some hypotheses about risk in venture capital investing

SOME HYPoTHEsEs

ABOUT RISK IN VENTURE

CAPITAL INVESTING

JOHN C. RUHNKA University of Colorado at Denver

JOHN E. YOUNG University of New Mexico

EXECUTIVE Venture capital investing difsers in important respects from investment decisions involving the securities of Fortune 500 companies, or decisions

SUMMARY to purchase established companies, which are generally made in accord with widely recognizedJinancia1 models. Investing in new ventures involves a high level of uncertainty as well as a high risk offailure. Venture capital investing is characterized by high variability in the outcomes of new ven-

tures and in the performance of venture capital portfolios. Venture capital investing decisions are complicated by a general lack of quantifiable financial

and market data for early-stage ventures, and investment decisions remain hostage to unanticipated competitors, market shifts, andfinancial cycles. Some observers have suggested that venture capital investment decisions are primarily subjective assessments. While the question of risk in venture capital investing has been addressed on an aa’ hoc basis in several empirical studies, there has been little effort to develop a theoretical framework of risk perceptions and risk-reduction strategies. Despite differences in investor experience, investment preferences, and tolerance for risk, venture capital managers share many common perceptions of the risks involved in investing in new ventures and the distribution of those risks over the venture-capital-fundedphase of development. Venture capital managers also utilize many common behaviors and strategies in adapting to these risks. These perceptions and reactions to risk in investing, and strategies for controlling risk can, in theory, be used to construct a behavioral framework that can predict how venture capital managers will behave in choosing between various investment opportunities in order to minimize risk and to maximize potential returns.

In an attempt to begin to identify various elements of such a behavioral framework of venture capital reactions to risk, the authors have drawn upon psychological risk theory of decision-making under uncertainty, including classic expected utility theory, later modi$cations to that theory by Kahneman and Tversky (1979) and Coombs and Huang’s (1970) “portjiolio approach” to risk, that

Address correspondence to Professor John E. Young, Anderson School of Management, University of New Mexico, Albuquerque, NM 87131.

Journal of Business Venturing 6, 115-133 8 1991 Elsevier Science Publishing Co., Inc., 655 Avenue of the Americas, New York, NY 10010

115

116 J.C. RUHNKA AND J.E. YOUNG

are applicable to venture capital investing. These expected behaviors to risk have been used in conjunction with empirical studies of venture capital investment and portfolio outcomes, distributions of investments within portfolios, and venture capitalist perceptions of risk, to propose nine hypotheses about how venture capital managers behave in making investment decisions. These hypotheses include differences in variation and magnitude of returns for early-stage versus later-stage ventures, expla- nations of how risk distributions change over the stagewise development of new ventures, differences in the behavior of “aggressive” versus “conservative” investors in screening investment prospects,

and strategies utilizing a lower “ideal level of risk” to reduce the chances of achieving negative or sub-normal final portfolio returns.

SOME HYPOTHESES ABOUT RISK IN VENTURE CAPITAL INVESTING

In uncertain environments, probably few psychological functions are as important as those that comprise the human system for evaluating and choosing between different environmental risks (Lopes 1984). As yet, however, no theoretical structure has emerged for relating venture capital investors’ perceptions of and preferences for various risks. This article addresses the question of how venture capital investors perceive and assess the very substantial risks involved in the process of selecting and investing in new ventures. First, the article discusses various theoretical approaches to decision-making in an environment of uncertainty that, in light of what we know about venture capital investor behavior, seem to have broad appli- cability to the specific situation of venture capital investing. The article next reviews the available empirical studies about venture capital firms’ perceptions of the risks involved in new ventures. Finally, drawing upon psychological risk theory as well as prior empirical studies, the authors propose several hypotheses for further investigation about how venture capital investors perceive the risks involved in investing in new ventures, and some of their behaviors for reducing these risks.

PSYCHOLOGICAL RISK TI-IEORY

For years researchers have attempted to formulate theories of how people assess risk. Ber- noulli (1967), a significant early theorist, proposed in 1738 that individuals evaluate risks by a quantitative process of choosing between different prospects or gambles by weighting the values of various possible outcomes by their probability of occurrence, and will select those prospects that produce the maximum expected utility or value. A fairly standard method of illustrating expected utility theory (Kahneman and Tversky 1979) is to say that a prospect is a contract that yields an outcome of x with a probability of p, and an outcome of 0 with a probability of 1 - p. For example, given the choice between the following two prospects, one would expect a rational investor to choose prospect B, since that choice has a greater expected utility.

Prospect A Prospect B

50% chance to win $100,000 60% chance to win $90,000 50% chance to win nothing 40% chance to win nothing

The expected utility of Prospect A is ($100,000) (0.5) = $50,000; whereas the expected utility of prospect B is ($90,000) (0.06) = $54,000, all other things such as cost of the prospect being equal. Extensive experimental studies of decision-making under risk have been conducted in laboratory settings by utilizing lotteries in order to verify expected utility theory (Lopes 1983).

RISK IN VENTURE CAPITAL INVESTING 117

While psychologists have found Bernoulli’s (1967) concept of maximization of expected utility of outcomes to provide a useful descriptive tool, this concept has found less favor as a unified theory for explaining economic behavior by some economists who have rejected the concept as too limited to adequately describe the full range of economic behavior (Arrow 195 1). Nonetheless, Bernoulli’s (1967) early conceptualization of expected utility theory, as an approach to assessing risk, has tended to dominate the analysis of decision- making under risk, and has continued to be generally accepted as a normative model of rational choice under risk (Arrow 1971).

Kahneman and Tversky (1979) have identified several areas of decision-making under risk where experimental results violate the axioms of expected utility theory. These modi- fications to expected utility theory better adapt it for describing a broader range of business decision making. The first of these anomalies is the so-called “certainty effect.” Given the choice between: (A) an 80% chance to win $4,000; or (B) a 100% chance to win $3,000, 80% of the experimental subjects chose Prospect B even though its expected utility was less than that of Prospect A, i.e., $3,000 versus ($4,000 x 0.8 = $3,200). In other words, given the choice between a greater but uncertain gain and a lesser but certain gain, most experimental subjects tend to be risk-averse and to weight the certainty of gain more than the magnitude of potential gain.

