Risk and Return in Venture
One of the core tenets of investing is to contextualise return with risk, and invest in assets that offer the highest risk-adjusted returns. But it’s important to be mindful of how this applies at different stages of investing.
I’ve often had founders ask me, admittedly confused, why do VCs decline businesses that could offer a sure-shot 5x return, but actively invest in companies that might shut down in 2 years? Why do they decline sensible and obvious businesses but invest in unproven, almost illogical ones?
Risk at Early Stage
At pre-seed and seed (sometimes even at A), risk is binary. The startup either succeeds or fails. When it fails, the investor loses most or all of their money. The downside is constant across every kind of company. Now, you might think that an obvious and logical business carries less risk but, from what I’ve seen, that’s not true.
One, I’d argue that when starting from zero, most businesses carry similar execution risks, due to which they could fail. Some carry relatively more and some carry relatively less, but because of the absolute uncertainty when starting up, there’s a large overlap in the risk profile.
Two, if the business seems sensible, it likely means that there’s an established market consensus about how it’s supposed to be built, and several similar businesses might already exist. In an established market structure, it’s extremely challenging for any new entrant to scale, so the business is likely to hit a certain revenue scale and stagnate.
When that happens, how will the investor exit the business and make any return? There are no new investors who’d want to buy into a stagnant business. The business won’t produce enough free cash flow to pay back in dividends or buy back shares. One realistic option is a strategic buyer acquiring the company, but even that’s a sub-optimal exit. So when the risks are broadly the same across most companies, investors focus on potential returns.
Return at Early Stage
For the same amount invested, 50x will be a fund returner and 5x might look great in isolation, but doesn’t meaningfully affect overall fund returns. That’s why venture investors look for moonshots v/s safe bets. Now, there are very few opportunities that can offer that kind of return within the venture investors’ holding period of 5 to 10 years.
Emerging sectors have higher potential v/s established sectors. It doesn’t matter that the market size is tiny to start with; what matters is how quickly it can expand. At the right time, startups can use capital to win disproportionate market share and scale. This is much easier v/s winning market share in an established, slow-growing industry with large incumbents.
The critical thing here is growth velocity. We’ve seen three key drivers that enable rapid growth: technological advancements, changing user behaviour, and favourable policies. Nearly all successful startups are built on the back of these tailwinds. In fact, when these catalysts are strong enough, startups can leverage them to disrupt even well-established markets. However, these can be extremely difficult to notice and build conviction on, which is why most startup investments might look illogical. Success in early stage investing is about making contrarian bets that will soon become consensus.
Evolution of Risk and Return
From Series B onwards, the investor has performance history and price/valuation history. It's now possible to draw up scenarios on what scale the business can reach, how it would be valued, and what the returns could be.
The size of the downside is largely the same, i.e. the investor still loses their capital or has a sub-optimal exit if the business fails. However, the likelihood of that happening can be different for different businesses. It’s difficult to measure that quantitatively, but can definitely be analysed qualitatively. Similarly, the upside potential for each business might be different. The benchmark might not be 50x but definitely 20-30x. It all depends on their performance history, growth potential, business model, market dynamics, and entry valuation.
That's what gives each business its own risk/return profile, and why investors start to actively compare opportunities and pick what fits their strategy. Some might prioritise lower downside risk for a given return, while others might work through risk-adjusted returns, but there will still be cases where the upside potential is so huge that the downside doesn’t matter.
When it comes to public markets or mature companies, there’s elaborate performance history, and while each business looks to grow, there’s a possibility that it might de-grow or grow less than expected. Most businesses will have clear fundamentals and established market structures. At this stage, there will be hardly any companies that present extremely high potential returns. In most cases, it’s a balancing act between how much return one could make v/s how much capital one is at the risk of losing. Here, the risk-return profile is probabilistic. And investors will focus on the downside as much as the upside.
Risk and return could mean very different things at different stages of investing. They are measured differently, and lead to different investment strategies. In fact, the same company is a different investment at every stage of its journey.