Thinking big is easy. Preparing for “big”? Not so much. The best VCs are always planning for the future, considering every angle. So how do good VCs manage to weigh every option and prepare for any eventuality? It’s simple: scenario analysis.
Scenario analysis is a discipline investors regularly engage in to form assumptions-based views of future outcomes for a fund and each company therein. VC’s sometimes fail to realize the value scenario analysis provides to both the firm and the ongoing health of the fund itself. Truth is, most VC’s refuse to engage in the practice of scenario analysis. It’s often seen as taking up too much time or as an exercise in futility. After all, “you can’t predict the future”. Why bother trying, right? Wrong. You don’t need a crystal ball to understand why scenario analysis is one practice great venture capital firms never neglect.
Why Waste Time on Assumptions?
VCs generally raise the same points when disputing the benefits of scenario analysis:
“You can’t predict the future, especially in the startup environment.”
“Scenario analysis is just false precision with bad assumption on bad assumption on bad assumption. Trash in equals trash out.”
Let’s get to the root of these justifications. Venture capital firms typically approach scenario analysis in one of two ways. Think of them as two ends of a spectrum. There’s the “Quick and Dirty” approach, wherein VCs arrive at and formalize a point of view regarding exit valuation, timing, and dilution for every company in their portfolio. Some may choose to model an upside case, downside case, and baseline case for each company. These three assumptions are applied per company per scenario to determine future proceeds from each investment. They can then be rolled up to the fund level to predict how that fund might return in different future states.
Then, there’s what we like to call the “Power User” approach. Firms choosing to pursue this approach tend to be bigger, with more resources at their disposal (specifically, a top-notch CFO and finance team). There are three broad steps to this approach:
- Create a pro forma view of each portfolio company’s future performance.
- Derive (from the pro forma view) the probable trajectory of future financing.
- Layer in (to pro forma assumptions) anticipated follow-on across companies as applicable.
This exercise produces an outlook of future proceeds for each company in your portfolio. As with the Quick and Dirty approach, firms will generate perspectives across a variety of cases (upside, downside, baseline, etc). The Power User approach, while time-consuming, carries the added benefit being able to compare and contrast a company’s actual performance metrics with pro-forma views. This helps investors quickly flag successes and challenges in a portfolio, empowering them to take proactive (not “reactive”) measures of course correction as needed.
What we’re really describing here are two ends of a spectrum. Firms that do engage in scenario analysis likely practice some hybridization of the two extremes, sprinkling in more or less assumptions as they see fit. However, the throughline for any structured modeling effort is repetition in regular intervals (e.g. quarterly, biannually, or annually). The practice of scenario analysis refers back to underwriting assumptions from the initial investment, building upon and improving itself over time as companies head closer and closer to exit.
Benefits of Scenario Analysis
Scenario analysis is a discipline. Investing is ultimately a discipline; scenario analysis, a discipline within that. Scenario analysis only works when repeated in regular intervals, with past results informing and building on future projections. Regardless of whether you’re in camp “no one predicts the future” or camp “practice makes perfect”, scenario analysis is a discipline worth engaging in. Accepting the impossibility of “perfection” doesn’t devalue the pursuit.
The discipline of scenario analysis—within a firm or between partners—gives you the opportunity to engage in meaningful discussions about future outcomes, for both the fund and the companies in your portfolio. Even if you can’t predict a singular perfectly-accurate future, debating hypothetical outcomes for companies or funds—over time—can have myriad advantages. These advantages include:
- Improving overall strategy
- Bolstering communication with LPs
- Guiding deployment of capital
- Steering support of portfolio companies
- Ultimately helping VCs become better investors
LP Expectations and Communication
Every investor has gotten the question: “so, where do you think the fund is going to land?”. Your answer, regardless of what it may be, prompts another: “why do you think that?”. Then, like clockwork, “walk me through the worst-case scenario?” followed by “…and the best-case?”.