Another anomaly is the so-called “reflection effect” when choices involve probable negative outcomes. Given the choice between two prospects that both involve high probabilities of loss: (A) a loss of $4,000 with an 80% probability; and (B) a loss of $3,000 with a 100% probability, 92% of the experimental subjects selected Prospect A, even though the expected utility of that choice was a probable higher loss ($4,000 X 0.8 produces a $3,200 loss, versus a $3,000 loss for Prospect B). The explanation for this behavior is that most subjects become more risk-seeking where probable losses are involved, and will choose the possibility of a higher potential loss so long as some chance remains of avoiding any loss, over the prospect of a smaller but certain loss.

A last theoretical basis of expected utility theory modified by Kahneman and Tversky (1979) is the idea of asset integration. Classic expected utility theory says that a prospect will be acceptable if the utility resulting from integrating the prospect with one’s existing assets exceeds the existing utility of those assets alone. If investing in a prospect will increase the expected final value of a portfolio by more than the cost of the addition, that investment will be made. Kahneman and Tversky (1979) strongly disagree with this view, and argue that most people normally perceive outcomes as gains and losses, rather than as final states of wealth. The key determinant of value is changes in wealth, not expected final asset positions that include current wealth.

A related psychological theory of decision-making under risk that also is applicable to the situation of investing in new ventures is the “portfolio approach” to psychological risk (Coombs and Huang 1970; Coombs 1975). Coombs and Huang posit that choice among various risks is a compromise between maximizing expected value and optimizing the level of acceptable risk involved in the decision. They argue that at each level of expected value among competing gambles, there is a preferred level of risk, which they refer to as the individual’s “ideal risk level,” that will influence which gamble will be selected.

Venture capital investing may be described in terms of modified expected utility theory and Comb’s and Huang’s (1970) portfolio approach to risk as follows. A venture capital investment is an opportunity characterized by a prospect of potential gain as well as a prospect of potential loss. Risk is a function of (among other things) the probability of losing and the amount of loss, which taken together are referred to as the prospect of loss. The

118 J.C. RUHNKA AND I.E. YOUNG

prospect of gain is a function of the probability of winning and the amount of the resulting gain. More risk-tolerant venture capital investors are willing to incur a greater probability of potential loss in return for a greater magnitude of gain should the investment succeed. More risk-adverse investors prefer a lesser probability of potential loss, but will maximize expected utility at that lower level of risk. In venture capital investing we would hypothesize that the preferred level of risk of a venture capital manager is determined by three factors: (1) the minimum portfolio target rate of return that the venture capital manager reasonably needs to achieve; (2) the level of risk (the potential gain and loss relationships) of the existing investments in the portfolio to which the prospect would be added; and (3) the fund manager’s general tolerance for, or aversion to, risk. In the situation where a venture capital manger is acting as an agent for limited partners or institutional investors, this level of “ideal risk” will also be influenced by the risk tolerance of the limited partners, as well as the structure of the management arrangement between the venture capital manager and his limited partners.

Thus in terms of the Combs and Huang (1970) “portfolio approach’ to risk, the screening of prospects by venture capital investors may be thought of as a two-step process. The first step consists of identifying those prospects with an acceptable prospect of loss- in terms of the probability and magnitude of potential losses. Once prospects having this preferred level of risk are identified, venture capital investors will then attempt to identify from among those ventures having an acceptable prospect of loss, those prospects that carry the highest expected gain should they succeed, or to maximize expected value in classic expected utility terms.

Risk Versus Uncertainty

Another theoretical concept from psychological risk theory that is important in venture capital investing is the distinction between decision-making under risk and decision-making under uncertainty. Decisions are said to be “made under risk” if the decision maker, while not knowing which specific outcome will result from a decision, knows all of the possible outcomes of the decision as well as the probability of occurrence attached to each such outcome. By contrast, decisions are said to be “made under uncertainty” if the decision maker knows the possible outcomes of a decision, but has no way to know the probability of occurrence of each outcome. It has long been recognized that entrepreneurs frequently operate in the face of unmeasurable or true uncertainty (Knight 1957), since the potential outcomes of entrepreneurial decisions as well as the probability of those outcomes are often unknown. Where a business concept involves a new product or service, for example, both the entrepreneur and the venture capital investor can only have opinions about the crucial factor of the degree of future market acceptance of the product or service, or how quickly competitors may arise.

In evaluating the risks implicit in a new prospect, venture capital investors are at- tempting to identify the various potential outcomes for the new venture and to assign probabilities to those outcomes, in order to transform the uncertainties involved into an aggregate reward-to-risk estimate for that prospect. Some practical methods for evaluating new ventures that implicitly assign probabilities to potential outcomes have been described by Lipper (1988).

Even at a portfolio level of analysis, the probability of a final positive or negative outcome for a portfolio of 10 or more investments cannot be projected with any degree of certainty due to the wide dispersion in new venture outcomes and timing differences. Analyses of venture capital portfolios by Liles (1977) indicates that losers tend to show up more


quickly in venture capital portfolios than winners, which typically take significantly longer to develop. A popular rule of thumb in the venture capital industry is that about 30% of venture capital investees will ultimately be “winners,” another 30% will be “living dead”

or “sideways deals,” that while marginally profitable fail to meet the expected 25-35% portfolio target rate of return, and that the remaining 40% will be “losers” losing some or all of the investment. This anticipated distribution is supported by empirical studies in its broad outlines. Dehudy, et al. (1981) reported a Venture Economics survey of 218 venture capital portfolios investments that showed 31% of investments returned a 2x to 10x + returns; 30% returned lx to 2x the original investment; and 40% were a partial or total loss. Huntsman and Hoban (1980) examined 110 venture investments by three major venture capital firms over the 15-year period 1960-1975, and found that while the overall annualized rate of return on the 110 investments was 18.9%) fewer than 25% of the investments exceeded this overall rate of return, and the remaining 75% returned less than the overall rate of return or were outright failures. Finally, Chiampou and Kallett (1989) analyzed 55 privately held venture capital portfolios and found that the standard deviation (SD) of average venture capital portfolio returns for funds that were 3 + years old was 37.6, whereas the SD of returns for funds that were 6 + years old was 51.2; presumably because of the timing differences in the appearance of losers and winners in venture capital portfolios mentioned earlier. This dispersion in returns for venture capital portfolios compares with a much lower SD of 12.3 for the S&P 500 stocks. Thus venture capital investments are characterized by wide dispersion in outcomes even after aggregation into portfolios.

