Advice on Risking Your Hard-Earned Money
As a venture capitalist, my advice is often solicited regarding ideas for starting a business or investment opportunities. Any advice that might be of benefit must consider the unique circumstances surrounding that opportunity. However, over the years I have found that I keep repeating some observations I make to people, regardless of the unique circumstances of the specific opportunity. I thought that I would share this generic advice, should you ever find yourself tempted by the lure of making “big” money.
Underscoring all advice is this fundamental tenet: Understand the difference in business between taking a risk and gambling. People willing to invest in a business opportunity never think in terms of gambling, but rather in terms of risk. They get even more excited when the investment opportunity is in a start-up company, particularly a hi-tech one. They are all aware of the fact that venture capitalists can make a fortune investing in high-risk companies and are very tempted to personally benefit by doing the same. This is a common wisdom that has a fallacy.
Let me dispel this common perception about venture capitalists and the venture capital industry. It is generally believed that a venture capitalist is in the business of taking high risks in order to benefit from high returns. Many venture capitalists may even agree with that statement. I would consider those to be pedestrian thinkers. The deep and perceptive thinkers will immediately understand the fallacy. Although there is some truth to the fact that venture capitalists invest in high-risk situations in order to benefit from high returns, it is completely wrong to think they are in the business of doing so. Understanding this nuance is the key to benefiting from my advice.
Venture capitalists do not take high risks. They take risks that they believe they can manage and thereby mitigate. The nuance should be clear: Venture capitalists are not in the business of taking risks; rather, they are in the business of managing risk. The former I consider to be more akin to gambling, and the latter I believe falls into the camp of legitimate risk taking. The industry even coined a term for the former category: “dumb money.”
The fundamental difference between the two lies in two aspects: (i) having the right knowledge and/or expertise to make a judgment on the magnitude of the risk and whether the risk is manageable, and (ii) having the ability to wisely and competently help manage the risk. Competent venture capitalists will not likely invest in other scenarios. If they do, they will fully understand that they are taking more of a gamble, even if they don’t consciously think about it that way.
Keep in mind that even for the venture capitalist the risk of failure of any given investment, even the best ones, is very high. About 50 percent of individual deals fail, even for the best venture capitalist, and this is after the VC has applied their expert judgment to the opportunity, completed thorough due diligence, and consulted with their partners, convincing them of the merits and wisdom of making such an investment. Deals fail because it takes much, much more than just a great idea to end up with a successful business. There are many other factors involved, including a large dose of luck, both positive—being lucky—and negative—being unlucky.
Now that you understand the above, you will have a better appreciation of the rationale behind my observations and recommendations below regarding investing in a start-up if you are not an experienced venture capitalist:
•No matter how simple it may appear to be, there is no such thing as a no-brainer start-up—not even a restaurant, a retail store, or a hot dog stand.
•Never invest in a deal, including your own start-up, that falls more into my definition of gambling, meaning:
○Where you don’t completely possess the necessary expertise to make a competent judgment. Knowing a little bit about it doesn’t count as expertise!
○Where you don’t have complete confidence that it is a situation where you can personally help manage and mitigate the risk.
•You may make an exception only on rare occasions, where you are making the investment based on someone’s recommendation, someone whom you completely trust and who will be in a position with the right skills and influence to place the opportunity in the non-gambling category. However:
○Never give this trust to anybody who is absolutely not very close to you, and who doesn’t have a long, established, and proven track record that you can personally vouch for, from your own experience.
○The person should not be just a decent friend whom you know.
○The person should never be a stranger, or somebody you don’t know extremely well.
•Don’t ever invest in start-ups or early-stage companies based on the advice of stockbrokers or investment professionals, regardless of the reputation of the firm they work for.
•Never invest money unless you absolutely also stand ready to lose it all, without major consequences to you, and over which you will not lose any sleep. In other words, never invest money you can’t afford to lose or are unwilling to lose.
○In fact, I always advise people before they make an investment to assume that it is all lost and just hope for a possible pleasant surprise in the future.
•You may ignore the above when:
○the amount is inconsequential to you, and you are fully prepared and willing to lose it all.
○you fully understand that you will be taking a gamble, with the same odds and expected outcomes you would expect from a pure gambling situation.
Never let greed blind you from following the above advice. That is exactly what the people who are trying to convince you to make the investment count on!