How Do Investors Think About Risk?

RiskI recently did an interview with Greg Stoller, a Boston College Carroll School of Management professor of entrepreneurship who is studying risk from different perspectives. He asked me for my thoughts on risk from the perspective of early stage investors, and since I have a lot of entrepreneurs as Scratchpaper readers, I figured I’d share my answers here.

1. From your financier’s perch, what’s the first thing that comes to mind when I mention Risk Assessment?

I guess the first question is what kind of risk are we talking about: market adoption risk, technology risk, team risk, future financing risk?

2. How much does risk, or things not going as planned, factor into your decision to make an investment?

We think about it all the time. When we invest, we are taking calculated risks. Markets reward risk-takers.

3. If you choose to invest, but determine the risks are substantial, how might you change your investment terms?

Markets are pretty efficient. People generally have to be compensated for taking on risk. In the early stage investing world, valuation – what is typically referred to as the pre-money valuation – is usually the first lever people reach for. Think of buying a used car – would you pay more for a car sold “as is” or for a car with a very good warranty? Less risk with the warranty. That will be reflected in the price. But there are other tools which can be used to mitigate risk or to allocate it to another party. Examples might include allocating some of the risk of founder departure back to the founders through vesting of stock, or mitigating some of the risk that things might take longer than planned through the accruing  of interest on preferred stock.

4. If the potential risks come from competing products, how aggressive are you in either purchasing those other products, or having your portfolio companies do that for you?

Competition doesn’t faze us as much as you might think. Sure, we’ll research it and try to understand the market dynamics, but show me a company with no competition and I will show you a company with no market, no validation of its concept. Sometimes that kind of blue ocean opportunity can be a great thing – every new market had to be invented at some point. But it is harder and takes longer than most people realize. There were a lot of god-awful MP3 players prior to the iPod’s seemingly overnight success. At the other extreme, we might shy away from a very crowded or mature market, but in most cases we are focusing more on finding differentiated solutions guided by exceptional teams.

5. What advice would you give to entrepreneurs on risk disclosure?

Put it all out there and control your own narrative. Investors evaluate stories like yours all day and they are usually pretty good at differentiating between competence and confidence. Just explain the challenges and what you do about them. Then ask the investor for help or advice in overcoming them.

6. Is their creativity in discussing how to mitigate them important?

Sure. How they think about it, discuss it, analyze it gives us great insight into the quality of their thinking process, their ambition, their tenacity, their pragmatism, their resilience, and their likelihood of success.

7. How about the disclosure of general business or economic concerns?

There is some scope for entrepreneurs to help themselves by having a plan that is realistic and viable in the face of some headwinds, but at the end of the day, those macro issues are the investors problem to assess. We expect entrepreneurs to be incurable optimists, so we make adjustments for that.

8. How much do you rely on sensitivity analysis, or scenario planning in determining the durability of the business model?

Less than you might think in terms of sophistication. At the stage where we invest, there is so much that is unknown, that it can be hard to look too many chess moves ahead. You quickly get into hypotheticals built on hypotheticals. The reality is that 90% of the non-fatal problems fall into the “takes longer and costs more” bucket.

Comments, questions or reactions to this post? Leave a note below and I will respond to your questions.
If you enjoyed this post, you might enjoy:Funding Startups (Panel Video)Swimming Against the Tide (Angel Investing)Nailing The One Minute PitchStart-Up Marketing SeriesConstructing a PitchDelusional EconomicsThat Vision ThingThe Power of An Advisory BoardTop Angel Investors in New EnglandAngel Video Interview Series, Thoughts on CrowdfundingEntrepreneur at Work: Caine’s Arcade,  The Crowdfunding Interview (Frank Peters Show), Getting Off The Ground; Early Formation EconomicsPitch Clinic at MassChallenge (Video)Are Entrepreneurs Wild Risk-Takers?Top 20 Dos & Don’ts with Angel Groups & Early Stage FinancingWhat I Look For In An EntrepreneurThe OvertureDo The Right ThingOpen Forum with Angel, Seed and VC Investors (Video)Pick Your Founder/Co-Investors Carefully & Reflections on the Nature of Entrepreneurs.

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Comments

  1. Mark Woodroffe says:

    Great article – I also really liked the “one-minute pitch” post. I’m a 3L at BC and wanted to say thanks for coming by to chat with our class yesterday morning.

    Also, going off of your “one-minute pitch” post, how does the strategy change for a five-minute pitch? Where would you recommend allocating the extra time? I’m guessing this post plays into that. Thanks.

  2. Mark Woodroffe says:

    That’s great, thanks. I’ll pass that along to my MBA teams. Also, if you ever have some time for coffee or a brief lunch, I’d love to pick your brain a bit more about your transition from public company to angel investing and talk further about Launchpad.

    My email is mark.woodroffe@bc.edu. Thanks – and have a nice weekend.

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