Before I was an investor, I didn’t understand the concept of risk. I thought that risk was bad and that smart investors got good returns by minimizing risk. Of course, in retrospect, this is completely wrong. What smart investors actually look for are asymmetric risks. That is, they invest in assets that have a positive expected value, because the expected return on the investment is greater than the risk.
This is generally a good basic model, but the trouble is that it’s hard to calculate risk. When you’re looking at the risks of a startup, there’s a million things that can go wrong. A cofounder might leave, or the market might tank, or part of the tech stack might collapse, or you might just run out of money. Any of these can destroy a startup, which is especially fragile.
There are other kinds of risk, too, some of which are even harder to quantify. Many investors don’t invest in companies dealing with cannabis or alcohol, for example, because of reputational risk. One interesting theory of ESG investing is that investments in companies that create negative externalities (like oil companies) are inherently riskier, because at some point regulations will catch up and force those companies to bear the costs of those externalities. So even if an oil company has great free cash flow now, it’s worth less because of future taxation.
The job of a good investor is to carefully weigh all of these risks in due diligence, and then look at the upside: how big can this get? That’s why VCs are obsessed with TAM, because if the opportunity is large enough, and the price is right, even a company with a lot of risks can be a good investment. On the other hand, even a startup that checks all the boxes - great team, solid tech - might not be a good venture investment if they’re focused on serving, say, the garlic bread/cryptocurrency fan market.
So the formula is: if investment risk < how big can it get * our ownership percentage of the company[1], then it’s a good deal. The trick to being a good investor is being better than everyone else at weighing both sides of the formula. Any semi-competent junior hedge fund analyst could have told you the exact interest default rates on subprime mortgage CDOs in 2005, but if you realized how badly the risk was being valued by the market, you got a movie made about you.
And good investors can cheat by tipping the scales. For example, if we invest in a young company with a great idea and some early traction, but a product with some kinks that need to be worked out, we may tap our network to help them hire a rockstar CTO to mitigate the product risk. The nice thing about this kind of intervention is it lessens the risk of the startup without decreasing the potential upside. So valuable investors not only attract the best companies, but can also more profitably invest in risky companies because they can directly increase the expected return of their (and the company’s) equity after they invest.
A financial advisor will tell her clients to diversify - don’t put all your money in one stock, because it’s risky to be that concentrated. But of course, that’s exactly what many startup CEOs do. Starting a tech company is a risky business, because often your fortunes are inextricably linked to your company. But if you think you can tip the scales - by spotting how big an idea can be before anyone else, or minimizing your risks by executing well - then the rewards can be well worth it.
[1] Ownership percentage is an important part of returns, too. We can mitigate our risk by diversifying our portfolio, and we have invested in seventeen companies to date. But this also limits our upside in any one company. The nature of venture is that a few superstars will be very successful (and some won’t be), and consequently we have to invest enough of our fund into the winners for it to matter.