VENTURE CAPITAL RISK REDUCTION STRATEGIES

While venture capital investing takes place in an environment of uncertainty and unmeasurable risks, venture capital investors utilize a variety of strategies to help to identify and to limit such risks, and to attempt to improve the reward-to-risk ratio of ventures they invest in. At the outset, a common requirement for prospects seeking venture capital funding is a detailed “business plan” that clearly identifies the major uncertainties involved in the business concept-such as factors bearing on the probability that a working prototype can be produced, or that a market exists for an untried new product or service, and the ultimate size of the anticipated market and anticipated competitors-so that these risks can be weighed by the venture capital investor and clearly addressed by the entrepreneur in the business plan.

A second risk-reduction strategy is incremental or “stagewise” funding, whereby funding commitments are earmarked for achievement of key developmental “benchmarks” in the sequential development of a new venture (Ruhnka and Young 1987). Specifying agreed- upon developmental objectives for a specific round of funding can provide objective measures for subsequent evaluation of investee performance, and helps to focus maximum investee effort on critical objectives that must be achieved before the venture can move forward. Stage-wise funding also permits a venture capital investor to cut its losses if key benchmarks are not able to be achieved. A portfolio-level strategy, which is related to incremental funding, is “parlaying of funding” (Stevenson et al. 1987), whereby portfolio funds reserved for follow-on funding are allocated as heavier bets on only those ventures identified as “winners” after earlier rounds of funding. Parlaying helps to “average-up” the amount of total portfolio funding invested in successful ventures. Another portfolio-level strategy is the long-term holding of portfolios for a period (typically lo-12 years) sufficient for the geometric av- eraging of compound returns from the winners in the portfolio to offset the losers and living-


dead investments, and to raise final portfolio returns to attractive levels (Stevenson et al. 1987).

A third type of reduction strategy used by venture capital investors is to diversify individual prospect risk by including 10 or more different investments in a portfolio. ln- creasing the number of “bets” in a portfolio decreases the chances that all of the investments might turn out to be losers, and increases the chances of including enough winners to offset the losing or below-average investments. Some venture capital investors also diversify portfolios among ventures in different industry sectors and geographic areas. Such diver- sification reduces the chances of portfolio disasters if a specific industry sector or geographic area goes into a prolonged slump. Business concepts that enjoy patent, copyright, or trade secret protection or that enjoy unique geographic or market niche advantages are also highly valued by venture capital investors, i.e., they seek ventures in inefJicient markets to reduce the risks of subsequent competition.

Venture capital portfolios may also be diversified among ventures in different stages of development. Based upon a survey of 53 venture capital firms, Robinson (1987) reported a wide range in the size (in terms of dollar amounts invested in specific ventures) and in the distribution of investees in various stages of development within venture capital portfolios. Robinson’s findings indicate that venture capitalists generally prefer a relatively greater

number of smaller early-stage investments than in more mature later-stage ventures. These same venture capital firms tended to invest larger amounts in fewer later-stage investees where presumably the individual risk of loss was less.

On a prospect level of analysis, the pricing and terms of the financing agreement negotiated between an investor and the investee can help or hurt the anticipated reward-to- risk ratio of a prospect. More venture capital ownership participation per dollar invested will increase the potential magnitude of final returns for a given exposure to loss, and thus increase the reward-to-risk ratio for a prospect. An overpriced investment, on the other hand, or a small investment that is diluted by much larger or cheaper follow-on funding by other investors, will reduce the possibility for significant gains even if a venture is ultimately successful. Venture capital investors with sufficient bargaining power or prestige may also attempt to limit down-side risk by negotiating rights in their financing agreements to ratchet- up their initial stake in subsequent rounds of funding to prevent dilution, and to elect directors, replace management, or to “put” their investment back to the investee for a forced cash-out should certain specified performance benchmarks not be met.

Finally, some venture capital firms utilize special expertise or relevant technical or managerial experience on their staff to attempt to alter the expected reward-to-risk ratios of their investees. Robinson (1987), based upon questionnaire responses from 53 venture capital firms, reported significant differences in staff utilization strategies by these firms. Some venture capital firms utilized extensive managerial and technical assistance for their investees, ranging up to one man-year of professional staff assistance per “average” investee, while other more passive investors invested only two to five professional staff days per year for the average investee in which they were lead investor.

EMPIRICAL FINDINGS ON VENTURE CAPITAL PERCEPTIONS OF RISK

In 1986 the authors conducted a survey of U.S. venture capital firms that attempted to determine the extent to which venture capital firms held common perceptions about the development process for new ventures (Ruhnka and Young 1987). Data were obtained from


the managers of 73 venture capital firms about distinctive stages in the development process for venture capital-funded ventures, and the characteristics of such ventures in each stage of development. Information was also elicited on the major risks involved in each stage of development and expectations of the risk of loss of investment involved in investing in ventures in various stages of development. These data are reviewed below together with empirical data on risk in venture capital investing reported by other researchers.

Major Risks by Stage of Development of Investees

Table 1 shows the major risks, both developmental and external, identified by venture capital managers in our 1986 survey for each of the five typical stages of development for venture capital investees. For “seed stage” ventures, it can be seen that most of these risks concerned flaws in the basic feasibility of the business concept: either the technological concept cannot be made to work (58.2% of the respondents), or further investigation shows the potential market for the product or service is not large enough to be economically viable (47.3% of the respondents). Other frequently mentioned risks included delays in product development causing funds to run out, failures to produce prototypes at a competitive cost, and failures by founders to manage the development process.

