At Crowdability, we often tell you about exciting start-ups that are raising capital:
Some are building flying cars…
Others are helping manage diseases like Parkinson’s…
Still others are developing technology to put bank lenders out of business.
But if you really want to be a successful angel investor – an investor like the ones we interviewed for The Angel Initiative – you need to understand something:
Success isn’t just about investing in the “next big thing” and picking winner after winner...
Surprise: It’s also about avoiding the losers.
Even when it’s very young, a start-up can exhibit major warning signs – “red flags” that can indicate a higher likelihood of failure.
And actually, the most fundamental reason a company fails is simple:
It runs out of money.
So here’s one of the very first things professional investors do:
They avoid the companies that are more likely to run out of money.
This is a critical part of their process… so critical, in fact, that when Wayne and I started investing in early-stage deals, we spent six months doing research on it.
In the end, after interviewing dozens of early-stage experts – and through a rigorous study we conducted in conjunction with consultants from the M&A team at Citigroup – we identified nine factors that are statistically correlated to a company’s likelihood of going out of business.
Then, using these nine criteria, we developed a method to rank and score investment opportunities.
We call this score the Risk of Ruin.
Risk of Ruin
Essentially, the Risk of Ruin is a metric for analyzing risk.
It provides an objective look at a company’s risk of running out of money, and shows how one company’s risk compares to others.
Here’s a simplified example of how it works:
Let’s say that two companies are raising capital.
Company 1 has revenue coming in, and has significant capital in the bank.
Company 2, on the other hand, has no revenue, and is nearly out of cash.
Sure, Company 2 might be the next Facebook, but all else being equal, compared to Company 1 at this moment in time, it has a higher risk of running out of money.
Good News, Bad News…
The good news is that doing a Risk of Ruin analysis on every investment opportunity can help you steer clear of the losers.
The bad news is that, in the real world, analyzing a company’s risk profile is complicated.
It’s challenging enough just to identify the right risk factors...
But even after you figure that out, you still need to find and evaluate enormous amounts of data for every investment opportunity you’re looking at.
Unfortunately, this process is absolutely necessary; it’s a crucial part of why the professionals are successful.
So last year, we decided to invest several months of our time, and over $250,000 of our capital, building a special piece of software.
This software automates the entire Risk of Ruin analysis.
And this brings us to some great news:
We’re about to share the software we built with all Crowdability subscribers.
This software handles all the hard work of evaluating nine critical factors that can affect a new enterprise’s ability to survive.
As just one of the simplest examples…
The software analyzes a start-up’s existing investors. It evaluates if these investors are bona fide venture capitalists. (To make this determination, you need to evaluate whether these are professional investors like Benchmark Capital or Union Square Ventures that have raised a specific fund to invest in start-ups – or whether an investor is just an individual Angel who invests on an "ad hoc" basis.)
The reason this is so important is that research has shown that a start-up backed by a venture fund – an enterprise that has a mandate and dedicated funds to invest in start-ups – is less likely to run out of capital.
In fact, according to a study conducted by Tomasz Tunguz from Redpoint Ventures, start-ups with at least one venture fund in their “seed round” raise future rounds of capital 64% more often than start-ups that only have Angel investors.
For Investment Success, Avoid The Losers
But that’s just one of the risk factors to evaluate…
There are eight others. Each one requires complex analysis.
But the Risk of Ruin software makes your research process effortless.
And critically, it can help you become a better angel investor.
By helping you avoid the losers!
To be clear, the software isn’t quite ready for you.
But later this week, we’ll start telling you more about it – and soon we’ll tell you how you can get early access to it if you’re willing to lend us a hand.