital, you need to use your experience, intuition and analytical skills to be able to distinguish between real risk and your own prejudice—and you need a dash of luck, too.

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Because even with all those skills, various factors can cause investors to misjudge projects, leaving founders without the capital they need. So, what scenarios can cause this to happen?

Past performance or failure does not guarantee future success

Simply trying to repeat successes or avoid past failures is no guarantee of future success. VCs can favor founders they’ve worked with before, but risk undiversified portfolios and neglecting the objective assessment of projects—and can see VCs fall for the bait of the so-called “conditional trust.”

Going with who you know blinds you to strong teams with great ideas – simply because they aren’t a known quantity. The reverse of this is where investors diligently avoid past mistakes, but given market conditions can change, the same result can eventuate, which means missing promising projects.

Small markets: ignore, or explore?

Today, 1 percent of a trillion dollar market is much more attractive. Even so, as Y Combinator partner Aaron Harris has written, many of today’s large companies grew from really small markets, rather than projects designed to be massive.

To ensure a VC doesn’t fall into the trap of false ideas about the size of the market, it is worth remembering about development issues and the penetration of new technologies, which we see on the S-curve below.

At first there are few projects, but a lot of hype around them. The first 2.5 percent of the most daring innovation lovers are first to try a new product, followed by everyday users catching up, but it’s often only after 5, 7, or even 10 years that 90 percent of the world’s population will join. Venture capitalists are betting on the future and on strong teams that are not afraid of competition.

Overestimation of innovation penetration

There’s also the danger of thinking there’s too much competition in a particular sector. Google disrupted terrible search engines of the time, while Facebook and Tesla certainly weren’t first in their fields, but they were in the right place at the right time with the support of venture capitalists.

The S-curve of innovation development explains why there are few monopolies in young markets, while more often there are many companies with a valuation of several hundred million dollars, which is directly related to users willing to include new products and services in their lives.

Dreaming of disruptors

I often hear about the need to invest in revolutionary projects and against established models. However, as the S-curve shows, disruptors often take years before they start making a profit, and not all investors are ready to wait a decade or longer for results. As a result, expectations and reality often diverge, and interesting investment opportunities are missed.

Betting on recognizable companies

Investing only in the most well-known companies or founders can seem less risky, and it is possible to still make gains, but in practice, much more can be earned from lesser-known startups.

Nobel laureates Daniel Kahneman and Amos Tversky discovered the brain’s ability to perceive easily memorized information as more significant, and they called this phenomenon the “heuristic of accessibility”. The better some events or facts are remembered, the less a person is critical of them. The accessibility heuristic is widely used in advertising and media, where the same simple message is repeated many times – just don’t neglect fact-checking and testing the business model of a startup, no matter how well-known it may seem to you.

Taking on the role of founder

It can be difficult for some VCs to avoid becoming part of the team that is actively developing a project, which can cause all kinds of issues which can often be an investor’s unconscious desire to start their own company.

Getting too attached to a company when it should have been put out of its misery long ago is also a risk. At the other extreme, there can be intractable disagreements within the team and/or with investors.

How to make more objective VC decisions

Investors often see what others don’t, but can sift through hundreds of projects a month to find one or two worth investment in the hope they become a future “unicorn”, and not a failure. Not all investors have learned to overcome their prejudices, giving savvy startups excellent opportunities to use this to their advantage.

Proper pitch preparation, taking into account common prejudices, identifying important info, preparing counterarguments and contacting special-focused funds all increases the chances of receiving funding. Bias can also be used to your advantage.

Dealing with prejudice is essential to developing a venture capital ecosystem and increasing the availability of funding for strong technology projects. Today, a new generation of funds is entering the market that already focuses on specific niches and has a fresh look at their industries. However, each of us can accelerate the evolution of the venture investment business. Let’s strive for objectivity, start by recognizing our personal biases and make smarter investments a reality.

Vlad Tropko is managing director at Digital Horizon, where he is responsible for European investments, including Bnext, Cuvva, Mel Science and others. Prior to joining Digital Horizon, Tropko spent eight years as the executive director at Rusnano, a nanotechnology-focused innovation development institution. His selected successes include partnerships and multibillion exits from companies like Quantenna Communications and Zipline International.

 

— Illustration: Li-Anne Dias

— Chart courtesy of Digital Horizon

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