At the second stage of development, the “start-up stage,” investors’ overriding concern

was with verifying the technological and economic feasibility of a business concept. These risks included technological failures (49.2%) and the risk that potential market size or market share was not large enough to make the business idea economically feasible (38.5%). Other major risks involved founders who proved unable to manage development (41.5%) and the risk of exhausting initial funding and not being able to attract additional funding (24.6%).

The third stage of development generally involved getting the product or service into

the market and ramping-up production. Risks resulting from management failures were identified more frequently for third-stage companies than in earlier stages. The most-often- cited risk (44.3%) was that the founders or management team would be unable to effectively manage the development process as the company grew, and 21.3% of respondents also cited problems with excessive bum rates for funds and inadequate financial controls. Other major risks identified for third-stage investees included: that the product was not sufficiently competitive in the market (41 .O%); excessive manufacturing costs or inadequate profit margins (27.9%); slow sales growth or inadequate market size (27.9%); and problems with market strategy and distribution (24.6%).

Major risks indicated for the fourth stage of development reflect increased concern

with competitive risks. Reported risks included: that the investee “hits a wall” and cannot increase sales or market share (38%); that the investee is undercut in the market by unanticipated competition (30%); or that the “window of opportunity” for initial public stock offerings closes so that venture capital investors will be unable to cash out their investment (22%). Subsequent interviews with the managing partners of six Denver-Boulder venture capital management firms with $300 million under management suggest that it is often in the third or fourth stage of development that a once-promising new venture slips to the status of a “sideways deal” or so-called “living dead” investment. “Living dead” investees, while usually generating positive cashflow and marginal profitability, are critical disappointments in that it now appears that their market share or profitability will not be enough to produce the 35% or higher annual compound rate of return originally projected for these prospects. Despite the increase in external or market-oriented risks in the fourth stage, the most often- mentioned risk (identified by 48% of respondents) was that investees’ managements could


TABLE 1 Major Risks by Stage of Development

Number of Percentage of

responses responses Percentage of

respondents

32 26.7%

26 21.7%

18 15.0%

12 10.0%

12 10.0%

9 7.5%

58.2% 47.3%

32.7%

21.8%

21.8%

16.4%

I. Workable prototype cannot be produced

E. Potential market not large enough I. Development delayed, funds run out

I. Product cannot be produced at a competitive cost

I. Founder cannot manage development

I. Cannot attract funding for next stage E. Technological advance/market shift makes concept

obsolete

I. Idea not good enough to attract rest of

management team

n = 55

8 6.7% 14.5%

3 -

120

2.5% 5.5%

100.0% 218.2%

I. Beta tests unsatisfactory/specifications not met

I. Founders cannot manage, cannot attract key

management

E. Potential market size/share not economically

feasible 1. Cash used up, cannot attract additional funding

I. Inadequate marketing/sales volume less than

breakeven

I. Product not cost competitive

I. Unanticipated delays in product development

E. Competition develops first

n = 65

32 21.1% 49.2%

27 17.8% 41.5%

25 16.4% 38.5% 16 10.5% 24.6%

15

13

12

12 -

152

9.9% 23.1% 8.6% 20.0% 7.9% 18.5% 7.9% 18.5%

100.0% 233.8%

I.

E.

I.

E.

E.

I.

E.

I.

E.

Founders are poor managers/inadequate

management team

Product not sufficiently competitive in market

Manufacturing costs too high/inadequate profit

margin

Market not as big as projected/slow market growth

Marketing strategy wrong/inadequate distribution

Excessive bum rate/inadequate financial controls

Unanticipated competition arises

Technical bugs hamper production

New technology obsoletes product

27 19.4%

25 18.0% 44.3%

41.0%

17 12.2%

17 12.2%

15 10.8%

13 9.4%

11 7.9%

8 5.8%

6 4.3%

27.9%

27.9%

24.6%

21.3%

18.0%

13.1%

9.8%

n = 61 152 100.0% 227.9%

I. Founders cannot manage formal systems

E. Inadequate sales/market share

E. Unanticipated competition

E. IPO window shuts/no exit vehicle

I. Cannot achieve adequate profit margin E. Technological obsolescence

E. Market sector goes into recession/economy slumps

n = 50

24

19

15

11

10

10 4 -

139

25.8% 48.0% 20.4% 38.0% 16.1% 30.0% 11.8% 22.0% 10.8% 20.0% 10.8% 20.0% 4.3% 8.0%

100.0% 186.0%

E. Cannot increase or sustain market share

E. IPO window shuts/cannot establish exit vehicle

I. Inadequate managemermloss of key management I. Eroding margins/inadequate financial controls

E. Technological obsolescence

n = 25

19 38.8% 76.0% 11 22.4% 44.0% 9 18.4% 36.0% 8 16.3% 32.0% 2 4.1% - 8.0%

49 100.0% 196.0%


50% RATE OF RETURN

40%

30% RISK OF LOSS

FIGURE 1

I I I I I I SEED STARTUP 3rd 4th EXIT

STAGE STAGE STAGE STAGE

Risk of loss expectations and rate of return demanded.

not or would not institute formal management and financial control systems required at this stage of development.

The fifth, and typically final, stage of development for venture-capital-backed ventures precedes the “harvesting” of venture capital investment by a sale or merger of the investee with a larger company, a public stock offering by the investee, a leveraged buy-out by management or some other group, or some other means of “cashing-out” the venture capital investors. The most frequently identified risks for fifth or exit-stage investees were that a venture would be unable to increase or hold market share due to the emergence of superior competition (76%), that market conditions would not permit an initial public offering or other investor exit (44%), or that the venture would be hampered by inadequate management or by a loss of key management (36%).

