Risk-Return Divergence

For your next entrepreneurial project, would you choose a 20% chance at making $1m, OR a 2% chance at making $10m? In pure statistical terms, the offers are identical in value: each has the same "expected value" of $200,000. But from a practical view, they're not the same at all. An entrepreneur that's not made any money might want a "safer" chance at a smaller outcome, where an entrepreneur on her 3rd or 4th company may want a bigger risk for a bigger potential return.

This thought experiment helps explain a startup dynamic I've lived through, and one I've seen in many startups: a divergence in risk-reward between the entrepreneurs and investors.

The problem happens when investors push the company to take on more risk for a (potentially) bigger return, and push the team to grow faster, hire faster, spend faster, etc. They talk about "getting big fast", "first mover advantage" and "being the gorilla". At the same time, the entrepreneur is being conservative, resisting fast growth, and hiring slowly. The investors feel frustrated with a team that isn't moving quickly, and entrepreneurs feel pushed into things that seem overly risky or premature.

At the core, the entrepreneurs and investors usually have different risk-return expectations. Many entrepreneurs will take a better chance at a smaller return, while many investors are "swinging for the fences" with a smaller chance at a much higher return. This divergence is one of the most common sources of investor-entrepreneur tension.

Why?

I think the root issue is the difference in portfolio. The entrepreneur's "portfolio" is one company: the startup. In contrast, the investor's portfolio is very diversified. A typical venture investor is directly involved with 4-8 companies, and is indirectly participating in many more through the firm's partnership. With a diversified portfolio, risk is spread out, and the investor will prefer riskier deals that offer a higher potential return. In other words, investors can succeed with a 10% of portfolio paying off, but the entrepreneur needs a 100% payoff.

This portfolio difference is further compounded post-bubble by the increased skewed-ness of startup investment returns. In software/Web/Internet/IT companies, for example, returns are more skewed than ever -- we've got YouTube, a few small hits, and a long tail of very small deals. The venture firms that participated in YouTube will show the best returns. This effect is pushing some firms to operate (not always consciously) in a mode of: "if one of our 50 investments is the next YouTube, we'll be fine".

The difference is also compounded by the excess of venture capital and the excessive size of many venture funds. This is a longer discussion for another day, but many venture investors are under subtle (or not so subtle) pressure to "put money to work", and they have a lot of money to invest. As such, they may be inclined to push entrepreneurs to take more money than they need. In many cases, it's easier for an investor to put $5m more into a known deal, than it is to find a new $5m deal.

(BTW, I am NOT saying that entrepreneurs should not be thinking big and aggressively. There are many cases where entrepreneurs had a great idea and initial leadership, failed to invest, and lost the opportunity. But there are an comparable number of cases that got wildly over-invested and blew up; Brooks' law applies to startups, too. My point is this: if you're going to ramp investment and take on more risk, do it explicitly and deliberately for the right reasons).

So, what to do about this? I'm not sure, but the first step is for investors and entrepreneurs to talk openly about their differences in risk-return tolerance.

-andy