Scenario analysis gives you the facts you need to answer these questions and explain your assumptions, both in the moment and over time. LPs don’t (or shouldn’t) expect you to know the future. But when they ask these kinds of questions, they expect you to have an answer. Anyone who’s worked a day in their life understands why an LP trusting you to invest their money is perfectly justified in wanting those answers to be well-informed. Both the discipline of regular scenario analysis and the insights produced helps investors set more realistic, data-driven expectations with LPs.
There’s a right way and a wrong way to deliver news, both good and bad, to your LPs. Even if they’re constantly evolving and offer no guarantee of perfection, when armed with well-researched views about the future, you’re better equipped to prepare LPs for what lies ahead; every victory and speed bump throughout the average 10-year journey of a fund.
Smarter Capital Deployment
In both the short term and in the long run, scenario analysis plays an important role in helping VCs find smarter ways to deploy their capital. Without a view of the future at the company-level and (more importantly) at the fund-level, it’s hard—if not impossible—to plan your fund’s reserve requirements and capital calls with any sort of confidence. Scenario analysis reduces the risk of underinvestment and sets you up to capture best the returns from follow-on.
Support The Portfolio Where Most Needed
Any investor who’s been in the game long enough will tell you: they exhaust the lion’s share of time focusing on a handful of struggling companies, never having enough to spend on the ones who ultimately find the most success. There’s a missed opportunity here.
What’s a better use of time: getting your “rocket ships” to the moon faster or helping your “sinking ships” sink slower?
Scenario analysis can be instrumental in allocating precious time and limited resources throughout your portfolio. It provides a shared, regularly-evolving view across the firm, showing:
- How portfolio companies are trending, and
- What these trends are likely to mean for the overall value of the fund.
With this in mind, you’ll spend more time launching your “rocket ships” and less on helping “sinking ships” tread water. Even if they don’t all make it to the moon, they’re still more likely to land amongst the proverbial “stars”. One small step for scenario analysis can easily become one giant leap for your fund. And now we’ve milked the metaphor for all its worth.
Be a Better Investor
Impossible as it may be, a venture capitalist’s success depends, in part, on your ability to predict the future. At the very least, it depends on identifying phenomenal entrepreneurs and higher-order macro, consumer, and technological trends. The only way to get good at that is by committing to ongoing practice and constant improvement. Obviously, each investment a firm makes will give your team the chance to debate assumptions and develop new perspectives about the future. Scenario analysis extends this opportunity even further, particularly when the practice is embedded into your firm’s regular operating rhythm.
The best VCs use the initial underwriting memo to form the basis of scenario analysis for each investment. Each iteration of scenario analysis creates an ongoing record of perspectives over time, with each iteration referring back to the original deal thesis and all subsequent perspectives. In this way, scenario analysis builds upon and improves itself over time. In that time, investors hone one of the core skills of venture capital: pattern recognition. Cementing the practice as a necessary long-term responsibility creates both the opportunity and the forum to reflect and debrief; discussing successes and failures, identifying which assumptions were incorrect, and speculating as to “why”. These are the conversations from which great investors are sculpted and refined.
What’s the Takeaway?
Committing to scenario analysis sharpens your ability to make accurate predictive assumptions, guiding capital deployment and empowering VCs to make better, more reliable investments. The best investors leverage technology to systematically analyze and report on their fund, making data-driven decisions.
We’ve made our case for the benefits of scenario analysis, both as an effective tool for making well-informed decisions and as a catalyst for meaningful discussions surrounding your portfolio. But the practice itself is not what makes a great investor; not on its own. It’s the practice sustained over time—the discipline—that sharpens and hones the talents and skills of a great venture capitalist. These skills include:
- Communicating effectively with LPs
- Championing thoughtful capital deployment
- Directing time and resources economically throughout the portfolio
- Applying valuation policies and methodologies which best reflect current and future value
The rabbit hole of scenario analysis runs deep; we’ve only scratched the surface. For more strategies and best practices in venture capital, visit the EquityEffect blog.