Stagewise Risk of Loss Expectations

In our 1986 survey, venture capital firms were asked to estimate the typical risk of loss of their investment at each stage of development, as well as the projected rates of return demanded for investments made at each stage-in effect their hurdle rates for new investments. These results appear in Figure 1. It can be seen that mean expected risk of loss was very high for seed and start-up stages (66.2 and 53.0%, respectively), decreasing to 33.7% for the third stage and decreasing further to a little over 20% for the fourth and fifth stages. The mean compound annual rate of return demanded for investments at each stage of development closely parallels the declining risk of loss expectations on a stage-by-stage basis (seed, 73%; start-up, 54.8%; second stage, 42.4%; third stage, 36.4%; and exit stage, 35%).

One important caveat to these stage-by-stage risk expectations must be noted. Our survey did not differentiate among investees situated in different industries, and stage-wise developmental risks may differ significantly among new ventures in different industry sectors. For example, in a high-technology venture, the early-stage risks of producing a successful working prototype at a commercially feasible price may be very high, whereas the existence of patent, copyright, exclusive licensing or other legal protection may reduce the risks of imitative competition once the product enters the market. In contrast, a low-tech retailing


TABLE 2 Expected Risk of Loss and Rate of Return Demanded-by Stage of Development

Ruhnka’Young (1986) Wetzel (1981) Sample: 72 venture 102 Individual venture

capital firms investors

Plummer/Qed (1987)

Sample: 288

venture capital

firms

Stage

Risk of

Loss”

Rate of

retumb

Risk of

loss’

Rate of

retumd Range of discount

rates used (Means)

1. Seed 66.2% 73.0% 70% 50% 75.4 to 49.2% 2. Start-up 53.0% 54.8% 60% 50% 59.6 to 40.6% 3. Third stage 33.7% 42.2% 50% 37.5% 49.3 to 34.7% 4. Fourth stage 20.9% 35.0% 40% 30% 45.7 to 31.2% 5. Exit stage 20.9% 35.0% 20% 22.5% 40.8 to 28.1%

“Mean risk of loss of investment expected in each stage. Some values adjusted for extreme outliers.

“Mean compound annual rate of return demanded.

‘Median number of expected “losers” where eventual losses exceeded 50% of originial investment--convened to percentages.

Nore: Wetrel’s stages are not an exact match with RuhnkaiYoung stages.

dMedian compound annual rate of return expected.

concept may have substantially lower early-stage risks in getting the concept to market, but is exposed to a higher level of direct competition resulting from freer market entry in later stages of development.

Table 2 displays our data on expected risk of loss over the stagewise development of new ventures, compared with data from two other empirical surveys. Wetzel (1981), in a survey of 120 informal risk capital investors in New England, asked respondents to identify the expected number of “losers” (defined as investments in which the eventual losses exceeded 50% of the original investment) in a portfolio of 10 investments in five different stages of development. Wetzel’s five stages (technology-based investors, start-up firms, infant firms, young firms, and established firms) correspond closely to the five typical stages of development identified by venture capital firms in our survey. It can be seen that the median risk of loss expectations reported by informal risk-capital investors in the Wetzel study, together with median rate of return expectations for investments in each of these five stages, closely parallels the risk expectations found in our study.

Plummer (1986) queried 288 venture capital firms on valuation methods used in evaluating and pricing venture capital investments. One of the questions asked was the discount rate typically used for investments at various stages of development. The Plummer study specified seven distinct stages of venture capital investments, and the median discount rates used in each of the stages appear on Table 2. These empirical findings confirm that venture capital investors believe that risk declines significantly from the seed stage to the exit stage where venture capital is typically cashed out.

One other empirical finding about venture capital risk expectations is also noteworthy- the significant dispersion in risk of loss expectations, particularly among earlier-stage investments. Figure 2 shows the distribution of risk of loss expectations reported in our 1986 survey over the five stages of development. A very wide dispersion of risk estimates can be seen for the seed and start-up stages, narrowing in the fourth and fifth stages. The distributions of risk-of-loss expectations for the earliest two stages must be viewed with caution, since significant numbers of respondents indicated that they did not invest in seed or start-up stage ventures because they were “too risky.” This may explain the presence of

Percent Of Respondents

10 20 30 40 50 60 70 60 90 100

Expected Risk of Loss 46

SEED STAGE

40

30 1

20

10

ml__

1’0 io 30 io so 60 70 so soho

THIRD STAGE

RISK IN VENTURE CAPITAL INVESTING

10 20 30 40 50 60 70 60 90100

Expected Risk of Loss %

START-UP STAGE

40

30

20

10

I 10 20 30 40 50 60 70 60 90 100

FOURTH STAGE

125

10 20 30 40 50 60 70 60 90 100

EXIT STAGE

FIGURE 2 Dispersion in expected risk of loss by stage of investment.

some 100% risk of loss expectations in the seed and start-up stages. A very similar dispersion in risk of loss expectations for early-stage investments was reported in the Wetzel study, and points up the fact that the evaluation of projected risk in venture investments is extremely subjective, particularly in early-stage ventures.

Causation of Risks by Stage of Development

The major risks reported for each of the five stages of development in our 1986 survey were further differentiated into internal risks such as poor management, an excessive bum rate for funds, or lack of internal financial controls, and external or market-determined risks such as the emergence of competitors, technological shifts, or economic downturns that slow market growth or Frevent initial public offerings. These internal/external differentiations are indicated by an “I” or “E” designation by each of the risk factors displayed in Table 1, and are similar in concept to the idea of “uncontrollable risk” used by Tyebjee and Bruno (1984) in differentiating the investment perspectives of venture capital firms. This differentiation


60%

50%

40%

AGGREGATE RISK EXPECTATIONS

SEED STARTUP 3rd 41h EXIT STAGE STAGE STAGE STAGE

tz INTERNALLY-DETERMINED

EXTERNALLY-DETERMINED

FIGURE 3 Aggregate expected risk differentiated into internal and external components.

of the major risks identified for each stage into internally and externally determined risks produced the following results:

Stage of Development Internal Risks

Seed stage 72%

Start-up stage 75.8%

Third stage 53% Fourth stage 37%

Exit stage 35%

External Risks 28% 24.2% 47% 63% 65%

It can be seen that the proportion of aggregate risk attributable to internally determined risks decreased as ventures developed, while the proportion of external competitive and market-determined risks increased. We would expect this progression, since seed and start- up stage ventures are typically focused on internal objectives such as product development and building the management team, and most investees do not usually fully enter the marketplace until the third stage of development.

