Venture capital: Evaluating the risk profile of investments 

How do VCs assess risk when looking forensically at investment portfolios? Here's how to assess venture capital investments

The heart of a venture capital fund’s strategy is to feed investors’ capital into high-growth, early-stage companies with the potential to expand rapidly and deliver high returns.

However, a company’s ability to deliver the kind of growth that generates outsized returns usually has a risk profile to match. So how do VCs think about risk in order to protect their investor’s interests?

All about the deal flow

Managing and evaluating the risk profile of investments is top of any VC’s agenda. Experienced managers have detailed processes in place for ensuring that each investment is a balance between significant upside potential and downside protection – i.e. when things that go unexpectedly well or unexpectedly badly.

This requires structured processes, combined with rigorous due diligence. In the first instance, a VC’s priority is the stimulation of a high-quality deal flow, and the ability to scrutinise that deal flow in order to find the best opportunities. It sounds obvious, but the higher the quality of the deals they see, the easier it is to put investors’ capital to work effectively and responsibly.

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These relationships are built up through various channels including the many pitch events happening throughout London’s various tech hubs. Add to this a strong external network of advisers and investors’ recommending companies and the result is both quantity, and more importantly, a high quality of deal flow.

It is also crucial to maintain a meticulous approach to due diligence. The more information the investor has at the outset of an investment, the less likely they are to run into any nasty surprises later on – and therefore the more receptive they’ll be.

Don’t jump on trends

We’ve said it once and we’ll say it again: don’t jump on the trends. The experts agree.

“AI may be dominant right now, but investors must recognise the importance of looking ahead and not solely relying on the AI boom, as areas of opportunity still lie beyond this domain,” Ekaterina Almasque, general partner at OpenOcean, told Growth Business.

She added that the long-term sustainability, product-market fit, and scalability of AI-focused ventures are now at the front of investors’ minds. Start-ups now need to prioritise low cash burn and efficient cost management strategies to successfully weather the storm. Founders should be encouraged to explore other growth avenues and consider the development of the infrastructure that AI and other emerging technologies will run on.

Alex Pavlov, partner at RTP Global, added that investors need to actively consider what it is that excites them about an investment. Without due diligence, they run the risk of contributing to hype cycles, having been won over by the ‘next best thing’ that may not have the long-term viability first assumed.

“For instance, I personally don’t believe that the vast majority of the wave of companies built on ChatGPT can survive. They just lack the substance needed for sustained growth,” he said. “That’s not to say that investors shouldn’t seize on the opportunities presented by new innovations – far from it. But those that will go the distance will be the start-ups that use these new technologies to enhance their products, rather than completely relying on them.”

But it doesn’t end there…

The assessment and management of a company doesn’t end with due diligence and subsequent investment. Continued risk mitigation is best delivered by fostering a positive working relationship with the company and management, including participating in the recruiting of senior executives and board members.

In almost all cases VCs require board seats and investor controls negotiated through the shareholders agreement.

A good VC will typically commit to serving on portfolio companies’ boards and see their role as supporting these portfolio companies and management teams at key strategic points (whilst also letting them get on with running their businesses).

Entrepreneurs should be able to go to their VCs for introductions, market insight and access to networks both externally and within the portfolio. In this way a VC is not just continuing to minimise on-going risk, but is adding value by promoting a free exchange of information with their companies.

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They can remain close to the business whilst helping their entrepreneurs on their journey. 

Putting your money where your mouth is

At a time when valuations are becoming increasingly stretched, a personal commitment can be a good way to ensure a VC is appropriately evaluating the risk profile of an investment. Typically, partners at a VC fund will be obligated to invest in the fund for this reason. 

The importance of managing risk in investments

So why is this important and what are the ramifications for growth businesses? Evaluating risk profiles is a vital component on the road to success with any investment. They look for companies who are open and honest about their numbers, as well as their perception of the challenges they will face as businesses.

The greater the understanding of a business, the more likely investors are to be able to assess deals based on an accurate evaluation of the risks involved. Making well-proportioned investments into the right businesses, capable of sustained growth, is crucial to getting the right result for portfolio companies, for investors and for the industry as a whole.

Thank you to MMC Ventures and other contributors for their help with this article.

Further reading

22 venture capital firms you need to know about – A Growth Business guide to some of the most active VC funds operating in the UK

24 venture capital firms you need to know about – Growth Business guide – Here are 24 venture capital funds you need to know about to fund your start-up, in every sector from AI through to deep tech

Growth Business UK venture capital directory – A comprehensive guide to every UK-based venture capital firm in the UK

Praseeda Nair

Praseeda Nair

Praseeda was Editor for from 2016 to 2018.

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