Will It Pay Off, or Become a Write Off? Managing Risk in Venture Capital Investing

Risk is part of the landscape when investing in start-up firms, and venture capitalists need to approach this peril across a range of dimensions, including geography, industry and the timing of investments in the product development cycle, according to speakers at a Wharton conference titled Innovation and Organic Growth: Balancing Risk and Reward, hosted by the Mack Center for Technological Innovation. “We have generated a lot of wealth for people and also created our fair share of losses,” Spencer Hoffman, a principal at Safeguard Scientifics, noted during a panel discussion titled, “Financial Perspectives on Managing Risks.”

Hoffman and his fellow panelists from the venture capital industry discussed how firms determine which new technologies — whether from the energy, high-tech or healthcare sectors — are good investments, and what strategies they employ to manage and mitigate risk.

Prior to the discussion, Wharton finance professor Andrew Metrick explained how financial economists view risk by citing two hypothetical companies — Box Co., an established manufacturer of corrugated boxes, and Drug Co., a biopharmaceutical company. Box Co.’s returns rise and fall with the overall economy, while Drug Co. is working on a cure for a host of diseases, but has little probability of success. Assuming both companies have the same expected cash flow, which company would be expected to generate higher returns for investors? Metrick asked.

He explained that while the drug company has a high level of individual, or idiosyncratic, risk, the box company should offer a premium to investors willing to back it in bad times as well as good. “The box company does well when people are already doing well. It has poor returns when the economy is poor and people are hungry,” Metrick noted. “If someone says, ‘I will hold Box Co., which will not pay much exactly when I am most hungry,’ then they need to be compensated.”

Investors in the drug company could mitigate their risk by buying up shares of many drug companies, hoping at least one will come up with a hit product to justify the overall investment.

More widespread risk may be difficult to insure against — such as a sudden hike in the cost of natural resources — but companies need to take steps against this type of threat if it begins to erode operations. He used the example of a well-run airline company facing a sudden oil price hike beyond its control. Shareholders in the firm could hedge against an oil shock by creating a portfolio that benefits from higher oil prices. But as owners of the airline, they also need to be concerned that the oil shock will impact sales and will result “in distress costs at the airline.” One strategy is using a collar on the price paid to limit exposure to severe, operational risk without attempting to insure against all risk at any price, Metrick said.

He also explained why small venture capital firms take on so much more risk in backing long-shots than do large corporations that have more resources or appear to have the ability to absorb a swing and a miss. Executives and employees at a large company all share in the downside of problems when problems arise at the targeted firm, he said, but the benefits of hitting a home run with a new technology investment are diluted. He noted that even the largest venture capital firms have very few partners, allowing each to win big if a high-risk investment pays off. “These are small organizations. When they get too big, the incentives for any one person aren’t so clear,” said Metrick. “If someone is better than their partner, then they leave and start their own firm.”

Panelist Michael DeRosa, managing director of the DFJ Element Fund, an affiliated fund of Draper Fisher Jurvetson in Menlo Park, Calif., agreed. “It’s not just that venture capital firms have more incentives to invest, but that large corporations have less,” he said, adding that he was surprised recently when a large public company came to his firm offering an ownership stake in an attractive new technology. The company wanted to reduce its own stake to less than 20% to get the development costs off its books where they were cutting into quarterly earnings. “This [technology] looks like a huge home run, but right now it’s a hit to their earnings and they don’t like that.”

The DFJ Element Fund is focused on technology, particularly in energy and other heavy industries, and on companies that are developing solutions to old economy problems, he said. “The theme is to take the venture capital method that works in high-tech information technology and biotech, and apply it to growth opportunities in the real core sectors of our economy,” said DeRosa, who added that rising petroleum prices are generating interest in the DFJ Element Fund’s strategy.

According to DeRosa, his firm approaches risk management on two levels. The first is at the portfolio strategy level, which calls for diversification across industries. He acknowledged that is not as easy for a fund with a specific strategy like DFJ Element, as it would be for a general technology investment fund that, for example, can invest in both biotech and software.

To combat that problem, DeRosa said the firm shifts from a risk-management approach to building expertise and networks in its own specialty. Investors can then select the best venture-capital firm in each area of technology to build their own diversified portfolios.

DeRosa added that the firm has tried to construct mathematical models to guard against putting too much money in one investment in case something goes wrong, such as a change in government regulation. He said the firm at one point was overly dependent on the pace of deregulation in the utility sector, which occurred slower than expected. Another influencing factor is the tolerance for risk in the public markets, which was high in the late 1990s and in 2000, but dried up in 2001 through 2003 with the collapse of technology stocks.

The firm’s second level of risk management entails making investments within the venture company. To diminish the risk of a technology firm failing, he said, DFJ Element installs good management and financial systems. “Then if the technology works, you’re golden.”

