Friday, April 25, 2008

Who Takes More Risk, The VC or The Entrepreneur?

In order to analyze this question we need to understand what risk really means.

Risk is a relative term. For example, if a poor person risks $100 on a lottery tickets, is that more or less risk than a wealthy person buying $1,000 worth of lottery tickets? Presumably the $100 is worth more to the poor person than $1000 is to the rich person. So part of risk is about how much the loss would impact your overall holdings.

The second part of risk is whether a given investment stands alone or is part of a broader risk reducing strategy. All smart investors (and all VCs) engage a portfolio strategy. They know that most of their investments will fail or only perform moderately, but they rely on the idea that one really good investment pays for a whole lot of bad or mediocre ones. Entrepreneurs do not, generally, have the opportunity of engaging a risk reducing portfolio strategy. And so if their venture fails, as most do, they do not have the opportunity to have placed a bunch of other bets, one of which can make up for any losses.

There are those that will argue that if the entrepreneur only risks $100,000 by not being paid for a year, and the investor invests one million dollars, then the investor is risking more. But if the investor is working with a $100 million dollar fund and has spread his risk across many companies, the single one million dollar investment is not nearly as risky as, for most entrepreneurs, not being paid for a year. This is both because the entrepreneur does not have a risk spreading strategy, and also because the entrepreneur is playing, with this one investment, with a much greater percentage of his or her net worth. Of course if the entrepreneur really *doesn't* take a substantial risk by investing his own time and money before outside money comes in this doesn't hold.

In discussions that I have had about this issue, some have suggested that the entrepreneur learns much from taking such risks and so the education of being an entrepreneur mitigates the financial risks. And there may be some truth to this. But my effort here is to analyze *financial* risk, because once you start throwing in those sorts of things, it becomes impossible to measure or discuss the mathematics.

For example, if an investor serves on your board, meets another board member, and ends up doing some business with that person at a later time and making a lot of money, has that mitigated the loss associated with investing in your deal? Did the investor learn something *from you* about a space that they were unfamiliar with that ends up being valuable to them at a later time? I don’t think we can examine risk based on these soft criteria because there are so many imprecise vectors that could come into play. Risk must be analyzed based purely on relative financial downside and upside.

And so, VC funds are at far less risk than the entrepreneur’s they invest in. In truth this doesn’t really matter much except to entrepreneurial psychology. You are not going to get a better deal because you tell a VC hey you should take less because I am taking all the risk! You will just sound silly. But understanding how the game is played and what is really going on is, I think important to being able to navigate the fund raising waters with a clear head.

4 comments:

  1. "the entrepreneur only risks $100,000 by not being paid for a year"

    ..except doesn't the VC's $1M investment cover the entrepreneur's salary for the year, whether the business takes off OR tanks?

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  2. Bartleby,

    The assumption is that the entrepreneur must make some kind of investment before the investor has anything to invest in. Its pretty rare to go to a VC with just an idea and get money.

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  4. Hank -

    I would say the entrepreneur risks significantly more than the VC. An entrepreneur's reputation is far harder to repair than a bad <1% of a fund investment for the VC.

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