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In finance, we measure an individual's ability to "take on" (i.e. make an investment in) a risky asset as risk tolerance. Startups are a unique breed of investment, and by that I mean they're one of the riskiest. Next to a Bernie Madoff investment.
This is the risk profile of a startup - that is, what makes a startup investment such a shot in the dark.
Why are startups so risky? Why do most of them fail?
To answer this question we need to look in two places: statistics and the psychology of the entrepreneur.
First, the numbers.
You may have heard the statistic that around a third of all startups fail.
And that would be true - even the National Venture Capital Association released estimates that 25% to 30% of all startups fail - if you knew what they used for the definition of "failure".
First off, "failing" for a startup, or any investment in a company, is a loose term.
It can mean one of many things, ranging from complete liquidation and loss of all capital (worst case) to not seeing the projected ROI (best case, at least when we're talking about failure).
Deborah Gage has an insightful article on this in the Wall Street Journal.
She introduces Shikhar Ghosh, a senior lecturer at Harvard Business School, whose research indicates that 95% of all venture-backed companies fail to meet their projected ROI.
That means that, by someone's definition, 95% of all startups fail.
The definition of failure isn't the topic of this post, but for the sake of clarity, we'll assume the definition of failure is complete loss of investment and liquidation of all assets.
...in which case we're talking about a third of all startups.
If we look at a recent report from Deloitte on overall investor confidence in VC investing, we can spot a bit of a trend.
The sectors with the highest investor confidence are almost all in the services and online areas.
These sectors are low in hardware and entry costs, meaning that investments go straight toward paying the smartest people for their time.
The sectors of lower confidence are heavier in hardware and entry costs.
Semiconductor companies require lots of hardware, Biopharmaceuticals require massive testing periods, and clean technologies companies, while on the rise (16% higher than confidence in 2013 - the largest increase in the report, by the way), still have a massive level of uncertainty.
Which brings me to my primary point: the nature of the uncertainty drives the investment decision.
To illustrate this, imagine you're about to invest in a Silicon Valley SaaS startup and Intel. Are you uncertain about both investments?
If you're smart, you are. But for different reasons.
Your uncertainty in Intel stems from their ability to make quarterly earnings projections and successfully release the next generation of processors.
There are hundreds of research analysts following Intel.
There are thousands of employees following procedures that have been successfully proven and tested over decades of company growth.
The stock market has had time to effectively value the company.
You know what to look for, you know where the warning signs in the stock are, and you can easily exit your investment if things start looking bad.
Your uncertainty in the Silicon Valley startup, however, is of a different nature entirely.
There are no analysts. There are 4 employees, no set or proven procedures, no (knowingly reliable) valuation, and your investment is locked in.
The nature of uncertainty surrounding a startup is threatening because there are few set metrics by which to gauge their risk, many of which pale in comparison to the hard statistical truth:
30% of your startup investments will be lost.
Even within the VC world, however, there's varying uncertainty.
Certain characteristics, such as high market saturation, are more easily dealt with than others, since many companies have successfully dealt with such a challenge (i.e. there are procedures).
SaaS companies and Mobile apps fall into this category.
Other characteristics, however, such as a technology still in its infancy, have fewer procedures and proven ways of bringing product to market.
Clean technologies and 3D printing fall into this category.
This is half of the reason why a startup is risky.
The nature of uncertainty surrounding startups (namely, having no set procedures by which to overcome possible challenges) is what keeps many investors from putting money into them.
But there's another half to this reason: the entrepreneur.
Entrepreneurs are a different breed of person- they zag when you zig- just to find out what zagging is like.
They don't give a shit what other people think they should do.
And when they're backed against a wall, they stick to their guns.
These characteristics are what make investing in a startup incredibly risky- there's massive upside potential as well as downside.
Because while the investor knows the founder/entrepreneur is going to put his heart and soul into the company (much moreso than an employee at Intel, for example), they could use that passion to drive the company either to the stars or straight into the ground - hard.
It's a responsible decision on the investor's part to recognize that the entrepreneur is a leader in whatever industry they're in, and given the right resources, a breakthrough is possible.
And breakthroughs are mucho profitable.
But it would be irresponsible for the investor to assume that the entrepreneur can automatically lead effectively, communicate effectively, manage finances, network, sell, grow a company, hire employees, source contractors, or any of the other functions that a business owner should be able to fill.
More times than not, a nervous breakdown is on the menu.
But most entrepreneurs learn. Most entrepreneurs actually get the hang of all that other stuff, because they know it's necessary in order to see their vision through.
The only thing that gets their startup over the finish line at this point, then, is how long it takes them to learn.
Startups have a finite (and often small) amount of cash to play with.
If it takes the founder a year to get his or her shit together in leadership and communication skills, then they're in bad shape.
Those are lost sales, lost research, and lost opportunities to hire more people.
That's what the investor worries about.
It's not often that someone will challenge an entrepreneur's drive - that's tantamount to telling an aspiring musician that they have no sense of discipline.
It contradicts their very character.
It is quite often, however, that an investor will thoroughly vet the founder before even looking at the financials.
It's easier to manage a balance sheet than it is to manage people, and there's no point in putting money in a promising company led by someone with a screw loose.
So here's the take-away...
If you're reading this and you're currently considering a startup equity investment, make sure you're well-diversified or on the board.
If you're reading this and you're in the position of seeking investment, consider the two risks I've talked about above.
Your top priority is your own mind. Do you have the grit to do whatever it takes - in less time than you think?
Your second priority is your financial situation.
In this area you have more support resources (both financially and from an expertise standpoint) at your disposal, including a VC or angel investor.
But be cognizant of the forces pushing against you.
Is the nature of uncertainty for your company one that can be addressed by well-established procedures, or is your industry still in its speculative stage?
If so, you need to have a solid plan - a freakin' laser-pointer focus among an entire universe of possible directions you can shoot your company.
Once you've addressed all of this, you'll have a much more productive (and possible lucrative) conversation at your next pitch.
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