Here’s a brief quote from an interview with an entrepreneur turned angel investor about types of startup risk:
Angels will largely take a product risk (they bet on the product or idea and your ability to build it). “A” round investors or late-stage seed investors will take a market risk (they want to see the product, vision and maybe even the first customers, and they bet on there being a big enough market). “B” round investors usually take a scale or product market fit risk (they bet that the company can scale and that this is going to be massive).
There are other types of financial investors, and they approach deals differently, which in turn dictates what deals they’ll do. Why is this information important? Knowing how to define and describe the challenge facing your company helps you determine which investors are actually interested in hearing your story and which are not suitable.
- Banks — banks used to make money on the spread in interest rates between deposits and loans, but a much larger percentage of profits comes from fees. Banks, then, seek to aggregate and deploy capital while retaining (traditionally, within the “banking” portion of the bank) little principal risk. Securitization has moved principal risk off of bank balance sheets, helping the transition toward transaction- (and fee-) based models.
- LBO funds — LBO funds are generally focused on financial engineering, meaning they often transmute debt or equity capital into the other kind, and even working capital gets a lot of attention. Changing the capital structure of a business, “right-sizing” ROIC (return on invested capital) across divisions, segments, or products, and even divestments and acquisitions can change a company’s profile. LBO funds take the risk that other capital will be available to suit the models they’ve created and that they can provide the right investment for those other capital markets participants.
- Private equity funds — PE funds clearly span categories in the broad sense, but we think of them in this discussion as the MBO crowd. Backing a management team to buy out a company, likely taking it private, means taking on the risk of product realignment, development, or expansion when those risks are not well-suited for a public company. The fund takes on the risk that the management team has it wrong or won’t be able to execute.
- Hedge funds — Hedge funds have a variety of strategies. Other than the “we’ll do anything” model, a substantial common denominator is arbitrage. But hedge funds don’t just arbitrage price in two different markets but also across time, benchmarks (interest rates), currencies, and imperfect substitutes (commodities vs. commodity companies). That type of risk is more likely to be relevant to a company in its commercial dealings (oil shipments) than in its own financials per se.
- Mutual funds — Mutual funds aggregate vast amounts of capital for investment in public companies and similar securities. These funds effectively take risk by allocating capital to stocks, bonds, and across large sectors (domestic v. foreign, tech v. agriculture). Because of the overall size of the mutual fund industry, it’s probably not meaningful to say that the industry as a whole really takes risks on specific stocks to an extent that used to be true: trillions of dollars have to go somewhere, and mammoth widely held corporations are the place.
- Turnaround funds — These more specialized funds focus on particular types of operating risk, and sometimes related working capital risks. Some focus on pure financial operations turnarounds, others on factory operations, and others on SG&A cleanup. The risk for these funds is based on doing enough diligence before an investment to formulate a plan and staffing a portfolio company with a team that can create and execute the plan as well as adjust it successfully when things change.
Remember, too, that knowing how to describe the problems that you like to attack and solve, as an individual or team, helps you figure out where to target marketing or job search efforts.