It's said that the angel investing game is won on home runs. Angels take on a serious amount of risk when they invest in startups. The rewards make up for it in more ways than one. So, how do the best angel investors manage risk? Each investor has their (secret) charm. But let's look at the data for a moment. According to studies, angel returns beat traditional investment classes.
That's not bad. So, what about the risk in venture and angel investing? More specifically, how can active investors do better due diligence to eliminate as much risk as possible? We can and do manage risk, after all. The returns show that angel investors can do this quite well. In today's blog, we will look at ways to approach risk and examine its scope for an active investor invested in a young business. To do so we will leverage the primal functions of our brain, the 'Quadrant of Risk' and finally learn ways to safeguard against risk.
So, without ado, let's look at how risk awareness helps us achieve better outcomes.
Thinking About Risk Differently
Most investments present a mix of the major categories: team risk, market adoption risk, technology risk, and all the nested issues within each category. We cannot evaluate and put equal weight on every risk at once, nor can we. Common solutions emerge in individual portfolios. For instance, diversification is critical. But what else? More importantly, can we think about risk in new ways? As Keiretsu Forum member, author and entrepreneur https://www.linkedin.com/in/rai-chowdhary-56b3081/Rai Chowdhary said in his keynote, risk is everywhere — woven into the fabric of a business and how it operates. With his help, we can look at risk in a new light.
The Dualities: Fast vs. Slow Thinking
Let's start with a little brain teaser: A baseball bat and ball cost $1.10 together. The bat costs $1 more than the ball. How much does the ball cost?
The answer is $0.05. But if $0.10 came up as an immediate answer, that's what psychologist Daniel Kahneman calls System One Thinking — the fast, intuitive mode that leads to off judgments. System One relies on shortcuts and emotion rather than reason and logic. It's what is dubbed the reptilian part of our brain.
The other side? It's System Two Thinking — the slower, analytical, and reasonable side, associated with the brain's pre-frontal cortex. It's the part that analyses deeply and reasons hard. Risk management requires striking a balance between the two modes of thinking.
Along with such an approach, it helps to think broadly about the possible scenarios one can encounter on the path to growth.
Are You Prepared for the Known?
Rai explained his approach to the possibilities of risk through a preparedness matrix with four quadrants. Most companies are on this spectrum. The four are:
1. Prepared for the Known: Risks known and anticipated. Plan created.
2. Prepared for the Unknown: With diligence or luck, you're sail past surprise risks.
3. Unprepared for the Known: Unserious! There's no good reason to drop the ball here.
4. Unprepared for the Unknown: Reasonable in cases of true unknowability, but what if it is a failure of due diligence?
Quadrant 3 does justice to the following story. Ford's bungled launch of the Escort in 1990s India. A two-dollar part – the horn – failed within months. Ford vehicles were unprepared for Indian road conditions and ended up ceding the market to Japanese competitors. The truth? Most companies linger too long in that unacceptable Quadrant 3.
Even with preparation, some risks can reach a point of no return surprisingly fast if left unchecked. It's the moment after which harm is virtually unavoidable, no matter what you do. The tragic 2003 Columbia space shuttle disaster demonstrates this. In startups, that point of no return might be a strategic supplier getting acquired, or a new regulation that renders your product obsolete before you can pivot. Vigilant mapping of potential cause-and-effect chains is critical to avoid careening past the point of no return.
The Mind-Boggling Calculations of Risk
Moving on, let's quickly emerge into another dimension of risk. Quantifying risk — the one area covered by many risk standards. The typical formula looks at the probability of a hazardous condition arising (called P1), the odds it escalates to actual harm (P2), and the severity of that harm (S). So that,
Risk = P1 x P2 x S.
Fairly straightforward, right? But it gets complicated — let's evaluate four promising startups based on just three financial metrics and four investors' projections. That's 48 data points to synthesize: virtually impossible for the human mind to integrate.
Now add operational, technical, regulatory, and strategic dimensions for 360° due diligence. Suddenly, we're juggling hundreds of variables dancing across multiple scenarios and stakeholder views!
The solution? There are a few. It involves, as Rai says, thinking in new ways about risk.
How to Deal (and think) about Risk
At its core, risk is about identifying threats and acting before you pass the point of no return. It underlies every facet of the business — regulatory, financial, operational, strategic, and more. For instance, it can go back to the team. There's always the opportunity to turn overwhelming complexity into rich dialogue by dividing the work. According to Rai, founders and investors can leverage the diversity of the team, combining analyses, and using data and software tools to facilitate meaningful discussions. It's a great starting point for active investors and young companies
The Path Forward
Risk is a constant battle, but there are powerful tools and practices to address it. Implementing them will require upfront effort but pays lasting dividends.
Rai advises the following:
- Bake System One vs. System Two Thinking awareness directly into your decision-making processes
- Create a feedback loop where teams are encouraged to pressure test proposals using analysis, data, and outside perspectives.
- Explicitly calling out ingrained mental blind spots is uncomfortable but quickly becomes a healthy habit.
The preparedness matrix should become a centerpiece framework. Investors can conduct bi-annual risk audits to classify all perceived threats into the four quadrants. Critically, it helps to go beyond known risks and dig deeper to identify unknowns through environmental scans, stakeholder interviews, cross-team collaboration, and third-party audits. The unprepared quadrants represent major hazard zones.
Investors can develop a plan and prepare for each risk through concrete mitigation actions, capability investments, and strategic adjustments. No risk should linger unnecessarily in an unprepared state. To avoid the point of no return, every initiative must have a defined, data-driven runway showing forecasted fail points and intervention timelines.
Rai also says that triggers or indicators should be recognized, and people can leverage risk management software to provide escalating alerts as they approach critical junctures. Establishing clear triggers for when to execute contingency plans or pivoting strategies is crucial.
Quantifying risks provides a common language. But the numbers are just a way to create targeted dialogue and balanced decision-making. Finally, leadership must model and reinforce risk mindsets continuously through communication, incentives, and governance. The periodic risk committee must become a lived core value. Risk paradigms like "prudent paranoia" and "calculated curiosity" could characterize the culture!
The path to risk management requires sustained commitment at every level. But the world's most successful companies navigate our turbulent landscape. With diligence, the right tools, and the right approach, it's possible to do so for almost any investor.
References:
Rai Chowdhary's keynote, Manage Risk or It Will Manage You
Dibrova, A. (2015). Business Angel Investments: Risks and opportunities. Procedia - Social and Behavioral Sciences, 207, 280–289. https://doi.org/10.1016/j.sbspro.2015.10.097
https://www.angelcapitalassociation.org/blog/angel-returns-beat-classes/
