What Is Capital Risk and How Do You Calculate It?

When deciding to invest funds into a risky (and hopefully high return) endeavor, one of the first decisions is how much money should be invested. It’s another way of asking how much money I want to lose if the venture goes south.

The funds invested in a risky project are called risk capital. Figuring out how much risk capital to invest is a necessary calculation. Let’s break down the definition of risk capital and how to calculate it in more detail.

What Is Risk Capital

We’ve already given a simple definition of risk capital. But why would anyone want to risk their money? The other option is just to keep it safe and sound and know that it will be there. That is true, but the enemy of cash is inflation. With more time, cash erodes.

Also, we generally want to try and get ahead on an accelerated schedule. That often means taking risk, whether through a new job, investment, starting a new business, or a new project within an existing business. All entail some form of risk and require capital to kick them off.

Specifically for real estate investors, risk capital is the money to fund a new venture. This might be the acquisition or construction of a new apartment building. Funds to purchase or construct the building need to come from somewhere. Funding sources may include a loan, investors, and some of your own money.

At its riskiest, a single person funds the project. This person is assuming all risks. Most projects don’t work that way, though. Instead, investors are brought in and potentially a bank loan. Those funds go into some type of business, which initiates and operates the new project.

If the business is established, it will have existing equity, possibly debt, cash flows, and assets. The business is putting some of these funds towards the new project. Those funds are at risk if the new venture fails. That is why it is called risk capital.

Analyzing Risk

Through analysis (of the impact of a total loss of risk funds), the business concludes if it can continue operations without being adversely affected should the new venture fail. This is a key risk management component when determining the amount of capital that can be dedicated to a risky project.

Businesses also need to factor in the project's impact of falling short of the desired goal. Rather than the venture failing, it may only achieve an 80% market share or profit target. Under such circumstances, the new venture returns less to the business than was projected. Is the business able to function normally under those conditions?

Another risk assessment strategy when using debt is negotiating better loan terms (i.e., lower rate, better covenants). Better loan terms can mitigate the adverse effects of a new venture coming up short.

Calculating Risk Capital

Now that we know what risk capital is, how is it calculated? At a high level, a business considers a percentage of its cash flows, equity, or debt that can be dedicated to a risky venture without negatively impacting daily operations should those funds be lost.

It may be tempting to take on high debt levels to build a new apartment complex. But if the expansion (i.e., apartment complex) is too large for the business's size, the company is likely to underestimate the expansion's risk impact. A fall in cash flows means expenditures and capital outlay will need to decrease. However, debt payments will remain the same. 

The result is a decrease in profit margins and the potential that the company won’t be able to make its debt payments and may eventually default. Even if the company tries to sell assets, it may not be able to raise cash quickly enough since assets can be illiquid. The expansion is too large in this case. 

When assessing how large is too large for a project, keep this business tenant in mind: The bigger the project, the more money it will lose if it gets in trouble. 

The above example outlined the business turning down, which could make it difficult to meet loan payments. But what happens if the project takes a turn for the worse. The outcome is similar. It will negatively blow back onto the business.

Management may believe the solution to these issues is to simply request additional debt. However, banks will be reluctant to finance a troubled venture, especially one they already have exposure to. There’s also no guarantee that any advanced funds won’t go to other lenders.

Real estate crowdfunding sites have a solution to minimizing risk capital. They distribute it across many investors. Businesses can and often do the same by pooling their risk capital from investors, debt, and equity (from the business). This reduces the business’ exposure to risk capital.

Going into a high-risk venture isn’t necessarily a bad thing. Going into it blindly or with little analysis is. It’s important to understand the adverse impact any loss of risk capital will have on the business. The loss shouldn’t be so great that it cripples the business or makes it insolvent. Of course, this type of analysis may reveal that the intended project is far too large and that a scaled-down version is more practical.