Investors are Tolerating Too Much Market Risk Because it’s What They Understand
In early stage investing there are two core types of risks:
(1) Technical risk: “Will the product ever get built?”
(2) Market risk: “Does anyone want this product?”
There are, of course, other types of risks (systemic risks, team risks, competitive risks, etc. etc.) but technical and market risk are the two biggest.
Some companies have very low market risk, but very high technical risk.
Example: A cure for cancer has very low market risk (it is obvious that people would want this) but very high technical risk (it’s not obvious that it can be achieved).
Some firms are very good at backing companies with low market risk, and high technical risk. Lux Capital is one of them, Andreessen Horowitz is another, and Osage Partners is a third.
But most firms are remarkably bad at it. In fact, most VC’s would much prefer to invest in companies that have high market-risk than moderate technical risk. I think this is because market risk is the type of risk non-technical VC’s understand.
We’re afraid of what we don’t understand, and in looking at the VC landscape I have become increasingly disappointed by how few VC’s (especially in New York, NY) are actually technical. It means that many of those VC’s are uncomfortable investing in startups that are pre-product.
They are not capable of evaluating the odds that a product will be built, so they don’t feel comfortable taking the risk before a company is either launched or in some version of beta.
Now this doesn’t go for all non-technical VC’s—but it’s a knowledge gap that is real and has caused a lot of VC’s to move a bit upstream to “late-seed.” The new “seed” investment is made post-product, even when there is little-to-no customer validation.
In my opinion, it’s the knowledge gap that has pushed most seed investors up-stream to “late seed” aka post-product. That’s fine, but it’s left a gap in the asset class that I bet will be filled soon. Notation Capital has already come in to begin filling that gap — and is run by two former Betaworks guys who are more than capable of investing on day one and evaluating technical risk. I wonder if others will come into the market as well.
So two main things have happened:
(1) VC’s are tolerating too much market risk because they are even more afraid of technical risk.
(2) This fear of technical risk has pushed many VC’s upstream to post-product.
It’s left some room for new VC’s like Notation to come in on day zero and invest in companies who still contain some technical risk, but in many cases will exhibit less market risk.