Downside . . . 

is the investor's risk that he will lose the money he invests in a company. While the downside in almost every venture investment includes some possibility that the investor will lose all of his money, most investors use the term in a more limited sense. They use it to describe a realistic appraisal of the probable risk in the situation.

Investors often talk about the downside in terms of possible scenarios the company's operations might follow. Some try to quantify the likelihood that the company will fail and the amount of money (or percentage of their investment} they will lose if it does. In the final analysis, however, there is usually as much "gut feel" in an investor's estimation of downside as there is hard analysis. For any company, the more likely it is to fail and the more money its investor stands to lose in a failure, the greater its downside and the less likely it is to attract an investor.

Venture investors use a number of deal-structuring devices to reduce their downside risks. Often, they delay part of their funding obligation and make it contingent upon the company meeting a predetermined benchmark. This allows the investor to postpone risking some of his money until the company has proven its ability to meet a goal. The later rounds of funding are put in at less risk when the company is more established. Taking collateral and guarantees also reduces the downside by increasing the probability that the investor can salvage something if the company goes under. Preferred stock and debentures do the same thing by giving the investor a preference over common stockholders when a company is liquidated.

Other investor practices also reduce the downside. Investor due diligence helps the investor pick good companies and avoid losers. Board of director seat and reports requirements from management help investors identify and, hopefully, correct problems early. Puts, buy-sells, redemptions, and registration rights can liquidate an investment before all is lost or help an investor get his money out of a modestly successful company and into something else.

Management can reduce the downside too. When they do, they increase the chance of getting funding at a reasonable price. The best way to reduce the downside is to anticipate strategic and operating problems and address them realistically in the business plan. This won't eliminate the downside entirely, but it will increase the investor's comfort and help management deal better with problems as they arise. Since most of the deal structuring devices that reduce the investor's downside also tend to increase the risks of management shareholders (by delaying needed funding, making it contingent on future events and giving preferences to the investor when the company fails), precautions that reduce everyone's risk (such as good planning) not only help attract new investors but also enhance the value of the management's shareholdings. See: Business Plan, Business Plan Format, Collateral, Convertible Securities, Co-Sale Agreements, Debentures, Due Diligence, Exits, Liquidity Agreements, Negotiation, Pricing, Puts, Stage Financing, Structure, Upside.