Counterparty Risk in Venture Capital

In a recent blog post, I discussed the importance of trust amongst investor syndicates and how a good group working together can reduce financing risk for a company.

This post expands on some of those ideas and further discusses the concept of counterparty risk in venture capital

Counterparty risk is the likelihood or probability that one of those involved in a transaction might default on its contractual obligation.

I use it more broadly here to describe any actions taken by one of the investors involved in a company that would adversely impact a company or its team

Success in a company is never a straight line – and good investment partners can increase the likelihood a business makes it through a difficult time – and bad behavior can have just as much negative impact on a company’s potential outcome

1.

It starts with a firm’s limited partners

At True, we screen our investors for mission alignment

Our second set of screens is around their sources of capital + their historical track record of investing in the venture capital asset class

We bias towards investors who have large, stable capital bases – and who have a long history of investing in venture capital with a track record of continuing to back the same managers they’ve selected over long periods to time

Within our current LPs, we also prioritize length of relationship – many of our investors have been with us since Fund I

These long-term relationships give us more stability in our operations and planning – which ultimately lets us be better partners to the Founders that we work with at True

2.

Next, it applies to our co-investors

One of my partners likes to say that “people like to invest with people they’ve already invested with” *

I didn’t fully understand it until later in my venture experience – it happens naturally, but has the added benefit of creating more trusted relationships which ultimately benefits the companies we invest in together

3.

At True, one of our most common co-investors is Indie Bio

We have done team strategy sessions together – we share information on what we see is working in each of our portfolios – and most importantly, we’ve been through a meaningful number of good and bad experiences together – so we know how the other thinks + will act

It turns a one turn game into a multi-turn game

4.

This applies more broadly for other investors we work with

There are 5 individual investors who I sit on more than one board with today

And 8 firms that I have worked on more than investment on together

Many of these people I’ve worked with for a number of years, met their family, gone on trips together

The degree of trust is high and behavior of the individual (and their firm) is more predictable

This creates more stability for the company – which makes us better co-investors

5.

And the fact that we will work together again encourages a positive feedback loop

Founders will usually only will raise a few rounds of capital during their companies life

As investors, we will work with many different groups, many times

Helping guide companies to investors who behave better (or are generally more stable) is more than something we should do – it will likely drive better returns for us long-term

6.

First example

Post seed company that has made tremendous product progress, but is early

Needs to raise a small A round to launch and prove their business model

It was too weird (or risky) for a new lead investor to lean in

The syndicate of 3 investors came together to underwrite the entire amount

This caused a number of other new investors to want to jump in and participate

The first part of this story is more normal than you might think

The second part where weird counterparty risk issues can emerge

And for each partner at each firm – it is a very complicated model to predict behavior

Except if you have real world data – from an individual’s behavior in previous complicated financings

7.

Second example

Another post seed company that has made tremendous product progress, but is early

Different set of three investors – but two of the investors have limited capital to allocate to follow-on rounds

Syndicate breaks – so if they can’t find additional new capital – it would be up to the one investor to support the company alone – or the company would end up going out of business

8.

A weird twist – one of the funds without additional capital in example 2 is actually a known multi turn player with the group – but due to a series of compounding internal issues – they weren’t in a position to participate in a way we’d seen in other similar situations

Working with known actors should reduce some risk – but it can’t reduce all risk and there remain volatility in an business that involves so many different human layers

9.

I used to think you should choose investors based only how much they can help

Over time, my thinking has evolved to also include thinking about which groups may have the lowest likelihood of causing issues downstream

Similar to how we approach raising money at True – our advice to Founders is to focus on groups that have large, stable capital bases that have a long track record of investing in companies like you at your stage

If you don’t already know them – spend time getting to know them.  And ask them for as many references as you can handle – no one will have a perfect track record – but the more you know – the better aware you’ll be for the moment things get weird

In a world where we’re all already taking incredible amounts of the right risk – product, market, timing – you shouldn’t compound it by adding all sorts of additional (and discoverable) risk around people

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