Understanding the Risk Curve

by G. Briggs Kilborne

For centuries, civilizations and investors have taken on great financial risk in the hope of great reward.  Wars have been waged to expand empires, and costly expeditions organized in the quest for riches.

Among the first high-risk, high-reward commercial enterprises was maritime trade – as trade in spices, tea and coffee produced huge profits.  But there were huge risks as well.  Ships could be lost to storms, mutiny, piracy, or navigation error.  Wealthy merchants and investors who did not already own ships often formed syndicates to hire a ship and captain and finance the cargo.  Fortunes could be made or lost on the basis of one voyage.  Of course, as such commercial ventures became more common, a secondary business sprang up: insurance, which gave investors a chance to hedge their bets if the ship did not return with its cargo.

Venture Capital – Dangers and Rewards

The private equity industry, as we know it today, emerged in the late 1950’s with ARDC’s (American Research and Development Corporation) $70,000 investment in Digital Equipment Corporation that turned into $355 million (post IPO), and the investment by another private group (that later became Venrock) in Fairchild Semiconductor.  Many of today’s great companies, such as Intel, Google, and Amazon, were funded by venture capitalists.

There have, of course, also been colossal failures, which is why it is important for venture capitalists to invest in many companies and diversify their risk: younger companies have a much higher risk profile than established companies with revenues and earnings.

The table below, provided by the National Venture Capital Association, illustrates the historic returns for the venture capital community.

Net IRR to Investors for Investment Horizon
Ending 9/30/08 for Private Equity Funds
Fund Type 1 YR 3 YR 5 YR 10 YR 20 YR
Seed/Early Focus -1.5 3.7 5.0 37.1 21.6
Balanced Focus -5.6 7.3 11.4 14.9 14.7
Later Stage Focus 9.1 11.1 10.1 8.7 14.5
All Venture -1.5 6.4 8.5 17.1 17.0
Buyout Funds -8.3 7.1 12.2 7.3 11.1
Mezzanine Debt 10.8 4.4 4.8 5.4 7.8
All Private Equity -7.1 7.6 11.0 9.3 12.9

Seed stage investments – those with the highest risk profile – have generated the highest returns, but only an estimated 1 or 2 out of every 10 seed stage investments becomes a winner; another one or two muddle along and may return the original investment, while the balance turn out to be losers.  For this reason, seed stage capital tends to be very expensive to account for the risk.  Angel investors (individual investors typically not affiliated with an investment firm) tend to have a poor “seed stage” track record because they typically do not invest in enough companies to diversify the risk.  They also tend to under price the risk and invest at higher valuations than professional venture firms – a good thing for the start-up – although professional firms can provide invaluable consulting.

Finding Where You Stand on the Risk Curve

As businesses look to raise capital, it is important for them to understand where they fit on the risk curve.  Often, early stage businesses go to their local bank looking for funds, when they really need equity capital.  Traditional banks are not in the business of taking risk to achieve a minimal (3-4 percent) interest spread.  In fact, many have an aversion to risk, as poor risk assessment over the past decade landed many banks in financial trouble.

Entrepreneurs should seek out investors who focus on the part of the risk curve (see below) that fits their business.  Start-up businesses usually turn to family and friends or angel investors for their seed financing.  Companies that have started to generate revenues and may or may not have earnings are best matched with early stage venture capital firms.  As companies expand and require more growth capital, private equity firms and investment banks may be a good source.  And when companies have consistent cash flow, they become candidates for traditional bank financing.

After an investor is comfortable with the product, the market opportunity, and the share price, their investment decision will rest on the confidence they have in the management team.  People make a business, and drive and character go a long way – in business, as in every other part of life.

Founders Forum Presents:

The Hunt for Capital

Featuring investment specialists Paul Suchoski, a successful entrepreneur and angel/venture investor, and Bob Mays, CEO of Florida Business Bank

January 25, 2011

6-9 p.m. at the Crowne Plaza Oceanfront Resort, Indialantic

To register, go to foundersforum.com