As a bank/investor in tech companies, we talk about risk a lot. Half of our business is selling money, and the other half of it is evaluating risk. A business development person for a bank or an investor has to sell the client on why they should take their money at the suggested return, and then they need to turn around and sell the credit department or investment committee on why the return is justified for the risk being taken, and how the risks of repayment or return realization are mitigated.
No doubt lending money is risky business. A lender must evaluate the reasons a company might be unable to pay its debts. These might include overspending or underestimating the time it takes to get revenue in the door, but could also include fraud, catastrophic events, legal issues. The list is long. Once the money is out the door, the provider of the funds has little recourse to get their money back (let alone a return).
One of the most enjoyable parts of my job is hearing the unending optimism of entrepreneurs. I love hearing about how they are going to blow the top off all of their conservatively planned targets (please never lose that!). A mentor once told me to “make sure to always shoot for the moon, and even if you miss it, you'll still be floating with the stars.” Don’t judge my correctness in astronomy – the point is that it's important to have lofty and aspirational targets. Just know that it is worth having a back-pocket guide that explains all of the potential risk factors affecting your ability to execute your moon shot and where you might land should these factors be at play.
There's some science to the assignment of risk in lending. Banks use a “risk grid” that looks at several categories in order to assign a risk factor to your business, to price accordingly and decide whether to invest or not. Those categories include:
Financial Strength: What does the balance sheet look like? What are the financial ratios and metrics? How much coverage does a client have to pay bills? What is their revenue growth rate matched against their expenses? What type of liabilities are current and long term? Where are other sources of capital going to come from?
Business Strength: How long has the client’s business been around? What industry are they in and are there any trends positive or negative? Do they have diverse and good-paying clients or is there any concentration risk. How long are their customer contracts? Is there additional funding in the space?
Management Strength: What is the creditworthiness of the leaders? How do they handle money? What industry experience do they have? What management experience do they have?
History: Is there a proven track record? Did the business achieve what its leaders said it would achieve? Has the business historically been able to attract investors/advisors and pay its bills?
Equity investing, on the other hand, is very different and uses far more judgement, assumptions and peer review. Investors in organized funds typically do a ton of due diligence and present their findings to a diverse investment committee to make decisions. One of the many differences in equity investing however, is that not only does an investor have to define, agree and accept the risks associated with a deal, there's also an opportunity cost to selecting the “right” company to invest in, since the resources in a fund are typically finite (by contrast, if a lender’s opportunity isn't too risky, the same constraint doesn’t exist).
Additionally, equity investors in tech companies are looking at:
Technology risk: Most funds have a domain expertise and can evaluate if the technology is likely to make it to market in a valuable and marketable way.
Market risk: Is the market big enough, ready to adopt, affected by external environmental factors? Who are the competitive players?
Additional investment risk: A company often needs to be able to attract additional investment in order to realize a return and continue to grow the business. Will it continue growing fast enough and be in a place where additional investors will want to take out early investors at a premium?
Ownership risk: Can an investor get to an ownership position they feel comfortable with now and will they be happy with expected dilution in the future?
In the end, a lender or investor wants to believe in your business as much as you do and help you turn it into something bigger. But risk management is a core component of what makes banks and investors able to keep writing cheques – food for thought as you're creating your risk mitigation story to pitch to your friendly bankers and investors.
In an upcoming article we'll discuss “pricing for risk” and the risk/return paradox.