What Could Go Right” Is More Important Than “What Could Go Wrong”

March 12, 2018

Angels Investors and Seed VCs are in the business of backing companies that have a substantial chance of failing and the earlier you invest, the more likely you are to see a zero return on your capital. What offsets this is that the successes tend to be outsized, returning 20x, 50x, or even 100x+.

 

The notion that tremendous value is created by a very small percentage of startups, and the financiers behind this businesses are counting on a few of these companies to make up for all the nonperforming investments is called a power law distribution.


 

 

 

This means that when I evaluates a startup opportunity I  am of course trying to understand all the reasons that the little company could fail, but I am more concerned about “how big can this be if it all works?” 

 

There are plenty of very good, very valuable businesses which are still not venture scale.

 

That’s fine — this post isn’t about whether venture is broken for depending on outsized outcomes or the tradeoffs a founder makes when deciding to go down the venture path.

 

No, the point I’m making is that when a venture-backed company fails, it likely wasn’t that their investors didn’t realize the risks upfront but rather they were interested in the upside, not the downside.

 

Accordingly punditry that just says “OMG, I can’t believe this business got funded when nominally there are so many other ideas out there” or “duh, didn’t the VCs know there was XYZ risk here,” is kinda flat. A richer unpacking would be around whether the bull case actually warranted the capital – was it a reasonable risk to take, not, was there risk.

 

Of course played out to its extremes this would suggest any investor decisions are beyond reproach because with fuzzy enough math and juiced assumptions you can always make the numbers work on paper. This too would be silly position and we as an industry would lose access to self-reflection and documentation if we cursed at reporters for analyzing our failures.

 

But I’d lay out a framework for understanding the risk/reward analysis that went into an investment, and believe reporting would improve if these were included:

For a failed startup….

  1. Was what caused the failure predictable or novel – ie were the risks ones that a reasonable person could have properly assessed upfront or did they emerge from changes in technology, market, regulation, etc.

  2. Under what assumptions or scenarios were the “venture scale outcome” dependent and how credible/achievable would that be given the degree of difficulty in execution.

  3. The firms which invested – do they typically invest in businesses with similar risk profiles and have they succeeded notably, or was the firm either stretching into a new area and/or hasn’t proved yet to be astute assessors of risk/reward.

 

Of course this is difficult information for a reporter to gather and assess, especially in a “must publish now” culture.

 

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