Risk Ratings
In evaluating potential investments, part of the due diligence process we go through is a risk rating. Recognizing that risks are uncertainties about the future, we consider brittleness in the outcome combined with consequences of the identified event(s) to be the key factors in evaluation of risks. When I say consequences, as an investor, I am interested in consequences to me. A failure of a company might be higher risk to the CEO than to me as a small investor, particularly since I have a fairly diversified portfolio of companies.
Our review process reviews deals in three areas:
Our ratings of Low, Medium, High, and Extreme consequences are generally defined as follows (from the next generation of our standards of practice):
| Risk level | Definition |
|---|---|
| Extreme | Anything that can cause global damage to the environment, large-scale loss of life, or other dire consequences. |
| High | Anything that can put the enterprise out of business, cause large-scale loss of shareholder value, cause significant damage to the environment, cause governmental agencies to stop doing business with you, cause loss of life, get officers thrown into jail, or result in other very serious negative consequences. |
| Medium | Anything that causes substantial negative publicity, substantial loss of business, losses in the range of 5% or more of annual revenues, legal difficulties for officers, workers, or others, things that interrupt production or cause quality control problems in important manufacturing systems, and other events that don't reach the level of high risk but are not in the low-risk range. |
| Low | Anything that is similar in consequence to a slip and fall accident, anything that normal business insurance standardly covers, and day-to-day office issues. |
An example
Here is an example of a risk review for a company I recently invested in. It starts with a roll-up that summarizes the tables that follow. We roughly estimate it as the majority of results, but we could also use metrics in more depth if we knew a good way to do the calculation.
| Risk category | Specifics | Level |
|---|---|---|
| ISO 31000:2009 identified risks | For the stage and valuation there are only a few questions left to answer and we will find the answers soon. |
Low Risk |
| Risks that are ordinarily present | Several obvious ones that can be readily mitigated. |
Low Risk |
| Special risks associated with this business | Regulatory approval, dependency on individuals, uptake rate once on the market. |
Low Risk |
|
Risk is defined by ISO as the 'effect of uncertainty on objectives'.
| Risk factor | Specifics | Level |
|---|---|---|
| An effect is a deviation from the expected - positive and/or negative. | Just as many substantive upsides as downsides. |
Med Risk |
| Objectives can have different aspects (such as financial, health and safety, environmental goals, personal goals). | Goals are well aligned |
Low Risk |
| Risk is often characterized by reference to potential events and consequences, or a combination of these. | A know set of anticipated futures reasonably characterized. |
Low Risk |
| Risk is often expressed in terms of a combination of the consequences of an event (including changes in circumstances) and the associated likelihood of occurrence. | Consequence range limited on the down side and high on the up side. |
Low Risk |
| Uncertainty is the state, even partial, of deficiency of information related to, understanding or knowledge of an event, its consequences or likelihood. | Really only 2 basic questions - Does it work (and get approved)? How well will it sell? |
Med Risk |
|
This review deals in the ordinary risks to businesses.
| Risk factor | Specifics | Level |
|---|---|---|
| Business cycle risks | Nothing apparent |
Low Risk |
| Risk reward tradeoffs with innovation and market disruption | Very positive disruptive technology. |
Low Risk |
| Business environment as it change over time | Nothing apparent |
Low Risk |
| High dependence on small numbers of key people | 2 key people must both continue |
High Risk |
| Location-related risks | Nothing apparent |
Low Risk |
| Financial instruments involved | Don't have PPM yet |
High Risk |
| Exit risks | Nothing apparent - should be an easy exit at some reasonable valuation - or IPO |
Low Risk |
| Investor communications | Quarterly |
Low Risk |
| Adaptability and pivots | Nothing apparent |
Low Risk |
| The response of competition to innovation | Strong patent portfolio existing and in process. |
Low Risk |
| The specialness of special sauce | Seems very special and well established technology - we will see FDA approval issues |
Med Risk |
| Assumptions in financial projections | The range is quite good for returns even at a fifth of the projected outcomes. |
Low Risk |
| Operations and execution in reality | All outsourced to large players in the business. |
Low Risk |
| Sustainability over time | Nothing apparent |
Low Risk |
| Legal and regulatory risks | FDA approval is the key risk. |
Med Risk |
| Growth-related and scalability risks | Nothing apparent - large scale outsourced capabilities. |
Low Risk |
| Inadequate funding (now and in the future) | Nothing apparent after this round. Might slow growth but financial engineering looks like it could solve this readily. |
Low Risk |
| Inability to get enough qualified workers for needed tasks | Nothing apparent - outsourced to large suppliers. |
Low Risk |
| Uninsured losses and insurance issues | Needs to get insurance as soon as round closes. |
Med Risk |
|
Specific risks associated with the business are described here.
