Avoid Risk, Embrace Uncertainty
Eric Rosenfeld - October 2022
Risk, Reward, & Uncertainty
“Nothing ventured, nothing gained.” The correlation between risk and reward is accepted wisdom. The greater the risk, the greater the potential reward. That may be true with most forms of investing, but it may not be always true with venture investing.
Investments in public securities are typically made using publicly available data and widely accepted financial models. Early-stage venture investing, in contrast, involves a high level of uncertainty, and a high risk of failure. A monkey throwing darts at the WSJ stock page might select a random portfolio that could very plausibly generate a positive return over time. That’s because each publicly traded stock enjoys a market and a market price that incorporates and reflects the market’s view of that stock’s relative risk and upside.
If the same monkey were to throw darts at a spreadsheet of companies in our deal flow, the randomly selected portfolio of startups would likely generate a negative return very, very quickly. Early-stage venture investing decisions are incredibly challenging to make because of the lack of quantifiable financial and market data. VC investments often must be based on subjective assessments of the team, the potential of the product, the potential market, and the potential exit, among many other uncertain factors.
It's easy for investors to conflate risk and uncertainty as one and the same. They are actually very different concepts. Risks have probabilities. Risks are identifiable, are often measurable, and sometimes controllable. Risks can be evaluated and can often be minimized.
Uncertainty, on the other hand, has no probability. Uncertainty is hard to identify, measure, control, or minimize. For those experienced with public securities investing, you could say risk creates beta; uncertainty creates alpha.
Taking a risk is like betting on the roll of a dice. You have a 1 in 6, or 17%, chance of correctly guessing the outcome. That’s the risk you take. Uncertainty, on the other hand, is wondering if you actually own a set of dice. Risks have probabilities; uncertainties have possibilities.
In Don Rumsfeld’s view of the world, risks are the known unknowns; uncertainties are the unknown unknowns. Understanding the difference between risk and uncertainty can help one make better early-stage venture investing decisions.
Case Study: Farmhouse Culture
A few years ago, we invested in a company called Farmhouse Culture. The company made organic sauerkraut – fermented cabbage – in many interesting flavors, like sriracha ginger. Our thesis and intent were for Farmhouse to bring to market several derivative products, including probiotic chips and beverages. Probiotic sauerkraut juice and gut shots, anyone? It’s pretty astounding how many different products a company can make from fermenting cabbage.
Our diligence concluded:
Team risk – low. Food scientists, former CEO of Dave’s Killer Bread. A well-qualified and experienced team well-suited for these products and this market.
Product risk – low. They could make the product as advertised. Developing and manufacturing in volumes was straightforward, although a bit expensive.
Financial risk – low. The company enjoyed existing revenue from selling flavored sauerkraut and, with this financing, had enough capital to go to market. The financial assumptions in the revenue model were reasonable.
Market risk – unknown. Will health-conscious consumers like drinks made from sauerkraut juice as much as they like sauerkraut itself? Were there enough health-conscious consumers interested in gut health to support a potential $100M+ revenue company? How much would consumers pay? How frequently would they purchase? In short, we were uncertain about the market and we couldn’t assign a risk. Our investment would be a bet on a potential new product category, whose market size was simply unknowable and uncertain.
It turned out that even the most health-conscious people don’t really like sauerkraut. They like sauerkraut juice even less. Farmhouse Culture was for us a low risk, high uncertainty investment that did not pay off.
Case Study: Inpria
Inpria was another OVF investment with low identifiable risks and an uncertain market. Inpria developed a new type of photoresist that could be used in the next generation of semiconductor photolithography, called extreme ultraviolet lithography or EUV.
Team risk – low. The early leadership team was comprised of materials scientists with deep semiconductor industry experience and a track record of success.
Product risk – low. Likely customers verified that the product should work as advertised. Inpria demonstrated their ability to manufacture the photoresist in increasingly larger volumes without sacrificing quality.
Financial risk – low. The company raised over $70M over its life. Running out of capital was never an issue.
Market risk – unknown. Everyone we interviewed was uncertain when EUV might be adopted by the industry, if ever.
Turns out EUV was officially adopted by the big 3: Samsung, TSMC, and Intel. JSR bought Inpria for $514M – a huge win not only for the Inpria team and OVF investors, but also for OSU, Corvallis, and Oregon’s world-famous semiconductor industry.
Case Study: DesignMedix
A team from PSU and OHSU developed a drug they thought had the potential to not only prevent malaria, but also cure malaria. The risk/uncertainty profile of this startup was the reverse of the prior 2 examples. One could say the market for a potential malaria vaccine and cure is large, attractive, and certain. There was no uncertainty about the market. However, the investment risks were plentiful. When we invested, we believed the company had maybe a 50% chance of curing malaria in mice, then maybe a 20% chance of curing malaria in primates, and a then maybe a 20% chance of passing each of the Phase I, II, and III human clinical trials required for FDA approval. The interesting thing about risks is they compound; they multiply: (.5) X (.2) X (.2) X (.2) X (.2) = .001 or 1 in a thousand. We were fine with that risk given the potential massive upside and beneficial impacts.
You can guess what happened. PSU and OHSU are not world-famous for developing a vaccine and cure for malaria. Remarkably, the drug did cure malaria in mice and primates. Unfortunately, part way through phase II human clinical trials at Duke one participant developed a systemic allergic reaction. The trial was immediately suspended, the company dissolved, and sadly this year another 600,000 people will die from malaria.
Learnings
What have we learned about risk and uncertainty after investing in nearly a hundred startups over the past 15 years? Remember, in venture capital the goal is to get the occasional 10X, 20X, or even 1,000X return. What kind of business has the potential to grow value that fast in just 5 to 10 years? Only businesses that are either dramatically expanding an existing market or, more likely, businesses that have the potential to create a whole new market.
We seek startups that can create something from nothing, perhaps define a new industry, and build value where none existed before. Consider these venture-funded successes: Google, SpaceX, Uber, Airbnb, Shopify, Snowflake, Beyond Meat. Before these companies started, none of those markets was certain, none of those markets existed. Investors in, and leaders of, those companies embraced a high degree of uncertainty and managed the associated risks.
The best things in life aren’t risky, they’re unknowable. Mustering the courage to talk to that beautiful girl in the buffet line years ago would change my life – who knew? Our advice: Do everything you can to avoid and reduce risk. However, if you want that 100X or 1,000X return, or to meet your life partner, instead embrace uncertainty.
The takeaway here is the importance of understanding both the risks and the uncertainties associated with each potential investment. The best VCs focus their diligence on risks that can be identified, measured, and therefore managed and reduced or, better yet, avoided. The best startups, those with the greatest upside, will require a reasonable leap of faith from their investors.
Successful venture investing is not about taking extreme risks, but rather about managing and reducing risks wherever possible and about embracing the unknown. In short, run from risk, embrace uncertainty.
©Oregon Venture Fund