The risks / rewards profile of startups for investors
I was just reading an interesting article by Gary Aitchison about startup risk assessment (available on Medium here) but thought he’s missing half the story: the rewards part!
I think his “phi measure” is an interesting way to visualise a startup risk profile and make sure any addition to the portfolio doesn’t increase a specific risk factor, or help mitigate some of the risks if you’re bringing skills in addition to cash.
The 11 risk factors he considers are:
- technology risk
- MVP edge case risk
- market timing risk
- monolithic customer risk
- scale risk
- execution risk
- gorilla incumbent risk
- legal risk
- capital intensity risk
- platform risk
- personnel risk
But as far as I’m concerned, all startups are extremely risky investments, and even though I’m glad to reduce my risk (through due diligence, terms sheet, diversification, etc), at the end of the day people invest because of the potential rewards, hoping to invest in the next unicorn.
So, to bring the flip side of the coin, here are a few critical aspects in estimating the potential reward:
- size of the prize: how big is the addressable market?
- growth rate: how fast can the startup grow top and bottom lines, as measured by compounded growth rate (CAGR) for the next 5 years? How realistic are the assumptions? What resources are required to make it happen?
- profitable scalability: at what stage does the CAC become lower than the LTV? What is the expected gross margin?
- what is the business unfair advantage? You can score it from 0 (none!) to 10 (monopoly)
In other words, let’s have an idea of how big it could be if all goes reasonably well.
The risk assessment helps us benchmark a probability of success (or failure?!). whilst the reward assessment helps us estimate an expected value and therefore, based on our IRR expectation, an investment budget and a valuation guideline.
My suggestion at this stage would be to use the “phi” risk measure as denominator and an “alpha” (simply because it’s the first letter of the greek word that means reward and all the greek alphabet seems to be taken!) as numerator, so reward / risk.
The Phi calculation is explained is the afore-mentioned article, available here.
The Alpha calculation is quite straightforward:
size of the prize * 5y CAGR in % * expected on-going gross margin % * unfair advantage score = alpha
You might want to add weighting factors if a criteria is more important than others for you.
So, you get this rewards / risk score, now what? Well, you can use it to rank the attractiveness of your potential investments, comparing the startups in your investment universe. You can also use it to manage the timing of your investments: if you like the potential rewards of a startup but can’t stomach the risk level, you can then decide to wait until the startup has more traction (and therefore a reduce risk) before you invest.
In the end, it’s incredibly hard to value an early-stage business as it’s all assumptions and rosy forecasts rather than actuals: no DCF to compute a valuation. But some key measures can help make more informed decisions. Hopefully, this reward / risk ratio will help!
Let me know what you think, and how you’d modify it!