Undiversifiable Risk In A Start Up

Posted: Feb 25, 2012 12:01 AM

When you invest in a start up company, it’s inherently risky. Heck, I think the odds are about 90% against you from the outset. I asked Steve Kaplan, professor at the University of Chicago Booth School of Business once about “do you bet on the horse or the jockey?” He said, in start ups, always bet on the jockey. Great jockeys can change their ideas (iterate) and create a good business.

That begs the question, what makes a great jockey?

One of the things I have found when investing is that a founder may have a perfectly unbelievable idea, but many of them find the responsibilities of being a CEO overwhelm them. Those responsibilities get in the way of good execution. They might begin to miss market cues which causes them to make further mistakes. Plenty of great ideas have been derailed because the person on the team acting as the CEO doesn’t have the leadership skills at the outset to run the company.

Certain people have leadership characteristics. They may not know how to use them, but leadership can be taught. The service academies have done it for years. There is no reason we can’t do it in the entrepreneurial community. The best way is if you are young, find a good person that is running a company and work for them. You will learn a lot about how to run a great operation just by observing and interacting with them. The second way is to take some leadership classes.

Many of the problems lie in the murkiness between investors and founders. Founders either are unclear in their communication, or investors aren’t clear on what they want communicated. The best investors are extremely upfront and clear about what’s expected, and what they want to hear. The best founders ask their investors to clearly state their expectations. This minimizes conflict.

Reading Brad Feld‘s blog, I learned that he expects to see data every day for awhile from his newly invested portfolio companies. Not too be a pain in the ass, but to get them to begin focusing a certain way and to keep those lines of communication wide open. The other thing is with daily numbers, both the investor and the founder can get a feel for how the business will operate and grow. If numbers slip, they immediately can ask pertinent questions why. If numbers bounce, they can ask the same questions. A big bounce sometimes is as dangerous as a big drop.

When I talk with investors, I hear a lot of the same things. They have a lot of the same concerns and problems. I don’t think there is anyway possible to de-risk a deal, short of not investing at all. However, there are some things you can do. Over the next year we will begin to explore them in this blog.

What do you do to try and eliminate some of the risk from investing in start ups?