Standing by themselves, these data give the impression that external competitive risks expand substantially over the course of venture development. This supposition is refuted by Figure 3 which separates aggregate expected risk at each stage of development into its internally determined and externally determined components. This was done by separating the aggregate expected risk of loss expectations reported in Figure 1 into their internal and external risk distributions in accord with the internal/external risk percentages reported above. When this is done, the proportion of expected risk attributable to external or competitive risks remains relatively constant over the five stages of development, and the significant decline in aggregate risk over the first four stages of development appears to be almost entirely due to reductions in internally determined risks. This result, although surprising, makes sense from a theoretical standpoint. Risk estimates for early stage ventures include


all of the probable risks that a venture will face, both internal and external, up to the point when the venture can be successfully harvested. Thus the anticipated external competitive risks that a venture will face in the later stages of its development are embedded in the aggregate risk expectations for its earlier stages of development, but do not begin to pre- dominate in importance until the fourth and fifth stages of development, when the venture is fully exposed to competitive market forces.

HYPOTHESES FOR FURTHER RESEARCH

The foregoing empirical findings on venture capital risk, viewed in the context of the psychological models of decision-making under uncertainty discussed earlier, suggest several interesting hypotheses about how venture capital investors perceive and react to risks in investing.

First, the significant decline in expected risk of loss over the stagewise development of new ventures reported in the Ruhnka and Young (1987), Wetzel (1981), and Plummer (1987) surveys, leads us to hypothesize that venture capital investors view aggregate risk in investing in new ventures subtrudvely. This concept can be illustrated by rearranging the risk of loss expectations from our 1986 survey in Figure 1 in the following fashion:

Developmental Stage

Seed stage Start-up stage Third stage Fourth stage Exit stage Harvest

Expected Aggregate Risk to Harvest

Risk Eliminated by Successful Development

66% 53% 34% 20% 20%

0

0%

13% 32% 46% 46% 66%

As critical early benchmarks in the development of a venture, such as developing a working prototype, are successfully accomplished, the risks associated with not accomplishing these critical developmental benchmarks are reduced or eliminated. Thus the remaining aggregate risk to harvest is lower in the next developmental (and investing) stage. That is not to say that venture capital investees cannot fail in later stages of development from risks such as the emergence of imitative competitors, or management failures to adapt to market shifts. More often, however, later stage failures are marginally profitable “living dead’ situations, when investments fail to achieve the portfolio target rate of return, rather than catastrophic total loss outcomes.

When the major potential negative outcomes identified by venture capital managers for the five stages of development were separated into “internal” and “external” risks on the basis of the causation and potential controllability of these risks, we found that internal risks predominated in aggregate risk expectations for seed and start-up stages, anticipated risks were fairly evenly divided between internal and external risks in the third stage of development, and external competitive risks predominated in risk expectations for fourth- and fifth-stage investees. Figure 3 indicates that it is primarily reductions in internal developmental risks that account for almost all of the reductions in expected risk in the first four stages of development, and that the bulk of the risks remaining in the exit stage before harvest are competitive or market risks. These findings may be expressed in the form of hypotheses as follows.


Hl: Aggregate risk in investing in new ventures is viewed by venture capital investors in a subtractive fashion, whereby each successful step forward in development eliminates the negative outcome risks contained in the earlier developmental stages.

H2: Almost all of the reduction in anticipated risk over the venture capital-funded phase of the development of new ventures consists of reductions in internally determined risks; the bulk of aggregate anticipated risk remaining just before harvest consists primarily of competitive or market risks.

Second, two findings from empirical studies of venture-capital risk expectations seem particularly significant for explaining investor behavior. The first is the high expectations of risk of loss in earlier stages of development, which declined sharply as venture-capital- backed companies matured. The second is the high dispersion of risk expectations in the earlier stages of the development, which narrowed in later stages of development. As discussed earlier, we found that a high proportion of the anticipated risks for early-stage ventures consisted of internally determined venture-specific factors, such as difficulties in product development, and the capabilities and weaknesses of specific management teams. Accordingly, in early stages of development we expect that the probability of occurrence of many of the potential risks is difficult to generalize to other ventures, and that expected probabilities of success or failure are necessarily highly subjective.

Based upon the significant dispersion in estimates of risk of loss at various stages of development in our sample and as reported by Wetzel (1981), as well as the high dispersion in performance of 110 completed venture capital investments reported by Huntsman and Hoban (1980) and the high SDS in the performance of 55 venture capital funds reported by Chiampou and Kallet (1989), it is evident that venture capital investee outcomes do not fall into classic bell-shaped distributions, and are subject to wide SDS with many outlyers. Because of this dispersion in investee outcomes, as well as the high proportion of internal venture-specific risks involved in early stages of development, we expect that there is little predictive value in the experience of other ventures that investors can use to assign probabilities to the potential positive and negative outcomes involved in the latest prospect. Thus in evaluating risk in early-stage ventures, we expect that venture capital investors are likely to focus primarily on subjective evaluations of a specific business concept and its management strengths, its products, and its potential competitive strengths, rather than looking for similarities or differences from other successful or unsuccessful ventures. This behavior is captured in the following two hypotheses:

H3: There is a greater dispersion of potential outcomes in early-stage ventures than in later-stage ventures.

H4: When evaluating early-stage prospects, venture capital investors will focus more on examining the individualized gain and loss probabilities of a specific prospect, than on similarities with or differences from established ventures.

Plummer (1987) pointed out that ex ante venture capital performance expectations varied with the industry sector in which a venture is situated as well as the stage of development of the particular venture, and has suggested that it may be more useful to think of risk in venture capital investing in terms of potential variation in expected rates of return for specific investments rather than risk of loss of investment. Business concepts with less


potential variability in returns need not produce as great potential magnitudes of return to be acceptable, whereas business concepts with greater variability in outcomes must produce greater potential returns to be equally acceptable. Thus, venture capital investors who seek maximum returns will have to endure greater variability in potential outcomes than investors who seek investments with less potential return and a lower level of risk.

