What is Risk Tolerance? A Complete Guide for Startup Founders

What is Risk Tolerance? A Complete Guide for Startup Founders

This guide is designed for startup founders to better understand the different sources of capital from the perspective of risk tolerance. You can increase the efficiency of your fundraising process by limiting your pitches to investors with the appropriate risk tolerance for your stage of business.

Investing is fundamentally the process of judging risk. Whether you are investing in Tesla stock or a pre-product startup, the question is the same: is the risk adjusted return on the investment positive?

The earlier you are in your business, the higher the risk tolerance required for an investor to participate. Once your startup gets going and its pathway to success is more clear, the overall amount of risk is lower. That’s when lower tolerance investors will become interested.

Investment Risk Tolerance By Role

The Founder

You are your company’s first investor. You took a risk to get started. Maybe you quit your job, mortgaged your house, or took a loan against your retirement account. You know that most startups fail so you are clearly open to taking a lot of risk. This is your baseline - essentially your definition of risk tolerance - against which you can judge every other class of investor’s risk.

Friends & Family

These are people that you know. They’re probably not experienced with the business you are starting but that doesn’t matter; they want to invest in you, not a product. Their risk tolerance around their investment is about the same as yours. That’s why they’re willing to invest at such an early stage, and they’re almost always the source of the first capital raised by a startup.

The Angel Investor

Angel investors have a special risk tolerance definition because they invest their own money. Usually, angels are independently wealthy founders who exited their own startups, or otherwise successful with their own business. Sometimes they were born rich. But their source of capital doesn’t matter; if you fail, angel investors have nobody to hold them accountable but themselves. This means they will tolerate a lot more risk than other investors and often participate in the earliest stages of a startup

And because it’s all their money, they will also tolerate lower returns than other investors. This means that you don’t need a “unicorn” plan to attract the attention of an angel investor.

The Venture Capitalist

Venture capitalists are the whales of the startup funding world. They write big checks with the hopes of even bigger returns. It might sound glamorous to literally spend money for a living but there’s a catch when it comes to their investment’s risk tolerance: it’s not their money. Before a VC can invest in your startup, she must first raise a fund from a group of third party investors (usually referred to as limited partners, or LPs). That means if you fail, the LPs get angry. This lowers a VC’s risk tolerance relative to other investors.

VCs also expect high returns on their investments and not just because it makes their LPs happy. VCs get paid mostly on a percentage basis of profits returned to their LPs. This means that you need to demonstrate a plausible pathway to an extremely high rate of return to get the attention of most VCs. Just becoming profitable isn’t good enough. This lowers a VC’s risk tolerance in regards to their investment even more, limiting their interest to startups that are well established.

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