Disproportionate Risk

One of the top reasons why I personally turn a deal down is when there seems to be a disproportionate amount of risk left on the table.

Don’t get me wrong.  Venture is extremely risky, but the reason why it works is because of the risk/return tradeoff.  You can’t make return unless you take risk—as a finance guy, I understand that.

But sometimes, the finance guy in me sees opportunities that seem to present way more risk—potentially unnecessary risk—than it would seem the investment has relative to some near term point where that could go away.

For example:

  • Raising money just a mere weeks before you launch the product.
  • Having a technically complex product without a CTO.
  • Having a completed enterprise product without a single sale.

Entrepreneurs often complain that investors on the fence always want them to get a little further before they commit.  Just a few more customers, a little more traction—I get that.  It’s annoying and it’s a failure of conviction.  There’s no difference between having signed up two customers or ten customers when your market is potentially hundreds or thousands of businesses.  The risk taken off the table there is minimal.

But the difference between a launched product and one that isn’t launched?  That’s pretty big.  Don’t get me wrong, lots of people invest in pre-launch products—First Round certainly does.  Usually, however, you invest months and months before a launch and that’s actually what you’re funding—the build.  The pricing of the deal should reflect that and mitigate the risk to some extent.  When you pay a much lower price, the return you can make increases.  You’re just further up and to the right on the risk/return spectrum.  Sometimes you find a great entrepreneur and a space you love and you’re willing to fund their path from idea to product and that works fine.

When you’ve got 80-90% of an idea built, however, it is doubtful that the entrepreneur will go for the same price as you would have given if there’s nothing built at all.  Even if they did, however, why would you, as an entrepreneur, raise money when a month from now you could say you had a launched product.  The bump in valuation you’d get combined with the increase in your chances of raising should dictate that it’s worth waiting that month—unless they’re already about to repossess your house.

One response is that the road is long, and that just launching isn’t that much of a milestone.  That’s true—I largely agree with that statement.  However, having even just a week or two of a launched product tells you boatloads more about what the future roadmap needs to look like—and it’s difficulty, than you knew before.  My experience having launched two products is that whatever you think is left on the todo list at the time of launch becomes 10x as big once you actually put the product in the end customers hands.  Things come up that you never even realized and the direction of the build will often take many turns.  It’s a very informative period, because now you’ve got real users on the other end—not hypothetical ones.  Sometimes you realize you need a complete overhaul just a week into the release.

Or, sometimes the opposite is true.  It takes off right off the bat and you’re off to the races.

In either scenario, what chances is what you think you need to get to the next round.  Whether this path is going to be more difficult or much much easier—you’ll actually need more money.  No one wants to stop the hockey stick growth to fundraise—so if you’re product takes off right off the bat, you might raise a little more to let it run a little further.

Either way, if you’re *so* close, I’m probably going to want to see that next card get turned over.  Will your whole deal be judged on two weeks of data?  Absolutely not.  I know it will suck and that it will break several times.  That’s fine.  I get what an alpha is supposed to be.  It’s more of an issue of what you learn as the product lead about the nature of the next 9-12 months of your business—as well as the possibily that you’ve so badly missed the mark in your customers eyes that it needs more than just some screw tightening here and there.  This might be true in terms of things you can’t test right off the bat—like recommendation tools or search engines.  Results that are even semi-promising (like if half the results make sense) are an order of magnitude more interesting than if I can’t find a single item that makes sense to return as a result. 

What may happen when you raise so close to a pivital, seemingly risk reducing inflection point is that it sends a signal to investors that you’re actually going short on yourself—that you’re not confident in the initial results.  Why else would you take the increased dilution?  That may be an unfair judgement—but the fact is that there are entrepreneurs in the market who are trying to go as long as possible without raising—achieving every conceivable milestone they can—in order to maximize their valuation.  They’re trying to get the first few customers in the door or the first few users, even if they have to do it on fumes, because they know it might make a difference in the valuation they get—and they’re ultra confident they’ll get it done.

So like I said—if you’re early, you’re early.  Pre-product?  No problem.  But a week away from your product?  Let’s wait to see what it looks like.