Risk – Embrace it – It’s where the Profits Are.

Risk – Embrace it – It’s where the Profits Are.

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Risk is impossible to avoid in any business. For Angel investors looking at the first rounds of funding going into a start-up the risks are particularly significant.

Angel investors make decisions to invest under conditions of extreme uncertainty. Angel investors face cases in which uncertainty is so extreme that it qualifies as unknowable. They decide on investments in ideas for markets that often do not yet exist, and they propose new products and services without knowing whether they will work.

For experienced Angel investors rather than being undesirable, unknowable risks are deliberately sought. It is by investing in companies with unknowable risks that they can find the most attractive, most profitable investments.

Experienced Angels do not seek to maximize each decision but instead seek potentially extraordinarily profitable opportunities and accept what may seem like a high failure rate. They rely on building a large portfolio to spread risk and accept that the overall failure rate, by number of investments, may be as high as 70%, even in the most developed capital markets[1]. Typically 85% of all returns come from just 10% of investments made. They are willing to accept that most of their investments will be total losses.

It is critical to understand that for Angels a ‘fail’ is not a company in liquidation. It’s a company that fails to return the investment capital and an investment return on top. Indeed, depending upon the local tax regulation a zombie company – one that keeps going but with no likely prospect of an exit for the investors – is worse financially than the liquidated company. At least if a company is liquidated I get to offset the loss in my tax return.

Angels use Due Diligence to assess risk. A due diligence process therefore needs to cover the key risk categories –

  • Management Risk
  • Technical Risk             
  • Competitive Risk      
  • Market Risk              
  • Intellectual Property Risk
  • Regulatory Risk
  • Team Risk

Many Angels however do not spend enough time looking at the two most critical risks – that will kill a return on investment even if everything else is as close to perfect as can be –

  • Capital Risk – how much follow on cash is this company going to need – can it get it, and on what terms?
  • Exit Risk – is anyone ever likely to want to purchase this company – and at what price?

[1] 2016 Angel Returns Study, Angel Resource Institute, 2016.