Our 1986 survey of venture capital managers, as well as Wetzel’s 198 1 survey, indicate that earlier-stage investments are perceived to include more potential failures and greater variability of final outcomes than later-stage investments. However, potential gains on early- stage investments are also perceived to be significantly higher on average than for investments made at later stages of development. Since early-stage deals are typically priced more advantageously for venture capital investors than later-stage deals, and early-funding positions provide opportunities to parlay successful early-stage investments into larger ownership positions through follow-on funding, really big “hits” in venture capital portfolios tend to come from successful early-stage wagers, rather than later-stage investments. Robinson (1987) noted that amounts invested in early-stage prospects are typically significantly smaller than amounts invested in later-stage prospects. Maximum loss on early-stage investments is thus limited to the smaller amounts invested. We would expect, therefore, that venture capital investors who seek the highest possible returns would seek early-stage prospects that offered the highest expected gain (probability times magnitude of gain) for a given exposure to loss. Although the expected probability of failure is high, so are the expected final returns on early-stage ventures that succeed, and potential losses are limited to the typically smaller amounts invested.

With later stage investments, Robinson (1987) found that the amounts invested are usually larger, and thus the magnitude of potential loss is larger as well. Offsetting this, the expected risk of loss in later-stage investments is much lower (about 20% for fourth- and fifth-stage investees in our sample). The fact that the magnitude of expected final returns is significantly lower for later-stage investments (about 35% annual rate of return in our sample) suggests that the SD of outcomes in later-stage investments is significantly less than in early- stage investments, and that there is a greater certainty of achieving positive returns than with early-stage investments.

Therefore, in screening prospects, more risk-averse investors have the option of not maximizing expected utility (which might suggest investing exclusively in early-stage prospects with the highest possible potential returns), but instead may choose a lower level of “ideal risk,” to adapt the concept of Coombs and Huang (1970). We would expect that investors with a lower level of idea risk would select prospects (typically later-stage ventures) with a higher probability of (albeit smaller) positive returns. This behavior also reflects the “certainty effect” of risk-averse behavior described by Kahneman and Tversky (1979). The following two hypotheses captures this expected difference in the behavior of “aggressive” versus “conservative” venture capital investors in weighing the probability and magnitude of potential investment outcomes.

H5: Venture capital investors that seek to maximize potential returns will invest primarily in early-stage ventures where the magnitude of potential gains are highest, since losses are limited to the smaller amounts invested.

H6: More risk-averse venture capital investors will not maximize expected utility value in selecting investment prospects, but will weight the certainty of positive returns more than the magnitude of expected returns.


On a portfolio level, classic expected utility theory would posit that in investing $10 million in a portfolio of prospects, a venture capital investor would screen as many prospects as possible and invest exclusively in those prospects having the highest expected final return. However, the wide distribution in the size and developmental stage of investments in venture capital portfolios (Robinson 1987) suggests that this is not often the case, and that initial investments in venture capital portfolios may have a wide range of different levels of risk. As a general proposition, early-stage investments have a higher probability of failure (and higher expected returns) than later-stage investments. If venture capital investors are not maximizing expected utility value in all cases in selecting investments to be added to a portfolio (i.e., are intentionally selecting some mid- and later-stage investments with lower potential returns), this behavior must presumably be aimed at arriving at a lower level of risk on a portfolio level, as described in the portfolio risk theory of Coombs and Huang (1970).

While the concept of varying the level of risk of individual venture investments to arrive at an aggregate “ideal level of risk” for a venture capital portfolio has not yet been empirically investigated to our knowledge, several portfolio managers reported in our interviews that they were experimenting with a strategy to reduce the risk of achieving very low or negative final portfolio rates of return that could impair their ability to attract future institutional funding. This “portfolio failure avoidance strategy” consisted of allocating a larger proportion of portfolio funds to “safer” later-stage investments that had a higher probability of achieving positive returns, and also of producing earlier cash flow for portfolio distributions. However, this strategy also arguably reduces the probability of achieving above-average final portfolio returns from lucky hits on more early-stage investments. To our knowledge there has as yet been no empirical testing of this strategy of structuring a portfolio to a lower level of risk to see if the trade-off of less early-stage positive returns has managed to achieve its intended purpose. Most venture capital portfolios typically have a life span of 10 years or more from initial investments to final distribution, so that many of the portfolios utilizing such lower “ideal risk” strategies are still in mid-life, and final returns cannot yet be calculated. This strategy of utilizing lower ideal levels of risk in selecting prospects is captured by the following hypothesis:

H7: Venture capital investors can reduce the probability of achieving below-average or negative final portfolio returns by selecting a lower level of “ideal risk” for screening new investment prospects.

Another risk-reduction strategy that merits further empirical investigation is whether or not venture capitalists’ technical or managerial expertise can alter the reward-to-risk ratio of their investment prospects. Robinson (1987) reported very wide differences in staff utilization strategies and the amount of venture capital assistance to investees among the 53 venture capital firms he surveyed. On a theoretical basis, smaller venture capital funds are less able to diversify away higher early-stage risk of loss through aggregation into larger portfolios, since they have less aggregate funds to invest. We would therefore expect smaller portfolio companies to be less receptive to early-stage prospects than larger funds that can better diversify higher early-stage risks by including more of these prospects in a given portfolio. However, anecdotal evidence from our interviews with Denver-Boulder venture capital managers seems to suggest the opposite. Several of the smaller fund managers reported that they not only invested almost exclusively in seed and start-up prospects, but also concentrated their portfolios in narrow “high-tech” sectors for the highest possible potential

RISK IN VENTURE CAPITALINVESTING 131

returns, relying on their expertise in a specific industry to actively “position” their investees in specific markets, and to act as a “match-maker” for subsequent high-multiple acquisitions by larger firms or other exit vehicles. This investing strategy suggests that special venture capitalist expertise is potentially able to alter both sides of the reward-to-risk ratio in selecting and growing new ventures. Special venture capital expertise is theoretically able not only to enable the highest potential reward deals to be identified, but subsequently, through active guidance of the investee, may enable potential risks of failure to be reduced by “positioning” the investee in anticipation of market shifts, and potential rewards to be increased by optimum positioning of the investee for a high-multiple exit by the venture capital investor. The hypothesis to be tested is:

HS: Venture capital investors with special skills and expertise are able to alter both sides of the reward-to-risk ratio for new prospects, by “positioning” of investees to anticipated market shifts, and positioning of investees for a high-multiple exit.