He added that fund managers look for a product or technology that works, but is not living up to its promise because it is locked in a company with operational problems.

The notion of risk in emerging technology is fundamentally different than with an established company, DeRosa said. “I think of risk as something you have and lose. We work with companies that don’t have anything yet and we work to get it there.”

Investing in Healthcare

Panelist Asish Xavier, a principal in Johnson & Johnson Development Corp., said the healthcare company’s 33-year-old venture group “[keeps] an eye out there for new technology.” Excluding early-stage seed investments, the fund’s managers view risk in two buckets: One is technology risk, and the other involves business issues, such as potential legal, financial and management problems.

Xavier’s firm also looks at long-term investments across several dimensions. First, the company is a global investor with holdings in Europe, Israel and Canada. During the recent bubble, European nations offered subsidies in biotech firms, but many of them are struggling since the market has cooled. Those firms are now rationalizing and merging, creating new opportunity for JJDC. “We’re not a fund tied by geographic ability to invest, so we can invest more broadly and manage our portfolio” with more flexibility.

The fund also invests across three major healthcare sectors — biopharmaceuticals, biotechnology and medical diagnostics — and builds its portfolio across different phases of product development, from the early preclinical stage through drug discovery and finally into clinical testing. Since the fund is not primarily driven by its internal rate of return, JJDC can invest in technologies that are out of favor, said Xavier. He noted that biotech products typically take 10 years to develop, while most venture funds have a shorter time horizon than that.

After the bust in biotech (following a boom based on the promise of genomics), healthcare has not been generating much interest among investors. However, he pointed out, healthcare technology companies are beginning to show some strength. A big trend driving the industry is an effort to reduce the time it takes to develop a new drug — from 7 to 10 years down to 3 to 5 years. Reducing the time to market allows companies to take more advantage of the time a new product remains protected by patents.

Another major trend bolstering pharmaceutical and biotech venture investing is the repositioning of compounds. Companies eager to fill weak drug pipelines are going back into product portfolios to test old drugs for new uses. Since the products have already been proven safe, the development time and costs are reduced. Companies are also looking abroad for successful compounds that could be introduced in the U.S. market. And the industry is benefiting from the increase in outsourcing of research to countries where costs are lower. He said firms are looking to move chemistry labs to Eastern Europe and clinical trials to India.

Healthcare venture investors are also active in looking for spin-outs of products, or parts of companies that could fare better on their own. In addition, medical devices are gaining new attention from healthcare investors, following the biotech bust. “The larger funds are diversifying into medical devices to hedge their portfolio,” he said, adding that healthcare investors are pulling back from early stage investments to focus on compounds that have been proven safe in the short-term and are in Phase 2 studies to determine whether they actually work against targeted diseases. “We know the returns will be capped, that there is a higher chance of giving up a home-run, but there is greater certainty.”

Liquidity and Diversification

Spencer Hoffman, a principal at Safeguard Scientifics, presented another take on venture investing and risk from the viewpoint of his company, a publicly traded investment firm specializing in information technology and healthcare.

Safeguard has had its share of success, Hoffman said, such as its investment in Cambridge Technology Partners, which was acquired by another Safeguard start-up, Novell Inc., in 2001. Yet it has also suffered with other firms, notably the well-publicized collapse of Internet Capital Group in 2000. “We have generated a lot of wealth for people and also created our fair share of losses.” As a public company, Safeguard provides investors with liquidity, he said. “If you like what we have to say, you can go out and buy Safeguard. If you don’t, you can short Safeguard or change either way in an hour.”

Most of Safeguard’s shareholders are individuals, not the large insurers or pension funds, or qualified investors that can participate in elite venture funds. “Our model is providing a liquid and transparent way for people to participate in alternative asset classes and get diversification that way,” Hoffman said.

Safeguard’s model is to mitigate risk and create above-average returns by selecting the right companies in areas where the firm has expertise. Then, using Safeguard partners or networks, the company uses its own entrepreneurial experience to help build or improve the businesses. “What we try to do is bring a little bit of the buyout model to the growth equity space and look for opportunities venture capitalists won’t touch because management isn’t perfect or some element of the execution isn’t there.” Hoffman stressed that a key to reducing risk is to pay the right price and structure the terms of the deal correctly in the first place. “The real way venture capitalists mitigate risk is with the terms,” he said.

Furthermore, in designing compensation for the founders and managers of venture companies, many funds have a bias against allowing management to cash out much of its equity in order to keep as much capital as possible in the business. Hoffman joked that this results in founders with bruises on their heads inflicted by spouses who see a lot of wealth on paper, but have been waiting years to buy a summer house or are concerned about how the family will finance its children’s education.