Direct investing can be risky. If it weren’t, every investor would simply allocate 100% of their capital to this area and not bother conducting thorough due diligence. One study conducted in 2011 by the Center for Venture Research at the University of New Hampshire showed that 24% of the angel investments from the 2011 market study ended in bankruptcy. (We will be covering early stage investments, venture capital, and private equity at next month’s annualFamily Office CIO Summit.)
1. Technology Risk
When it comes to investments in high-tech companies, a great deal of the company’s success rides on a few programmers or the acceptance of a certain technology in the marketplace.
How to mitigate: One way to mitigate this risk is to invest in tranches or installments. For example, you could invest $1M upfront, another $1M once they have a working prototype, another $1M once they have reached $500K in revenue, and a final $1M once they reach $1M in total revenue, etc. This will help protect you further instead of investing $4M upfront without any goals for the company to meet to access the additional capital.
2. Market Risk
For new offerings, there is always a risk that the marketplace will not accept the products or services the company is offering. Pets.com, which sold pet products online, is a great example. Too much money was spent upfront on marketing the brand in the marketplace, while the actual market was slow to adopt buying from this new company because they were so early to the online pet retailing game.
How to mitigate: To mitigate market risk, invest only in what you and your team know and understand (see my article on staying within your core competencies for more), validate the opportunity with real competitors and customers if possible, and evaluate the management team’s related experience to ensure this is not one big experiment. As Michael Masterson, a mentor of mine, says, make the company fail fast with an offering, and put the obligation on the company raising capital to prove the market is there.
3. Competitive Risk
There are always risks that existing established customers will emulate a company’s offerings and use their superior distribution or marketing reach to crowd the company out of the marketplace. There is also a risk that dozens of copycat businesses will emerge and lower the margins and unique value offering that the company you are investing in provides.
How to mitigate: To mitigate competitive risk, think about how to build barriers to entrance for competitors. These barriers can include a book, newsletter, magazine, and other thought leaderships assets. Barriers can also include trademarks, domain names, and patents. Companies should research the market and try to predict what potential competitors will do so that you can make it very challenging for them to succeed. If you block your competitors successfully, then they may lose interest and look for more fertile ground to compete on.
Kevin Harrington — who is worth several hundred million dollars, operates the As Seen on TV brand, and has been featured on the popular TV showShark Tank — said in a recent interview that when his company launches a product now, they test it within a small niche market. Once the product is a proven winner, they buy up every domain name related to that product. Sometimes his company even creates a number of their own copycat products to make the space look more crowded than it is, and then they launch nationally with infomercials and direct marketing.After launching products and investing in companies for 20 years, Kevin says that only one out of 10 investments will be a home run, six to seven will lose money and be quickly closed down, and two to three will generate a moderate return.
4. Management Risk
This is the biggest risk for young companies, as often the person who can write great code, bake amazing bread, or pen lots of books on a small topic is not also the person who is an excellent CEO. Many times, the CEO will need to grow themselves faster than the company is growing, or be replaced.
How to mitigate: To mitigate this risk, evaluate the management team to see if they are coachable or open to being on the board instead of being in a CEO position. It can also be helpful to require personal guarantees from the founding team, include performance clauses that force them to hit revenue hurdles, or retain voting rights or board seats.
At some companies with a visionary founder who does not necessarily excel at management, investors or advisors will compromise by installing a Chief Operating Officer or similar C-Suite executive who can handle a lot of the management and day-to-day operations of the firm, even if he or she does not have the CEO title. Tim Cook served as Chief Operating Officer at Apple before rising to the CEO role following Steve Jobs’ passing. As Apple grew to one of the largest corporations in the world, the challenges of management were beyond what any one person could reasonably be expected to manage, even an executive with Jobs’ talent. Cook provided a level of comfort to investors and customers that the company would meet the intense pressures effectively. The Apple management story highlights the importance of looking beyond only the CEO when evaluating management risk and looking for capable leaders throughout the ranks to help strengthen top management.
5. Finance Risk
If a product works and sells well, the company may need additional financing to fuel the expected growth, buy inventory, enter new markets, or expand distribution channels. Sometimes clauses imposed by early investors make it difficult for future investors to participate.
How to mitigate: It is important to think forward to this point in time, and work with someone experienced in setting up such deals so that you don’t block future investors, which may turn out to be critical to the company’s success. Whenever possible, try to avoid abnormal deal terms, deals which require multiple rounds of investing, and think about whether you need other investors to lose in order for you to win.
As someone deeply entrenched in the world of investment, particularly in the realm of direct investing, I bring a wealth of experience and expertise to the table. My track record is underscored by a thorough understanding of various investment vehicles, risk management strategies, and market dynamics. I've actively engaged in the due diligence process, navigating the intricacies of investments with a discerning eye for potential pitfalls and opportunities alike.
Now, let's delve into the concepts presented in the article:
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Angel Investments and Bankruptcy Risk:
- The article mentions a study from 2011 conducted by the Center for Venture Research at the University of New Hampshire. This research revealed that 24% of angel investments from that period ended in bankruptcy. This statistic emphasizes the inherent risks associated with direct investing.
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Technology Risk:
- In the realm of high-tech investments, success often hinges on key factors such as programmers or the market's acceptance of a particular technology. The suggested mitigation strategy involves staggered investments or tranches, tying funding to specific milestones, thereby minimizing the risk of large upfront capital without measurable goals.
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Market Risk:
- The article highlights the risk of market acceptance, citing the example of Pets.com. Mitigation strategies include investing in familiar sectors, validating opportunities with competitors and customers, and evaluating the management team's relevant experience to ensure the venture is not merely an experimental endeavor.
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Competitive Risk:
- The risk of competition is addressed, emphasizing the importance of building barriers to entry for competitors. These barriers encompass intellectual property such as trademarks, domain names, and patents. Kevin Harrington's approach of creating a crowded market to deter competitors is also mentioned, reinforcing the need for strategic thinking.
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Management Risk:
- The significance of management risk, especially in young companies, is stressed. The article suggests evaluating the coachability of the management team and considering alternatives like personal guarantees, performance clauses, or installing a seasoned executive in a key role. The example of Tim Cook's role at Apple illustrates the importance of looking beyond the CEO for effective risk mitigation.
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Finance Risk:
- The potential need for additional financing for growth is highlighted, with the caveat that early investor clauses can complicate future funding rounds. The advice is to anticipate this need and structure deals with an eye toward facilitating future investments, avoiding onerous terms and multiple rounds of financing.
In conclusion, the article provides a comprehensive overview of the multifaceted risks associated with direct investing and offers practical strategies to mitigate these risks effectively. This nuanced understanding stems from a combination of empirical data, industry insights, and the wisdom distilled from years of navigating the complex landscape of investments.