| Risk factor | Specifics | Level |
|---|---|---|
| Risks associated with the nature of the business | Nothing apparent |
Low Risk |
| Risks associated with the team | 2 key people required for success |
Med Risk |
| Risks associated with the offering and exit | Nothing apparent |
Low Risk |
| Risks related to the go to market strategy | Nothing apparent |
Low Risk |
| Risks related to the competition | Adoption rates are in question till it's on the market. |
Med Risk |
| Risks related to the special sauce | Nothing apparent |
Low Risk |
| Risks related to finance and controls | Nothing apparent |
Low Risk |
| Risks related to the operations plan | Nothing apparent |
Low Risk |
| Risks related to sustainability and impact | Nothing apparent |
Low Risk |
| Legal and regulatory risks | FDA approval |
Med Risk |
| Risks identified from interviews | Nothing apparent |
Low Risk |
| Risks related to other information identified | Nothing apparent |
Low Risk |
How do we use this?
Investment is taking risks for rewards. That is, the uncertainty is balanced with the potential return so that more uncertainty for higher return is justified. More to the point, when we find a relatively low uncertainty with a relatively high return (multiple on the invested amount) in a reasonable time frame, it is desirable.
The explanation of the bets we are making come in the form of a bet sheet. Basically, a list of the assumptions being made, the basis for the assumptions, the evidence for that basis, and the level of certainty mixed with the consequences of it being wrong (i.e., risk). Investing in this company, as an example, has a few basic assumptions apparent from the risks, and ignoring all of the "low" risk items:
| Assumption | Basis | Evidence | Risk Level |
|---|---|---|---|
| Key persons continue | They survive and remain healthy and committed | They have worked it for a long time and have worked together on a previous similar success. | High |
| Investment terms acceptable | PPM has not been completed | Still answering questions about PPM and closing discussions | High |
| Timely FDA approval | FDA approval is a regulatory requirement for selling this product | FDA letter detailing likely rapid (~9 month) approval process and predicate devices | Medium |
| Market acceptance | Other devices have been adopted in the same field over time, adoption of less that 0.3% over 5 years is adequate for projections | Several previous analogues in the same general field | Medium |
| Uninsured losses | Key person and D&O insurance not in place | Owners assert not to have it yet - require as condition of investment | Medium |
What are those numbers?
The numbers are of course specific to the company and situation, but we do measure some things. In particular, using out GWiz™ package and doing a regression analysis against other pre-market medical companies with banked investments, this company's offering was at half the estimated valuation of comperables, making it a better bet. The return on investment under reasonable projections is about 50x in 5 years, while the average angel investment return is about 9x in 10 years (24% IRR), and a typical minimum requirement for this stage company is 2x every year, or 32x in 5 years (required to compensate for the failure rates of companies at this stage).
A call to action
If you haven't done this analysis for your company or your investment decisions, you are creating impediments to investment and likely increasing your dependency on luck. As the saying goes, luck favors the prepared (from "The Incredibles", Louis Pasteur said, “Luck favors the prepared mind.”). You can prepare by starting with our
In summary
Join us and let's have a conversation about how to understand risk for investments.
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