As a venture capitalist, you need to measure and manage the performance and risk of your portfolio companies and funds. But how do you do that effectively and consistently? In this article, we will explore some of the key metrics and tools that you can use to benchmark and monitor your VC activities and outcomes.
One of the most common ways to evaluate VC performance is to use return metrics, such as internal rate of return (IRR), multiple of invested capital (MOIC), and cash-on-cash return (CCR). These metrics capture the annualized returns, the total returns, and the realized returns of your investments, respectively. You can calculate them at the individual company level, the fund level, or the portfolio level. However, you should also be aware of the limitations and assumptions of these metrics, such as the timing and valuation of cash flows, the effect of fees and carry, and the comparability across different funds and stages.
These metrics all have their merits and limitations. Thus when choosing which one to use, bear in mind several factors, namely, time value of money, cost of capital, non-cash returns, etc. For example, IRR is favored over its simplicity, but it assumes the reinvestment rate is at the IRR itself, which is untrue especially when the cost of capital is lower, or there are sign changes in the cashflows (thus different IRRs) in different periods. Multiple of Invested Capital is a straightforward measure of absolute return on investment, but it does not consider the time value of money. Also, cash-on-cash is intuitive since it measures the cash return on cash invested, but it does not consider the non-cash items, nor the time value of money.
Another important aspect of VC performance is risk, which refers to the uncertainty and variability of your returns. Risk metrics, such as standard deviation, coefficient of variation, and value at risk (VaR), can help you quantify and manage the risk of your portfolio. These metrics measure the volatility, the relative risk, and the potential loss of your investments, respectively. You can use them to assess the risk-adjusted returns, the diversification benefits, and the downside scenarios of your portfolio. However, you should also be mindful of the challenges and limitations of these metrics, such as the data availability and quality, the distributional assumptions, and the sensitivity to inputs and parameters.
Usually start-up's financial performance can be volatile and the data is not necessarily distributed eventually throughout the period. This poses challenges in quantifying (e.g., extrapolating) the existing data to future periods. Non-financial measures, such as the stage of development (e.g., start-ups at an earlier stage should bear a higher risk premium than those at a more mature stage), or due diligence process to uncover potential issues regarding the products, operational teams, and more. Understanding the competitive landscape (e.g., Five forces analysis) can also help deepen the understanding of the future revenue streams. This strategic information should be embedded in measuring the risk profile of the investment target.
To put your performance and risk metrics in context, you need to compare them with relevant benchmarks, such as market indices, peer groups, or industry standards. Benchmarking tools, such as public market equivalent (PME), quartile ranking, and hurdle rate, can help you do that effectively and consistently. These tools measure the relative performance, the peer comparison, and the minimum required return of your portfolio, respectively. You can use them to evaluate your performance against different markets, funds, or objectives. However, you should also be careful of the selection and adjustment of these benchmarks, such as the representativeness, the comparability, and the alignment of interests and incentives.
To track and improve your performance and risk metrics over time, you need to monitor them regularly and systematically. Monitoring tools, such as dashboards, reports, and alerts, can help you do that efficiently and transparently. These tools provide you with visual, comprehensive, and timely information on your portfolio performance and risk, as well as any issues or opportunities that arise. You can use them to communicate with your stakeholders, identify best practices and areas for improvement, and take corrective or preventive actions. However, you should also be aware of the design and implementation of these tools, such as the data sources and integration, the key performance indicators (KPIs) and targets, and the frequency and format of reporting.
Assess how well your portfolio is diversified across industries, stages, and geographies to mitigate risks.Evaluate risk factors such as the stage of investment, market volatility, and sector-specific challenges.Make sure you have the right tools and software to continuously monitor the VC.
Balanced Scorecard (BSC) can also be a very useful tool. Despite being an established framework for many years, BSC remains a robust tool in strategic and performance management. It’s known for its holistic approach by integrating non-financial aspects that are directly linked to the company’s overarching strategy. At its core, BSC consists of Key Success Factors (KSFs) that are subsequently translated to Key Performance Indicators (KPIs). This framework consists of four perspectives, namely, Customer, Finance, Internal Process, and Learning & Growth. Using BSC as a dashboard during routine performance reviews can be a game-changer. It facilitates meaningful cross-functional dialogues and enhances the goal congruence of the organization.
One of the most useful and powerful tools for VC performance and risk management is sensitivity analysis, which allows you to test how your metrics and outcomes change under different scenarios and assumptions. Sensitivity analysis can help you understand the drivers and impacts of your performance and risk, as well as the trade-offs and uncertainties involved. You can use it to explore various what-if scenarios, such as changes in valuation, exit timing, growth rate, or market conditions. However, you should also be careful of the validity and reliability of your sensitivity analysis, such as the choice and range of variables, the correlation and interaction of factors, and the interpretation and communication of results.
Sensitivity analysis is indeed one of the most important decision-making tools. However, it is worth mentioning that it is often mixed up with scenario analysis. They both fall under the umbrella of “what if” analysis to address the uncertainties of decision-making. Sensitivity analysis focuses on gauging the effect of one single variable at a time, while scenario analysis casts a wider net of variables to discern various potential outcomes. In a nutshell, sensitivity analysis offers a micro view, evaluating the effect of changes in individual variables, scenario analysis adopts a macro view, delving into the multi-faceted interplay of various variables to anticipate a range of potential outcomes.
To effectively and consistently benchmark and monitor your VC performance and risk metrics, it is essential to define objectives and criteria clearly, choose metrics and tools carefully, collect and analyze data accurately, compare results with relevant benchmarks and peers, monitor and update metrics regularly, perform and validate sensitivity analysis rigorously, and communicate and act on findings promptly. By following these best practices, you can improve your VC performance, risk management skills, and ultimately achieve better outcomes for yourself, your portfolio companies, and your investors.