Note: This article is the ninth in an ongoing series for angels new to investing. To learn more about building an angel portfolio, download this free eBook today Angel 101: A Primer for Angel Investors or purchase our books at Amazon.com.
Early stage investing is an inherently risky way to invest. The list of high level risks is long and includes financing risk, technical risk, and market risk. As angel investors, you need to be aware of the key risks you are taking with your investment. By understanding the risks, you have a way to monitor the progress of the company and provide human capital assistance in areas that will matter for the long term success of the company.
With his legal training and through his CFO role managing a public company board, Christopher is all too familiar with the issues around risk management. With the understanding that managing risk in a large corporation is quite different from managing it at an early stage startup, we asked him what keeps him up at night after he makes an angel investment.
Q: Will you give us a quick summary of the key risk areas that you focus on with startups?
This is not an easy question to answer because every startup situation is a little different, and there are so many nested layers of risk with any start-up. For example, you might wonder “is there an opportunity here?” or you might wonder “is this team good enough to go get it?” or you might wonder “is this company being smart about how it is writing contracts with customers?” or “does this company have complete and up to date personnel records and fiscal controls?”
Obviously, you cannot evaluate every risk at once, nor would you want to. The key is to focus on the major risks first and leave the secondary and tertiary risks to the side to be addressed at the right time. For example, there is not a lot of point in worrying about the board minutes of a company that does not yet have product/market fit.
So as a general matter I try to establish comfort on the big things like whether this is a great team, whether there is a likely big market here and whether there is a smart, defensible and differentiated product. I try to document the key assumptions necessary (what, at Launchpad, we refer to as WNTBB or “what needs to be believed” in order to invest) to get an overall sanity assessment.
Then, once I have a general comfort level on that stuff, I try to get a handle on details around the go-to-market approach, marketing methods, and defensibility of the solution. Only then will I spend time on the financial model to make sure it makes sense. Ultimately, I try to think through the exit options: who are the likely buyers, what aspects of the business will they want, what will they be prepared to pay, and what milestones are going to need to be achieved in order to get bought.
Q: Are there any areas of risk that concern you to a level that you might decide to pass on an investment in a company?
Regulatory risk is obviously a biggie. If the company’s legal right to execute its business plan is in doubt for regulatory reasons (for example, FDA approval is required), or the proposed plan is potentially illegal (for example, the SEC might decide it is a regulated activity) or it is very dangerous (for example, a product associated with ultra hazardous activities or extreme sports that could give rise to huge product liability issues) or the business model is just yucky or misleading (as with certain spammy or privacy invading activities, or certain business models preying on young consumers) then I am probably not going to be interested. One of the nice things about angel investing is that you get to pick whom you do business with and what you get involved in.
Q: What approach do you take when you advise a CEO on how to manage risk?
To be brave and recognize that they are paid the big bucks to take measured risks, that they have to take risks to be successful, and so they cannot obsess about eliminating all risk. After all, if you don’t fall down, you are not skiing hard enough (I’ve meditated on this subject before). But I also advise them to focus on the really big existential risks and delegate the smaller ones to capable team members. Too many CEOs hold on too tight, to too many silly things, for too long and don’t leverage a strong team well enough.
Once the company starts to grow, the risk-taking attitudes will mature and the situation will require a little more conservative and thoughtful approach - in the beginning when the business is nothing and it has no assets, risking it all on a hunch doesn't mean much because the “all” isn’t yet a valuable going concern. Once it has a big revenue stream and assets and is responsible for the livelihood of many people, it can be harder to “bet the company”. It is still going to be necessary to take big risks, to innovate, to pivot, but it is generally going to take more strategy, planning and thought.
Q: As a board member or advisor, what do you do to help the CEO manage risk?
Ask lots of questions starting with “Have you thought about…” or “Have you considered what you’d do if….” or “What are your thoughts on….” Since I am unburdened by the day to day distractions of running the business, it is easier for me to step back and look a little farther down the road. Together we can spot issues a bit earlier and plan for them so that we can take advantage of them rather than just reacting to them in permanent crisis mode.
Q: As a board member or advisor, how do you work with the CEO to monitor and track the progress on risk mitigation?
By helping them develop a good dashboard of all the key performance indicators and monitoring it regularly. If you have the right measures on your dashboard, and you keep your measurement set up to date as the business evolves, it is just a matter of looking at the numbers that are out of whack relative to the initial assumptions and asking “why?” and “what are we missing here?” (Read more on the roles and responsibilities of Board Members and Advisors).
Want to learn more about building an angel portfolio and developing the key skills needed to make great investments? Download Angel 101: A Primer for Angel Investors and Angel 201: The 4 Critical Skills Every Angel Should Master, or purchase our books at Amazon.com.