Investment Returns and Risk With Startups

Investment boils down to the very simple concept of risk versus reward. Investors, in aggregate must be compensated for the risks embedded within a particular security. Although risk is subjective and varies die to differences in valuation technique, reward is universal. Investors are constantly seeking investments that offer the highest returns given the risk. In particular, due to market inefficiencies investors are often looking to achieve "Alpha." Alpha is simply a return achieved above the required return.

In this pursuit of higher returns, investors risk losing large sums of money as unforeseen events occur. Chart 1 provides a visual representation of this concept. Investors, seeking higher return must unfortunately take higher risk. Risk in this instance is NOT defined as Beta as many academics use. Instead, here risk is defined as the propensity for permanent capital loss. As investors move further left, notice the variance of returns becomes larger. Although the return could be potentially be higher so to could the loss. This makes intuitive sense.

If all risky investments yielded a higher return, then by definition they would not be risky. The potential for permanent loss is what makes investment risky. Chart 1 above represents this concept masterfully. Capital losses are a result of failed and often misinformed analysis. In general, investors are risk averse and would like to avoid risk if at all possible. Unfortunately, to achieve superior returns, investors must accept the risk embedded with the security.

The possibility of capital loss therefore discourages market participants who do not want to accept the risk embedded in the security. In provides a check and balance against market forces that tend to drive prices to extremes. In regards to startup companies, the risk and rewards are very high. Many small businesses fail within their first few years of operations. For every Apple, Facebook, and Google, there are thousands of failures.

In fact, these failures are what drive the required rates of return demanded by investors for startups to begin with. Investors realize that many startups will ultimately fail to produce any meaningful results. They therefore must be compensated for this risk in the form of higher returns. Startups are particularly unique as they are often unprofitable from an accounting standpoint. Many have strong innovative products that are very difficult to monetize without arousing competition.

Due in part to their overall lack of meaningful cash flow, startups often needs a multiple rounds of capital infusions to simply maintain operations. Capital is not free. In fact capital has a cost that can be determined using a weighted average cost of capital formula. To justify investment, startups must earn a return above the cost of capital, otherwise shareholder value is destroyed. If a startup cannot earn this a rate higher than the cost of capital, investors are discouraged from providing investment.

Without capital infusion, the startup is doomed to fail as it has not appropriately monetized it product. Common examples include cloud or social media companies. These companies must first establish a network by which consumers can receive value. In order to establish this network, startups often offer their product or service for free. To attract clients to the network the company must spend heavily on marketing and customer acquisition expenses. All of this occurs while the company has yet to make any meaningful profit.

The investor provides the capital and accepts the initial losses in hopes of a much higher payout in later years. However, if the costs outweigh the risks associated with the investment, the investor will become discouraged. Particularly with tech startups, innovation occurs so rapidly that an initially viable solution becomes obsolete in a matter of months. Obsolescence lowers the return potential of the business and ultimately discourages investors in the.