When investors look at an innovative new project, they may get very excited about the vision. But smart investors will quickly look for all of the ways the project might go wrong, and how they could lose capital.
Unfortunately, investors are rarely experts in the industry. So when they look at the risks, they often identify several that aren’t real. I call these “phantom risks,” because they look scary, but have little or no actual effect on the investment. For all intents and purposes they are immaterial. Unfortunately, they may still be very real and very scary to the investor.
Phantom risks can be almost anything—they are limited only by the imagination, and fear, of the investor. And often they are very specific to the situation. Still, some common ones include:
- Political concerns in a jurisdiction the investor doesn’t understand. We see this a lot when investment crosses the red state / blue state divide in the US, or when investors go overseas.
- Technological obsolescence—the concern that some unknown new and amazing technology will be released that immediately decimates the industry.
- Regulatory changes—an issue that can seem large, if you ignore the fact that such changes typically take many years, are very slow, and are generally easy to see developing far in advance, giving you plenty of time to prepare.
So how do you get rid of these phantom risks, and give the investor comfort to fund the project?
One obvious step is to use sensitivity analysis: build a model and show the investor, quantitatively, that even if the worst possible scenario were realized for that risk, it would not affect their return. But sometimes that isn’t possible—the investor may not trust the model, or may not be willing to take the time to understand it. Fear of poorly-understood risks can be pretty irrational.
Another approach is to find a smart third party who is willing to guarantee the risk to the investor, or to the company. Depending upon the situation, they may be willing to put their name and balance sheet behind the risk, in the form of a contract. A simple example of this might be a supplier, who is willing to guarantee the on-time and on-spec delivery of their own products, thus alleviating supply-chain risks. Another example is an “offtake agreement” in which a buyer guarantees that they will purchase the company’s products when they become available, addressing an investor’s concerns about market risks.
If this third party is a large, well-regarded player in the market, their credibility and reputation, combined with the contract, can give the investor a lot of comfort and enable the funding. The third-party may require some contractual concessions to do this, but since they understand the phantom nature of the risk, those concessions should be minimal.
An alternative approach is to create a bespoke insurance policy that triggers and pays out if the risk hits. To issue such a policy, the insurer needs to put work into fully vetting the risk and analyzing the likelihood of loss. They are obligated to do this even if they recognize the risk is a phantom risk. So they will need to charge a premium large enough to justify their time. However, in a large project, where the funding is substantial and critical to moving the business forward, even a relatively large premium may be acceptable to the company receiving the funding.
Either way, the investor sees that a large, credible third-party is willing to put their own reputation and balance sheet on the line. Structured properly, such a guaranty can remove the perception of risk entirely, creating a clear path to investment.
