I spent last weekend thinking about a framework that can help visualize the risk/return continuum for different stages of maturity strategies in VC: seed investing, early venture, late venture & growth, and secondary investing.
Let’s start with risk. There are typically four inherent company-specific risks, with their importance varying across the company’s stage of development:
1. Team risk — the risk that the management team does not possess the necessary skill set required for the venture or is incompetent.
2. Product risk — the product being developed is not able to provide the value intended.
3. Customer risk — the risk of not having a sufficient number of early customers, or signs that the company cannot support the creation of a sizable customer base for the product.
4. Business Model Risk — the risk that the company is not able to transform into a coherent business with attractive unit economics, and is therefore unable to generate sufficient financial return on equity.
The return/price curve, on the other hand, is a relatively linear curve as it is based on a constant multiple of revenues.
Seed strategy
Typically these investors aim to enter into investment during the early phases when the curve supports at least 10x return. The most pressing risks of this stage are team risk and product risk.
Early venture
In the early venture stage, investors are aiming to have returns of more than 5x. The sponsors are typically looking for an established team, mature product development, and early clients. Hence, this corresponds mostly to risks associated with product and customers, or more broadly speaking, the ability to gain market share.
Late venture and growth investors aim to generate a 3x-4x return. This stage is typically associated with customer risk, and business model risks, like share and unit economics.
Pre IPO or secondary
At this stage of the lifecycle, investors are looking to generate 1.5–2x return on their invested capital. The risks associated with this stage are typically business model risks, such as unit economics and profitability risk, to the extent that they are not apparent in the technical due diligence process. Team risk is negligible as the management can be changed without extensive key man risk.
