The Entrepreneur Gap

A Theory on Investor Risk

 

Investors look at any prospective investment as a risk-profiling exercise. They want to know what risk is present and what steps can be taken to minimise it. As a rule of thumb, there are three key areas where this applies – tech, traction and team.

However, there are two risk-factors I’d like to propose which cannot be quantified in advance, but certainly exist. In both circumstances, which are connected to the founding team, the very act of investing can be the trigger-point at which risk explodes. This article is about the Entrepreneur Gap.

Let’s look at a graph of how a venture business grows over time.

Phase 1 loosely represents organic sales growth without external capital – slow and steady adoption is typical – underpinned by the efforts of a founding team.

Phase 2 sees a burst of cash enter the business as external finance is brought in.

Phase 3 is the accelerated sales growth usually experienced as the cash raised in Phase 2 is deployed.

 

Founder Ability Risk

 

The first factor at play in the Entrepreneur Gap model is the Founder’s Ability Gap. Except on the rare occasions where Founders have prior experience running businesses (of any type, not necessarily in technology businesses) then, in most circumstances, the Founder is always learning, trying to keep up with the business. We can show this as follows:

The external financing event is designed to increase business performance overnight. While here we label the green line as business growth, equally we could label it as “Investor Expectations.” Either way, the stakes for the Founder have increased overnight but it is implausible to suggest that a Founder’s ability could possibly increase at the same rate. At best, the rate of learning increases and the gap narrows over time.

The greater the gap between the blue and green lines, the greater the risk for an investor.

Most investors are aware of this gap. It can be somewhat understood in advance through due diligence – references, examples of past work and academic achievements can be helpful indicators – and therefore mitigated with coaching, mentoring or education.

However, it isn’t the only risk and – unfortunately for investors – the second is much harder to quantify and even harder to tackle.

 

Founder Ego Risk

 

Let’s be clear – some ego is good when it comes to running a business. It’s intimately linked to resilience and fear of failure. It’s an essential part of the mix required to get back up every time you get knocked down.

However, it can also be a major problem. The second risk factor in the Entrepreneur Gap model is that of the Founder’s Ego Risk. This attempts to demonstrate how large swathes of Founders perceive themselves and their ability, and how external financing can trigger a disaster. It can be modeled as follows:

 

Entrepreneurs have many qualities but plenty of tech entrepreneurs suffer from over-confidence bordering on arrogance. They often consider themselves to be much more capable than they are and a fundraising event is exactly the kind of self-reinforcing milestone which can trigger an explosion of hubris. At this point, the gap between a Founder’s perception of their ability and the reality of their ability is at it’s widest.

Once again, this represents risk to the investor as highlighted in the gap between the green and red lines. Again, the greater the gap, the greater the risk.

 

Narrowing the Entrepreneur Gap

 

Prudent investors may not be able to accurately quantify the risks associated with the Entrepreneur’s Gap prior to writing a cheque. However, the extent of the issues should soon become apparent post-investment and steps taken to narrow the gaps between ability, ego and performance. This could take the form of education of the founder and placing an experienced management team around them. However, this takes time:

Conclusion

 

This model demonstrates why investors prefer to invest in proven goalscorers – those Founders who have built other businesses. In such circumstances, where the Founder has dealt with business challenges before and learned to balance their ego with those challenges, additional investor risk – beyond the fundamental quality of the business model – can largely be removed:

While this is undoubtedly exaggerated to illustrate the point, here the investor risk has been converted into a margin for error in the investment.

Let us know if you agree with our model or if we could improve it. Do you know Founders that this applies to? Maybe you are one yourself! We’d love to hear your views.

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