On risks versus uncertainty

I’ve been on a panel recently and the moderator asked about how we assess risks when making an investment decision. Some of the other VCs in the panel gave technical explanations, talked about valuations and investment criteria. Of course, they were right. But I also think it’s about gut feeling.

Matt Ward wrote an article on this — I am adding a few things given my own experience in managing (death-facing) risks.

Risk is manageable. Consider this: it took a strong set of rules and regulations, high safety standards and procedures, active measures, and trained personnel to turn flying from the riskiest way of moving around into the safest. Comparatively, driving is much more democratic, it is open to all, the rules are loose compared to those in aviation, the personnel is barely trained — that’s why, counter-intuitively, even skydiving is actually safer than driving. When you manage risks, the returns are great.

Managing risks is the technical skill at the heart of late-stage VC and all forms of PE — the onion theory of risk is one expression of how to approach taking risks. But applying this mindset to early-stage VC would always lead to sub-par results.

On the other hand, uncertainty can’t be managed. It can only be embraced.

Making investment decision in uncertain conditions is a leap of faith. That’s BASE jumping as opposed to skydiving.

Skydiving is a regulated sport: there are federations and sport associations, there are exams to pass and a whole book of rules to apply for specific “incidents” (whenever something goes wrong). BASE jumping is not regulated. It functions based on an unwritten code of conduct: when a fellow BASE jumper needs assistance you give it to him. That’s it. And when it comes to “incidents” there is only one rule: “Do something”. Anything. Just don’t freeze. Because there is no AAD device on the BASE rig to automatically open the reserve. Because there is no reserve parachute.

In BASE jumping, when you open the parachute you don’t know which way it will head to. There is no way to tell — it may head towards the cliff for absolutely no reason at all. That’s embracing the uncertainty. All you can do is pack the parachute as well as possible — that’s risk management.

Embracing uncertainty in VC investing is taking a leap of faith with startups that come up with something completely new. It’s venturing into uncharted territory. Not blindly, but bravely. The examples are countless — take all the great companies that created their own markets. They played by their own rules — and the value of that is pretty much impossible to assess in the beginning as you don’t know the game.