A final very important risk in venture capital investing revealed by the empirical data discussed earlier, is exit or liquidity risk. Venture capital investments are almost totally illiquid unless, and until, they are able to be ultimately sold or “harvested.” In Figure 1, it can be seen that the perceived risk of loss for fourth- and exit-stage investees did not drop below 20%, even though typically most investees in these later developmental stages were profitable. Similarly, the rate of return demanded for investments in the fourth and fifth stages also remained quite high in relation to the expected risk of loss-a mean annual return of 35% in our survey and a range of 26 to 40% in the Plummer (1987) survey. One contributing factor to this fairly high level of expected risk in later-stage investments may be the so-called “living dead” phenomenon that typically occurs in later stages of development. This refers to investees that were once expected to equal or exceed portfolio target levels of return, but that stall out in their sales growth or profitability or are undercut by imitative competition. Thus the relatively high-risk expectations reported for fourth- and fifth-stage investees may not reflect a fear of absolute loss of investment so much as the fear that a once-promising investee may fail to survive the rigors of competition in later stages of development and slip into “living dead” status, dragging down portfolio returns and impairing the chances for a profitable exit.

Figure 3 indicates that external or competitive risks are a very significant portion of aggregate estimated risk in new ventures, and that these competitive risks began to predom- inate in the risk expectations of venture capital managers as ventures reached later stages of development. Huntsman and Hoban (1980) found that most of the contribution to above- average final returns in venture capital portfolios typically results from a very small percentage (about 10% in their sample) of “home runs,” investments that achieve very high final rates of return. Thus, if above-average final portfolio rates of return are to be achieved, it is critically important for portfolio managers to achieve very high final returns on at least some investments to offset the expected high proportion of losers and “living dead” investments.

Achieving high final returns on venture capital investments usually depends on achieving high valuations in initial public offerings, or in the sale or merger of an investee-all of which are subject to unpredictable industry and stock market slumps, as well as the constant threat of imitative competition. Although several venture capital firms that we interviewed reported that today only 20% or less of venture capital investments are typically liquidated by means of an initial public stock offering (IPO), the availability of a successful IPO (either directly, or by IPOs in a related industry sector as a “pricing surrogate” for a


private sale or merger of the investee) depends on the cyclical stage of the new issues market and the amount of future competition anticipated in that industry sector. Thus, the magnitude of final returns achieved on venture capital investments is subject to substantial uncertainties affecting liquidity right up to the point when liquidity is finally able to be achieved that, independently of the performance of the investee, can skew the final rate of return achieved by 100 to 300% or more. The importance of liquidity risk in risk expectations for later- stage investments may be captured in the following hypothesis:

H9: Uncontrollable competitive and stock-market liquidity risks that can impair the ability to achieve a successful “high-multiple” exit from a private venture capital investment are the major determinations of perceived risk in later-stage venture capital investments.

LIMITATIONS OF THE STUDY

Because of the limited empirical data that relate risk expectations of venture capital investors to investor, investee, and competitive variables, our efforts to explain how venture capital investors behave in making reward-to-risk investment decisions in terms of psychological risk theory are necessarily incomplete. Venture capitalists do not operate in a vacuum, and other factors, both internal and external may potentially influence their reward-to-risk assessments in addition to the factors we have identified. For example, as discussed earlier, the pricing of venture capital deals can affect potential returns to the investor independently of the subsequent performance of the investee, and thus can influence the reward-to-risk assessment. Pricing of venture capital investments, in turn, is influenced by the relative stature of the venture capital firm and the investee’s management, the popularity of a business concept at the time, and the availability of funds and competition for deals in the venture capital industry at large. One reviewer suggested that the phenomenon of too much venture capital funds chasing too few good investment opportunities during the 1983-1984 feeding frenzy for venture capital deals, made the subsequent prospects for attractive final returns on investments made during this period almost nil. The growing popularity of venture capital funds in the 198Os, and the increased access to funding for imitative competitors, markedly shifted the final return expectations for a number of venture-capital-funded concepts during this decade.

The incentive structure of the deal struck between a venture capital manager, and the limited partners who are putting up the funds, can also influence the reward-to-risk assessments of the venture capital manager, and the level of prospect risk selected for a portfolio. For example, high annual management fees for the general partner, and overrides on portfolio profits exceeding fairly high hurdle rates, would encourage the selection of higher-riskhigher- potential return prospects, whereas low annual management fees and high profit overrides on all portfolio profits with no hurdle rate would tend to encourage lower-risk/higher-certainty prospects, all other things being equal. The fluctuating influence of market factors and fluctuating competition for attractive prospects means that venture capital risk assessments are not static and are influenced by a number of factors beyond the limited arena of the specific investor and investee.

However, the fact that venture capital investment decisions are potentially complex does not mean that investor behavior in evaluating prospect risk and arriving at reward-to- risk trade-offs in portfolio decisions is a wholly subjective ad hoc process. We believe that available empirical studies of risk perceptions of venture capital investors, interpreted in conjunction with psychological risk theory, are sufficient to suggest several common be-


haviors of venture capital investors toward some of the key risk and reward assessments involved in making investment decisions. Clearly, other variables not included in our hypotheses may potentially influence these decisions as well. Additional research will be necessary to construct a more complete behavioral framework of venture capitalist risk and reward assessments, and to measure the degree of success of various venture capital strategies to reduce the very substantial risks involved in these investments.

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some hypotheses about risk in venture capital investing

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