Many of you have seen this great post at Tech Crunch by Andy Ratleff from a couple of days ago. One of his points is that angels tend to lose money because they take on companies with high market risk and low technical risk. I find this to be a compelling insight about the investing process that has a lot of implications for the way most angels think about their decision making process.
You can think of this a couple of ways.
Risk, of course, is what is at the center of the investment premise. More risk, in theory, drives higher potential returns. And risk comes in many varieties. In growth stage companies, for instance, we talk of execution risk.
However, execution risk really doesn't describe the type of risk. That is, when we think a company primarily has "execution risk," do we mean that they're facing scientific and technical hurdles to achieve results, or do we mean that they are facing the risk of selling to their market, or of delivering a product to customers who've bought?
Andy's comment, that " ... you want companies that are highly likely to succeed if they can really deliver what they say they will," is a comment about scientific and technical risk as a predominant factor, and perhaps production risk secondarily. It implies that selling to the market is a task that needs to be accomplished, but that the business is focused on an existing market that has high demand for the product.
Think "Porter's Five Forces."
And then, companies with scientific risk retire that risk primarily with the talent they have on the scientific or technical side. When this risk retires, the rest works pretty well.
For those of you old enough to remember, think about Jimmy Treybig, the founder of Tandem, whose VC, Tom Perkins, said something like "when the Tandem computer system performed as expected, (i.e., the really hard technical risk of failsafe computing in the 70s had been retired), the market took off.
This is much different than companies who have very low technical risk, i.e., they can write a really good "app," but who ultimately cannot sell enough to make the business perform. This risk is out of their control.
We often talk of this as "will the dog eat the dog food?"
It's interesting to think about the typical selection process for angel investments. Often the investments they prefer are the ones that they understand. They believe they can see the market need, sometimes make a personal decision about whether they would buy or not, and get "bought in" by the prospective sales pitch to the market. This tends to lead them down the path to market risk dominant companies, including a lot of consumer internet deals.
I talked to a company recently that had market risk in the educational business but also had a distribution agreement with a big player. My advice was to execute with the big player by bootstrapping and then, as the market risk retires, to think about deploying outside capital.
Greg Gianforte at RightNow Technologies in Bozeman, Montana (recently sold to Oracle) is a famous proponent of bootstrapping for this exact reason. He took market risk out of the RightNow product by finding a market and selling to it before he'd gotten down the road with outside money. He also, of course, invented some very cool algortithms that make up a substantial intellectual property base.
Another example that comes to mind is Yieldex and Doug Cosman, its Boulder-based founder. Doug solved a very difficult technical problem that had been worked on for a decade. And as the technical risk retired, he added Tom Shields to run the company and bring the product to market.
It is true, of course, that there's sales execution risk in Tandem-style deals as well. Customers ask for demonstrations, evidence of performance, price concessions, proof of financial stability -- all of that stuff. But those are manageable risks to retire with talent and money.
This all leads to asking how angels could invest in high technical risk startup opportunities about which they have little domain expertise. For us, when we have taken steps in that direction, it almost always involves both a long process of following a technical trail, finding experts, and often helping to put those experts in place to be company managers.
And, I suppose, it's critical to make sure angels understand the lack of control they have when they take market risk and trying to find ways to invest only at stages at which there is evidence of market acceptance. This is Andy's comment also about VCs "outsourcing" these risks to angels. If angels are going to invest at the idea or seed stage, they are taking this risk which is largely outside of the entreprenur's control. If they wait to invest until there is evidence of early acceptance, especially in non-California markets, they may be able to achieve better returns.