When investing in early-stage companies, there are a plethora of risks to evaluate, including execution, competition, monthly burn/running out of money, monetization and market growth.
But the biggest two? One is technical: Can you build the product?
The other is market risk: Can you sell the product?
I used to see plenty of startups with technical risks on crowdfunding sites. Many of these were companies that didn’t even have a minimum viable product (MVP). They were companies without a product. Most serious investors just aren’t interested in companies that don’t have a product to show. And nowadays, you have to have not only a product but also product sales… and not only sales but also a track record of sales growth.
I don’t see many of them anymore – a sign of the growing maturity in the space.
But there’s another kind of productless or pre-product company that should command your interest.
These are companies that sidestep market risk entirely. The classic example is cancer.
The hard part is finding a cure. But here’s the thing…
If a cure is found, there will be a huge market.
At the very least, it’s an intriguing investment proposition. But if you focus on the first part of the sentence, “If a cure is found,” it becomes very clear just how risky an investment proposition it is.
A cure for cancer is a huge market only because a cure has never been found… despite mountains of money and a huge amount of effort.
For cancer, at least, the technical risk seems almost insurmountable. But the reward (and desire to cure cancer) is so big that private investment (as well as public) keeps pouring in.
These companies that tackle technically challenging problems are not the same as companies led by founders with a “big idea” looking for money to carry out that idea.
Pre-seed-stage, “big idea” startups should raise money from friends and family to develop an MVP.
Startups trying to master difficult technology often take several years to get past the pre-product stage. Their track record is not one of sales growth but of technical progress. And that progress should be open to evaluation to determine if it meets expectations.
As it so happens, I just recommended (to First Stage Investor members) an early-stage (Series A) company that fits this example. Instead of cancer, though, this company has targeted severe pain relief and opioid addiction.
Its upside is off the charts.
Then again, it’s basically pre-product. It hasn’t even begun its human trials yet.
What’s more, I’m not a doctor. I don’t have a degree in biology or biotechnology.
How do nontechnical specialists weigh enormous potential upside against high technical risk? And how do they measure technical progress?
I don’t have THE right answer. I can tell you only what I did…
- Review the studies. In my case, there were preclinical studies on animals that showed very positive results. Large swaths of these studies were quite technical. I didn’t understand everything (or even most of it). But I did pick up a lot of knowledge that helped me evaluate the technology. At the very least, I noted that the preclinicals went very well.
- Find a variable that tips the scales. Statistically, only a small percentage of pharmaceuticals make it all the way through from the preclinical to the final stages of human trials. I searched for factors that increased the odds. In the case of this company, I found a great one. I got lucky. That’s seldom the case.
- Confirm the upside. How big is the market? What other pain relievers are under development? Could they divert demand?
- Get an expert opinion. I have several friends who are doctors. I reached out to a couple whose opinion I could trust on this subject. I wasn’t looking for definitive feedback. More like, does the technology make sense? Are there flaws I’m not taking into account?
My vetting process led to a recommendation, so yes, the information and feedback I developed was both positive and encouraging.
It’s a big bet, and the risk-reward is very different. Not many investors, even large venture capital (VC) investors, are comfortable assessing technical risks, let alone writing a big check based on that evaluation. The few that have made several of these kind of investments include Lux Capital, Andreessen Horowitz and Osage Partners.
Most investors prefer committing money to companies that have much more market risk than technical risk. I can see why. I can dissect markets and marketing seven ways to Sunday. And I prefer investing not only in things I understand but also in things I feel I can tease out insights from.
Of the last 15 startups we put into our First Stage Investor portfolio, only one – the pain relief company – was a technical risk investment opportunity.
That’s more than a lot of investment and VC firms do. But as far as I’m concerned, it’s not an ideal ratio. I would like a couple more.
But I’ve found a surrogate that I believe works better than these high-tech risk, super-high-reward investments.
It combines low market risk with moderate technical risk to create potentially high returns.
The goal is to take available and proven technology and use it in a novel way to address a new problem.
Two companies from our last 15 recommendations have this very attractive combination. One is a cancer-detection company that uses proven biomarker tests plus machine learning to provide highly accurate detection.
The other is a drilling, tunneling and aerospace company that, for the first time ever, applies proven technology in a new way to possibly disrupt these three sectors.
Old and proven technology repurposed to address huge needs has now become one of our major investment theses. It’s capable of delivering big returns without incurring significant technical or market risks.
This category of companies may never get the buzz it deserves because it’s fairly small. These companies don’t grow on trees.
But I believe there are more of these companies than you may think. And because of their unusually high upside and moderate-to-low risk factors, they’re worth searching for.