Why I Don't Want to Get in on the Ground Floor of Your CompanySavvy investors avoid ground-floor investments, because there is typically too much risk to offer attractive risk-adjusted returns.
ByCarol Roth•
Opinions expressed by Entrepreneur contributors are their own.
I've played many roles in an advisory capacity for companies, ranging from helping them raise capital -- more than a billion dollars' worth -- to giving strategic advice and even investing my own capital in a variety of private entities. Between that and being a well-known business personality, I often get approached regarding making investments.
For brand-new or even pretty early-stage companies, they often try to lure me with a phrase that they must think is enticing, but really is a turn-off: "It's an opportunity to get in on the ground floor."
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Well, given my choice of when to get into the elevator with you, I'd much rather get in on the floor right before we get off than on the ground floor or even the first floor. In fact, the greater majority of private investments that I have made have been in well-established companies seeking later-stage expansion capital, with a preference for investing in the last round before a company explores strategic alternatives -- a financial industry code phrase for "seek some type of exit or liquidity event," like a full or partial sale of the company or an initial public offering (IPO).
The reason is that I, like most investors, I am looking for probabilities, not possibilities when it comes to making investments. That means I am more concerned with risk-adjusted returns -- how much I am getting from my investments when looking at the risk that I am taking on -- than total face-value returns.
While there may be some altruistic elements in investing, the reality is that any savvy investor is looking for a return on capital. When I make an investment, I am not seeking to play the lottery by investing, hoping that one will be that big jackpot. I am looking to earn a return on my money as part of my portfolio strategy. Some private investments can offer a better return opportunity than public equity, debt and other investments, but they come with added risk. Therefore, the risk / return has to make sense for that investment on a standalone basis and as part of my broader investing strategy.
The problem with ground-floor investments is that there's typically too much risk to offer attractive risk-adjusted returns. The earlier you get in as an investor, the fewer the milestones that have been accomplished, and the more risk inherent in the business. You have no idea whether the team is going to be able to acquire customers at a reasonable cost. You have no idea how sell-through at retail looks over a long period of time. You have no idea if there's a major competitor looming that's going to make the business's innovation obsolete.
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And you have no idea if the management team is going to make smart decisions when it comes to spending your money or running the business in general.
If something goes awry -- which I have seen happen with many businesses, including a few that I have invested in over the years as an early investor -- you see your investment get squeezed by later-stage investors. Raising capital for a business that stumbles, which many early-stage businesses do, means that the post-stumble investors can dictate terms, or they won't invest.
Desperate businesses don't have lots of choices. So, often an early investor's reward for being early is looking like a chump when they are diluted down by the new investors, making even a future hit basically a worthless investment for them.
I'll take a "pretty certain to return me a nice double digital annual return" investment opportunity over one possible "next big thing" opportunity any day.
This is the challenge for new, growing businesses. The businesses that least need the capital are the ones that investors want to invest in the most. The ones that most need the capital are the ones that investors want to invest in the least.
The lesson for your early-stage business? Take as much risk as you can out for investors and start moving the business up by yourself, because there's nothing appealing about getting in on the ground floor.
