Why startup investors will not fund your startup and how investors are incentivized to be risk-averse.
Early-stage startup investment is, in theory, all about taking a lot of risk, necessary to find that one outlier that will return the fund (aka The Power Law of VC). In a European context, that would mean looking for the next Spotify.
In real life, however, we are incentivized to take less risk, and here's why:
A. Building an early-stage "ground-breaking" startup takes a long time—often 10 years, especially for deep tech where the initial years involve R&D rather than generating revenue. This makes it hard to measure progress, unlike in a simpler SaaS startup where growth can be compared to industry peers.
B. Additionally, there is a food chain of startup investors, starting with Friends/Family, then business angels, and later venture capital funds focusing on different stages. We all depend on the next type of investor, and as rounds typically become larger, the initial investors can't fund much further; they need investors with deeper pockets.
So, startups take a long time to build, it's hard to measure progress in the initial years, and investors need "next round" investors.
Now, imagine being an early-stage investor considering an investment. Part of your due diligence will not be about whether this startup has a chance to disrupt a huge industry. Instead, you'll be wondering if the startup can convince a next-round investor in 18-24 months.
The bigger the opportunity, the crazier the startup often looks. Imagine being a first-round investor in Spotify: How would they solve almost impossible problems, including convincing all record labels to work with them, in 18-24 months when they need the next investors?
There is, therefore, a huge risk that you pass on "crazy" deals not because of the case itself but because you are uncertain if next-round investors would take the same amount of risk as you do.
This is exactly what is happening in the current down-market, where many early-stage investors are passing on high-risk/high-potential deals since the chain of VC funding is disrupted.
So, let's bet on something that feels less risky.
How do investors reduce PERCEIVED risk?
A. Traction: Invest in startups that have commercial traction, which they know are easier to fundraise for the next round or bring to profitability. It might look like a wise move on paper, but are we then missing the true outliers that will likely require more R&D to bring to the market?
B. Team: Let's bet on repeat founders with successful startups in their belt -not only because it reduces the chance of failure but also because there is a higher chance that they can close the next round of funding. The downside is that all investors are chasing these, resulting in much higher valuations.
C. Hype: Let's do a lot of AI deals at crazy high valuations since this is the area the next round investors are really looking for...
#startups #funding #risk
