John and Mary are a dynamic young couple with a great idea for a start-up. They are convinced that they can make it work if they can secure a bit of funding and assemble a good team of people around them. So, should they go for it? Only they can answer that, but one of the things they will have to seriously think about is risk aversion. In other words, how much risk are they willing to take?
There are no guarantees in business. For every start-up that goes on to be a solid moneymaker there is another that crashes and burns. Just having a good idea and some money in the bank does not necessarily guarantee success. So the final arbiter at the end of the day is risk. Generally speaking, risk and reward are commensurate; the biggest rewards come from taking the biggest risks.
In terms of funding, John and Mary are seriously looking at a series of startup loans. Business wisdom dictates considering such loans in light of various levels of risk.
Risking Personal Assets
Let’s just say John and Mary determine that their best shot at start-up loans is to apply for a series of personal loans taken out in their own names rather than the name of their new company. Those personal loans put John and Mary’s assets at risk. How much risk is involved depends on the kinds of loans obtained.
A secured loan taken out against the equity in the couple’s home puts their most important asset at risk. An unsecured loan does not involve any collateral, but the couple could still lose significant financial assets in the event they fail to repay the loan and it goes to collection. Either way, the risk of personal assets is part and parcel with personal loans.
The Lender’s Perceived Risks
Start-up loans are not only risky to borrowers but are also risky to lenders as well. Indeed, risk aversion is one of the most important factors in small business lending. Loan managers and underwriters are tasked with evaluating every single loan application for the purposes of determining how risky it is. The greater the risk, the less willing the lender is to make a loan.
This matters to John and Mary because the amount of perceived risk associated with their loan application will determine interest rates, terms and conditions, and even the amount they can borrow. The more risk they present, the less likely it is they will be approved by a traditional bank or private lender. And even when approval is forthcoming, higher risk means a higher total cost of borrowing.
Risk Aversion in Private Investment
The risky nature of start-up loans is such that John and Mary may not be able to get the funding they need from a traditional financial institution. They may be forced to look at private investment options including angel investing, private equity, and peer-to-peer lending.
The good news is that private investors tend to be less averse to risk. For better or worse, they tend to be more willing risk takers. This is good in the sense that private investment makes it easier for business owners like John and Mary to obtain the funding they need. That is bad in the sense that such funding rarely comes without a cost.
Private investment almost always includes partial ownership. In other words, investors are given partial ownership of the company in exchange for the funding they provide. They are able to exercise a level of control commensurate with the amount of funding they contribute.
As you can see, risk aversion can influence start-up loans in many different ways. The three mentioned here only scratch the surface. The lesson for John and Mary is one of sitting down and seriously considering all of the risks involved before they start searching for funding. Their goal is to find a source of funding that maximises value and minimises risk.