How Venture Capitalists Assess Risk with the Scorecard Method
Many venture capitalists (VCs) use a scorecard technique of assessing the risk of an investment, which can also be mapped to value. This table shows what this might look like. This valuation method breaks the risks into five main categories: technology, disruption, market, financial, and people. These are the biggest risk categories for a company, so this is the simplest way to assess risk.
|Type of Risk||Description|
|Technology||R&D risks: Likelihood that the technology will fail
|Disruption||Major, unforeseeable change that will negate all plans|
|Market||Time to capture market and amount of addressable market|
|Financial||Likelihood that the company will run out of liquid capital|
|People||Chance that the right people will not be available to drive
Different risk types may overlap. Technology risk, for example, overlaps with management risk. What would happen if the company lost key development personnel? It also overlaps with funding risk if the entrepreneur depends on future capital raises to complete product development.
To use the scorecard method, VCs perform a series of steps. This table shows an example of what the scorecard method might look like for game-ibuy.com, a fictional company; refer to this table as you read the steps:
The VC assigns a weight to each of the five risk factors.
This weighting is different for each company, but each VC may have a standard value that he uses for most companies he looks at. If the VC believes that the most important factor is the team, then he may assign 30 to 40 percent for the team, for example. If the competitive environment in the market is small, then that may only get 10 or 15 percent.
The VC creates a confidence factor for each element.
This factor has a base amount of 100 percent. If the VC is extremely confident in the team, for example, he may give a factor of 150 percent for team. If he is less confident about the market, then that may only get 70 percent.
Using this model, you can go as low as 0 percent if risk of failure is certain or 200 percent in an extraordinary event where success is absolute and without risk.
The VC adds all the weighted factors together to get the total weighted factor.
The VC multiplies the total weighted value by the company’s initial value to arrive at the company current valuation.
|Risk Type||Description||Weight||Confidence Factor||Weighted Factor|
|Technology||Technology not yet done.||20%||70%||0.14|
|Disruption||Environment is competitive.||10%||80%||0.08|
|Financial||Need Series A in 12 mos.||10%||100%||0.1|
|Other||Other factors –supplier relationships.||10%||110%||0.11|
|Total Weighted Factor||1.05|
|Initial Valuation||Based on early-stage companies in your area||$2 million|
|Adjusted Valuation||Initial valuation x total weighted factor (2,000,000