How To Assess Risk in Private Company Deals

By far the biggest aspect of private company investing, which causes severe hesitation on the front end and sleepless nights on the back end, is risk. 

All of us, of course, are profoundly interested in getting early stakes in high-flying companies but are downright frozen in our tracks by the considerable risk-taking involved in actually doing so.  And once invested, the hard realities of company-building quickly take hold:. These include: longer than expected times-to-market, lower than expected cash flow, harder to attain market recognition, etc...

So on the one hand, there's opportunity of significant capital appreciation, and on the other hand, there is the unwillingness to act because of the realities and the perceptions of the risks within the deal.

For a more dispassionate approach, I suggest that we remove the all-too-common and unfortunate connotation that the word risk had garnered in our "sky is falling" media and in our litigious culture.   The intelligent investor views risk simply as a measurement of the likelihood of a set of future outcomes, or of probability.  There are three main drivers of the probability of success:

1.  Technology Risk. Can the enterprise actually bring-to-market the product or service as designed and on what timeframe?

2.  Market Risk. Once the product is in the market, will anyone care?

3.  Execution Risk. Can the the people of a business manage its technology and market risk to build brand, asset, revenue, and most importantly, cash flow growth over a sustained period of time?

In future blog posts, I will go in depth into the key drivers of each of these risk factors.  Suffice to say for now that risk for any business is driven not by the addition of these factors to one another, but by their multiplication to one another.  Lack of performance on any one of the above has an exponential impact on a business' overall risk profile.

My anecdotal conclusion in regards to how risk is actually handicapped in the real, rough & tumble world of entrepreneurial investing is this:  The risk involved in the "lesser" deals is greatly under-estimated while the risk of the better deals is significantly over-estimated.   And as should be obvious, the process of separating the betters from the lessers is via an analysis of the risk dimensions above.  The better companies will quite simply have better answers and analysis when queried regarding their technology plans and their understanding of their market, and their people will have better past execution track records.  

On my next post, I will explore what "better" answers actually entail and what questions to ask to illicit them.  For now, I will close with the words of perhaps the greatest entrepreneur of them all - Thomas Edison - who once said, "Restlessness and discontent are the first necessities of progress." 

Let us not perceive the restlessness and discontent of the best entrepreneurs as risk.   Rather, it is how they translate this "chaotic" energy into their operating models, into the work and achievement cultures of their companies, and into that balance of flexibility and pig-headedness of the best entrepreneurs that provides us with the true risk profile, and thus the investment return potential, of a company.