Understanding risk from an investor’s perspective

The Game of Risk

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Mitigating risk is a big issue for angels who often have little tolerance for bad bets. But opportunities are skyrocketing. What’s an investor to do?

The CPAs speak.

Joanne Baginski and Brent Peterson of Colorado consulting firm Ehrhardt Keefe Steiner & Hottman PC spilled the beans on how to reduce investment risk.

Access to adequate deal flow: The duo recommends diversifying the portfolio as one of the most important aspects of risk mitigation.

Methods for achieving that aim can come in a number of ways. First, establish a wide network of people who know your interests to introduce off-the-radar investment opportunities. Then, consider ante-ing up smaller amounts of money across a larger number of deals. Like any strategic game player, spread your risk.

Develop a selection criteria: Play to your strengths and stick to it.

Baginski asks clients to identify where the deal fits in the investor’s expertise on markets, regulations and finance, etc. Likewise, pre-determining the acceptable runway for future rounds and the anticipated exit puts the investment in a quantifiable frame of reference from which to evaluate risk.

Consider, too, the amount of time available to mentor startup founders. It’s not just money on the line for angels—it’s time and reputation.

Set the terms of the investment: Tying capital allocation to specific startup milestones helps narrow critical questions that can push a deal to go south in a hurry. Baginski and Peterson urge angels to sketch out expectations on capital structure projections, equity rights and privileges and liquidity events early. Milestones can also serve as important metrics for keeping management accountable and as an early warning system to re-allocate resources or priorities.

Another problem that can make investors squirrelly is a large, demanding board that risks becoming a distraction to the management team.

Due diligence: Keep your friends close and your enemies closer.

One of the first things to understand is how the company’s maturity stage aligns with investor goals. Is it conceptual, cash-flow positive or a ready-made, revenue-generating acquisition target? Then, consider what that means for the investment—early in/limited dilution/big risk or late in/fighting for scraps/sure bet?

Then, inquire about the entity’s structure. Peterson argues that the standard practice of blindly registering as a C-Corporation in a nimble regulatory state, like Delaware, isn’t always the best approach. There’s no one-size-fits-all answer.

Next check out the management team’ experience and ability to execute. Where are the gaps? What is the motivation and loyalty of key employees—especially those whose knowledge is critical to the company’s success?

Little can override market forces in an early stage startup. Is there a clear, addressable market? Is the startup’s proposal to penetrate that market logical? Is the product/service solving a acknowledged customer problem that they can’t live without? Who are the competitors and what’s their barrier to entry?

How does the company’s infrastructure shape up? Is it able to produce product, fulfill orders and provide customer service? If not, why not and is it resolvable?

Now step back for a moment and imagine the customers’ experience.

Are the legal terms of service so extreme or onerous that they, at worst, scare off potential users or stoke an unnecessary public relations disaster (hello, Path)? Same goes for vendor contracts and accounting practices.

This is where things can get sticky.

Intellectual property is a key asset that drives businesses. But inadequate legal attention to patents, non-compete agreements, contracts and the like can sink a startup. It’s especially critical during an exit when many disparate issues need to align.

Think bad IP can get ugly fast? Try a poor cultural fit between the investors and management team.

Baginski warns that a strong sense of trust among the angels and startup founders is crucial. That goes double for syndicate deals where different personalities, goals and work styles come into play.

Last but not least, finances. Early stage, pre-revenue companies can be a real handful to evaluate but there are tactics for determining riskiness.

Realistic projections that are supported by facts is key. Scrutinize the revenue and cost drivers and the balance sheet implications for each, including total/working capital and fixed asset needs, burn rates and time horizons. Startups with rosy projections may be looking too far ahead. Baginski and Peterson agree that a 18-24 month look forward is a good rule of thumb.