July 6, 2020
Venture investing has always been based on a healthy understanding of and appetite for risk. Even during the long bull expansion that ended in the first quarter of 2020, success in venture investing was characterized by a small number of big winners in portfolios of companies that achieved only modest outcomes.
The onset of the global COVID-19 pandemic delivered a spectacular jolt to the economy, including all aspects of capital formation and allocation.
With such dislocations very much in evidence, Ulu Venture Partner Kevin Hoffberg sat down with Miriam Rivera and Clint Korver, Managing Partners at Ulu Ventures to talk about how they think generally about investment risk, and how COVID-19 and the economic downturn affect their risk attitude.
The interview transcript has been edited for clarity and length.
You and Miriam have been venture investors for more than a decade. Both of you have thought deeply about the concept of risk. What does the word mean to you and how do you think about it in connection with venture investing?
A lot of people define risk as a small chance of a bad outcome. Another way to think about risk is that it’s a set of potential outcomes with high variance. The wide range of possibilities is what makes something feel risky.
As investors, we prefer the notion of uncertainty instead of risk. In particular, there are two questions we ask ourselves.
The first is, “If successful, how big could this company be?” The second is, “What’s the chance of it being successful?”
Those are the two separate sets of uncertain outcomes we consider.
Let’s take the first question, “What does success look like?” We want to understand the potential market size for a product and how much of that market a company can capture assuming the company is successful.
Based on our analysis of the market, the company, the team, and so on, we believe a potential investment could become a $10 billion company. We would all agree that would be a huge potential outcome. From there, we would evaluate what would have to happen to achieve such a great outcome.
As early stage investors, we are prepared to take a fair bit of risk because the upside could be so great. In a situation like this, for every dollar invested we would expect to receive a 500 times return. Invest enough times in companies with such prospects, and even with a 2% chance of achieving such returns, , the math still pencils out. So a portfolio of such high-risk, high-reward is a no brainer decision for Ulu.
But let’s say our analysis doesn’t show a $10 billion outcome. Instead, it’s a billion dollar outcome or $200 million. By most measures, that would be considered a business success. However, using the same assumptions around probability of success, our return on invested capital is much less. So, for Ulu, one of the ways we manage the second risk, risk of achieving mass market share, is to look for ventures with massive upside potential.
Miriam, how would you say your attitude towards risk has evolved?
We made dozens of angel investments using decision analysis before we ever raised a fiduciary fund. It’s the best tool out there for evaluating risk and also for communicating about risk in a partnership. Often, managers don’t have a mechanism for calibrating and honoring each other’s risk attitude and that can lead to horse trading to get deals done or conflict. We took Clint’s expertise in decision analysis and created a process for evaluating risk and reward at the seed stage I called “market mapping”.
I’m very comfortable taking informed risks. I’m much less comfortable with the hand-waving or fist-pounding “conviction” managers offer to justify their gut-feel investments at the seed stage. So Ulu Fund I was our family office, investing a pool of capital to train ourselves to work together as seed investors. We took a learning approach around risk.
Early on, we made 20 investments where we didn’t use our market mapping process. And we made 44 other investments using the process we now use every day at Ulu. In other words, we wound up doing an A/B test of sorts.
The results are highly informative. We learned that we had a much higher failure rate on companies where we didn’t use market mapping:
- The loss ratio not using market mapping is 50% to date.
- The loss ratio using the process is 15% to date.
Those loss ratios are better than average. On average, about a third of venture capital investments turn out to be zeros. Another third are likely to be not very interesting, not doing more than returning capital. But we know that in venture capital, loss ratios are not as important as the small number of outlier deals that generate great returns. Sure, market mapping allows us to eliminate certain investments so we have more and better shots on goal. But it’s the use of a 10X probability weighted multiple hurdle rate that allows us to get outlier potential into each fund’s portfolio. And it’s the use of data-driven portfolio construction using decision analysis to determine the size of portfolio necessary to to generate such outlier returns that means we can consistently outperform, fund over fund.
For institutional investors with capital to deploy across a broad range of asset classes with different risk profiles, investing in Ulu, a “pure play” high-risk, high-reward seed fund can be very attractive. Especially because we’re evaluating and managing underlying risk at both the company and portfolio level.
How do you account for economic risk in the current COVID-19 environment?
We’re pretty close to being risk neutral because we take a very logical approach to calculating how much risk we’re willing to take. We keep emotional fear of loss of money or risk out of our decision making. The result is we’re willing to take a lot more informed risk than many other investors, even in venture capital.
COVID-19 and the resulting economic shock increase a number of the risks our framework takes into consideration. For example, we know companies may have lower revenues for a time. This may make it more difficult to raise additional capital. Some will raise capital at lower valuations and that will increase dilution. Exits may occur at lower multiples. All these underlying risks may increase but our framework doesn’t change, only the input values and the outcome values change. Our market mapping process has been developed over three economic shocks: the 2001 bust (when we were entrepreneurs and angels), the 2008 Great Recession when we founded Ulu as super angels and this 2020 historic downturn. It’s withstood the test and so has our portfolio construction.