Understanding Investors — why it matters for your pitch
The aim of this post is to help entrepreneurs with limited finance or investment experience understand the relationship between risk and return in the context of Angel and Venture Capital Investing.
As an entrepreneur, it is critical you understand this basic concept in order to ensure your business model and pitch are suitable for investors. So let’s put our ‘investor hat’ on and get started.
What is Risk?
The heart of any investment is the trade-off between Risk and Reward. If you ask a finance professional they will have lots of jargon, numbers and methods for defining and measuring ‘risk’.
For the purposes of this brief overview — when we say ‘risk’ we are simply talking about the value of an investment going down. I.e. losing some or a whole amount of invested money.
What is Reward / Return?
When talking about return or reward, we are simply talking about the increase in value of an investment. I.e. ending with more money than was put into an investment.
Risk vs. Reward — The relationship between the two variables
All things equal — someone willing to take more risk will expect a higher potential reward for taking that risk. So as risk increases, so should potential return.
Low Risk = Low Potential Returns
Very low risk investments, at point A on the chart, would include cash savings products, developed government bonds, and other financial products that have a very low risk but often a low return.
Depending on the economy, it is possible that these very low return assets will return less than you put in, when adjusting for the power of inflation. The main reason an investor would put money into these investments is a need for security, and liquidity (the ease at which they can get their money back quickly)
Medium / High Risk = Medium / High Return Potential
As you start to move up the risk scale, targeting a higher return, the chances that you lose some or all of the invested money increases. There are many investments that would fall into this category but the most common example would be publicly traded stocks/shares in a company. For example, ‘Apple Shares’ These investments would be clustered around point B on the chart — reasonable potential for good returns but also with a much higher risk than putting money into a cash savings account.
Very high risk = Potential for ‘Outsized’ Returns
You guessed it. Angel investing and Venture Capital (VC) is all about trying to achieve ‘outsized returns’ think >100x or ‘Unicorn returns’.
Investors are up at point C on the chart. They are placing extremely risky bets with a very high chance of losing all of their money, but they hope a few of the businesses they invest in will achieve these ‘outsized returns’.
You will notice that the chart isn’t a straight light from point B to point C, but curved or ‘exponential’. In simple terms — things can get much riskier without the chance of a big return increasing at the same rate.
Type 1 vs. Type 2 Errors
You have probably heard about Type 1 and Type 2 from a science or maths class. We don’t go into too much detail here, but at a high level, they can be applied to Venture Investing.
Type 1 errors, in this context, refer to the risk of investing in a company that fails.
Type 2 errors, in this context, refer to the risk that you don’t to invest in a company that does turn out to be a great success.
Given the risk-return profile discussed above (i.e. most investments will fail, so an investor needs to make lots of money a few companies that do work), type 2 errors for a venture capital firm could be very serious.
Example: The chart below shows 10 hypothetical portfolio companies. The VC firm decides to invest £20m in each of the 10 businesses. Companies 1–7 & 10 fail with a loss of the initial investment.
Company 8 makes a reasonable return, but only company 9 produces an ‘outsized’ return. It is the return of company 9 that enables the VC firm to stay in business and keep its investors happy.
Now think about the type 2 error in this context. What if the VC firm had decided not to invest in company 9? This is one reason why you often see a ‘fear of missing out’ (FOMO) when a fundraising round starts to get some attention amongst investors. You want to try and generate this FOMO when fundraising.
Why understanding how Angel and Venture Capital firms think about risk and reward is important
If you are pitching and trying to raise money to fund your startup, you need to understand the investor mindset to successfully raise money. The relationship between risk and reward is at the center of this and therefore very important to understand.
When making a pitch, be sure that it convinces potential investors that the business has potential to make ‘outsized’ returns (point C on the chart). Remember, any investor will need to balance this risk and reward relationship to justify the investment. We will explore different types of risks that are particularly important for startups in a later post, but for now make sure your pitch conveys potential to achieve outsized returns.
You will also need to be organised when raising money and should try to create some ‘hype’ around your deal. The more investors that are potentially interested, the more likely you will be able to generate some time pressure and ‘FOMO’ amongst investors, which will help tip the balance of power from them to you during the fundraising.
How to achieve outsized returns
- Target a large market (£1bn+ Total Addressable Market)
- Solve a real problem with a unique solution to achieve Product Market Fit
- Develop a long-term and sustainable competitive advantage
Looking to understand venture capital (VC) in more detail? We recommend every entrepreneur reads ‘Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist’, our ‘go-to’ for people looking to understand more about startups and venture capital investing.
Need help with your pitch deck? See how we can help.
Pitch Smarter. Raise Money Faster.
Originally featured: https://pitchhive.com/risk-vs-return-understanding-angel-and-venture-capital-investing-and-why-it-matters-for-your-pitch/
