Entrepreneurship is all about risk. Building a startup is a risky exercise. But research has shown that most successful entrepreneurs are masters at analyzing and minimizing/avoiding risk. Just like investors, they view entrepreneurship not as a business of taking risks, but as one of mitigating and minimizing risk. From this perspective, we at StarterSquad developed an approach to de-risk your startup. It’s a way of looking at your startup from an investor’s perspective. It not only focuses on the upside of your enterprise, but builds in security to limit the downside. In this post we’ll summarize the approach, and offer a sheet you can use for yourself.
Upside focus: flaws in ROI statistics
In most pitches and business plans we see, founders make an estimate of the opportunity, showing the return on investment [ROI] in the course of a few years. That’s fine if all goes well. However, in these pitches it’s extremely rare to see any quantification of the risks.
There’s a problem with that. The best way to show this is by using a bit of simple math.
Let’s say the opportunity is described in terms of ROI. It usually boils down to an equation like this:
ROI = Success / Investment
Painting a pretty picture of the size of the success, asking for a relatively modest investment, will surely increase the ROI.
But the success depends on the investment, so let’s refine this a bit. A model I’ve seen a few times assumes a linear relation between the investment and the success:
Success = Opportunity * Investment
You could say that if the ROI is known, the startup is a machine that will turn money into more money at a certain factor. Depending on the total size of the market, and the likely penetration, you can then calculate what amount should be invested, and how much growth should be powered by reinvesting profit. I won’t go into that, because there’s a term missing from the opportunity. This is the risk: the likelihood of things not going according to plan.
Let’s replace “Opportunity” with “Opportunity (1 — Risk)”. This means that if there’s no risk, we assume Opportunity, and if there is some risk of failure, we negatively correct Opportunity for it. That gives us “Success = Opportunity (1 — Risk) * Investment”, which we can rewrite to:
where S = Success, O = Opportunity, I = Investment, R = Risk
This means that if the risk is higher, we need to repeat the investment more times to reach success. Investors do this by taking stakes in multiple, similar, and competitive startups.
As you can see this is a (1 — x) — 1 type relation. A graph will illustrate the problem.
The average startup failure risk is above 80%. At this magnitude, the influence of the risk on the investment is already five times larger than the opportunity itself. And this average risk, so the majority of early startups pitching to investors will have even higher risk. So why is nobody quantifying and mitigating risks as their top priority? Let’s change that.
The problem remaining is to quantify R. To do this we need to split the risk into categories that we can realistically estimate alone, and then calculate the total risk from that. Let’s start by identifying the sources of risk.
Sources of Startup Risk
Starting a new business is a risky exercise. As experienced entrepreneurs know, many things can go wrong. In general, four sources of risk can be distinguished when you look at startups:
- Team: Do you have the right skills & experience on board? What about the entrepreneurial aspirations of the team members? What personality styles do the founders have, and do they mix well?
- Market: Is there a market for the product? Do you solve a big enough problem? How do you get customers? What about the competition? Is there an unfair advantage that helps you get into the market?
- Finance: Do you have enough funds to have a runway? What routes to initial cash flow are present? Can you bootstrap the business in any way?
- Technology: What technological complexity are you facing? Can you re-use existing components? What technology choices do you need to make? