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Friday, January 11, 2013

Managing risk is critical to success

Risk management includes your distance from the alligators.

People are different and individual tolerance for risk varies.  It is amazing that many people will walk up to an alligator just to get a good look.  The photo above shows two such animals just behind the tree.  Standing from a SAFE distance, I saw many people approach the animals as if they were pet dogs.  Some even took their children with them.  Alligators have an ability to run at around 30 mph for short distances.  They may attack if they are hungry or if they feel threatened.  The lack of fear of those that move so close is something I just do not understand.  The desire to see the animal over rules the sense of fear in some people.

Taking risks with one’s life or wellbeing can result in great harm.  Harm may also come to those that take risks with their money.   Loaning money to a person you know nothing about carries risk.  The risk level drops if you know the person very well, they have a great stable job, they pay all their bills on time, and you know how to contact them.  Risky loans were a good part of the financial meltdown around 2007 because of failure to adhere to proper standards some banks.

Holding company equity has risk just as loans have risk.  Companies may grow and succeed but some fail.  Even great companies can get into trouble and cause big losses for investors.  If you doubt this fact, look at the history of certain banks from 2005 to the present; at least the remaining ones! 

The same goes for startups and entrepreneurs.  Evaluations of the risks are essential to investors.  It does not matter whether the investment is as a loan or as equity.  Managing the risk would be up to the investor risk tolerance and risk management style.  One method of managing risk is extensive diligence on all aspects of the business and the people.  Couple diligence with diversification of a portfolio provides further protection.  For example, consider investing $100,000 equally over 10 investments with the performance of each investments being the following: 1 company increase 10 fold, 2 companies fail completely, and the other seven remain unchanged.  An investment of $10,000 in each becomes $170,000.  The fact that 2 resulted in complete loss was offset by a huge gain in the one that went up 10 fold.  The example of portfolio management becomes more important when a person is managing someone else’s money.  When you manage your own funds, you may elect to take greater risk.  Managing money for others usually comes with a more conservative approach. 

Fund managers and VCs manage money for other people.  They must mitigate risk by selection of companies that fit a portfolio strategy.  Balancing a portfolio may mean picking 10 different companies, but is can be further diversified by spreading investment over different technical areas or industries.   Funds often have a lifetime, which results in return of investors’ money with profit or loss factored in to the return.  VCs sometimes pick 7 years for this lifecycle.  They may elect to invest in greater risk and potential big return companies at the start of the fund.  Toward the end of the fund, the investments may become more cautious.   This means that companies selected toward the end of the cycle are those that are more advanced, expected to have modest returns, and certainly highly likely not to lose value. 

Funds have a responsibility to make money for their investors just as you do.  They manage risks and develop portfolios like you as well.  The decision to invest in your company becomes a balancing act for them.  You may have a fantastic company but the investment decision is based on much more than the business.   Eliminating internal risks in your business can help, but the management of risk for the institutional investor includes many factors.  The point is that a turndown by an investor may not reflect negatively on you or your company.  Investors may raise a new fund and your chances may be greater in their early stages.  Try to understand the fund situation before your first visits.  Knowing their timings and restrictions may help you understand their final decisions.