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26TH March 2012

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Angel Series #8: Failure to launch: how to hedge operational risk in startup investing


EO: Great Group of Entrepreneurs

This excerpt is serialized from a whitepaper titled Angel Investing for Single Family Offices (SFO’s) by The Family Office Association and Vaux les Ventures. For a complete copy, visit the FOA website. 

Any SFO considering allocating a portion of their assets in venture toward angel investing has to acknowledge the significant risks in the market. One sobering take from the US Small Business Association is that roughly 80% of small businesses fail in the first year, 10% in the second and 5% in the third, leaving a paltry 5% of new ventures that even qualifies to deliver a return for investors. I am a member of EO (logo at left), a global organization with 8,000+ members that fosters entrepreneurs, and the odds are just slightly better there I think.

Sticking with the digital media businesses discussed in the last section, here’s a brief summary of the early stage venture risks associated with this sector:

Operational Risks are legion in startups. First out of the gate is execution on the development of the product. Many products and services simply fail to launch, whether due to poor specs, loose design
concepts, or from just plain misjudging a market need. Another common problem is never solving the cold start challenge and acquiring users. Assembling talent, accessing sufficient capital, maintaining differentiating advantages over competitors, and a go-to-market strategy are a few more risks to consider.

Timing Risk — also referred to as Luck. Often, an entrepreneur’s vision has merit, but market conditions have not yet gelled to support it. Frequently, capital is wasted on development and/or marketing in
anticipation of a developing market. When the tide doesn’t rise in time, the company is left high and dry. One example? The many mobile/ social networks that tried to deliver hyper-local advertising audience and failed. In the meantime, Gowalla and FourSquare entered the market just as mobile and social converged, and were propelled to higher and higher market caps. Likewise, any mobile/social solution launched now with similar attributes would be too late and face heated competition.

Funding Risk can be mitigated by an SFO in the early stages of the company, but in our digital media example, additional capital will be needed — or at least easy to acquire –in order to scale the business. A good example of funding risk affecting returns would be the inability for mobile ad networks/ platforms to raise capital before mobile was “proven” viable (see AdMob’s sale to Google and Quattro’s sale to Apple within a 6 week period). Before those landmark deals, funding sources constantly questioned whether there was a “real” market in mobile, citing the struggling networks who hadn’t succeeded, despite $250,000,000 of combined capital. Several early stage companies faltered for lack of capital, and several other investors suffered dilution from large downdrafts in valuations. An SFO can, of course, prolong the agony by continuing to fund (Fred Wilson’s famous quote here is “I have a 0% mortality rate- I just keep funding!”) but the effect on returns when others do NOT fund, or fund at lower prices, is undeniable.

So, if you are considering angel investing with your SFO be sure to match the risks with the rewards. There are more of the former than the latter!

 For a complete copy of the complete paper, visit the FOA website. 

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