Early Stage Risk

Let me start by defining risk as the possibility of zero returns. I don’t want anyone to think that when I say risk, I mean “price volatility” because that is a silly way to look at risk, prices of things bounce around all the time and really has no bearing on how much risk is taken on any single investment.

One of the difficulties in working with early stage portfolios and mentoring early stage investors is a lack of the broad transparency that exists in public markets. This can be frustrating at times when trying to determine angel investment levels and how those equate to exits. This can also be hilarious when reading the comment wars on the CB Insights blog where multiple sets of data from different groups (CB, PitchBook, etc.) are used.

This is problematic for the average angel investor working to build a solid portfolio with the intention of improving the economy and generating a reasonable return.In one of his memos, Howard Marks sees risk appetites increasing. This is interesting by itself, but the more interesting aspect is how he frames the meaning of risk appetite. It is not the same context of risk that is used in this Pepperdine Capital report where it is reported that angel investors are indicating a decrease in their appetite for risk. Obviously two very different opinions and views of investor risk appetites across the entire spectrum of early stage, late stage, and public capital markets. Understanding this entire spectrum though is important.

When I think about how to design a portfolio that includes public and private asset classes, these economic shifts in corporate finance are incredibly important to be aware of. If early stage risk appetite is high (see this summary by PitchBook on the current seed stage valuation discussion), will there be enough risk appetite at later stages to support those early risks? If there won’t be anyone to take the risk at a later stage, will the type of investment reduce those risks before additional capital is needed? This risk per stage assessment is very similar to the capital per stage assessment and is a critical component to understanding if a company will be able to continue on their growth trajectory.

Right now we are seeing a lot of companies get to what has traditionally been the end of private market financing and found that public markets may not have the appetite to fund their business. This is a visible outcome of the type of assessment I am referring to, what is interesting is that while companies like Box have a long way to go to be industry leaders, they have been able to find private market investors willing to take the risk to fuel their amazing growth. Now they are in a position where they may be too big for private markets, but still have risk associated with them. The question now is, does it make sense to spend the money to go public when there may not be enough public market investors willing to take the risks associated with their business. They have done a lot to reduce those risks; however, there are still enough risks to their business to cause them to second guess going public. Examples like this make me wonder what Howard Marks really means when he says risk appetites are increasing because obviously there is still room for them to grow larger. I hope that the Pepperdine report is more of an indicator that risk appetites are declining at the earlier stage and the result is that Howard’s increase in risk appetite will also decline.

Yes that is a bet against companies like Box; however, it is also a bet for companies like Tableau. Recently there were a few statements on twitter about how Groupon would have been better off if they stayed private. I think this is true for any company where they are forcing their risky endeavor onto public investors. The reason is that public markets are much shorter term. Early stage private capital is in for 5–12 years and risk is evaluated on that same scale. Public market capital is in for 9–24 months and risk is evaluated on that much smaller scale, and it is evaluated on a quarterly basis. These are much different types of investments from both a risk and a capital perspective.

This post is adapted from an article on joshmaher.net.

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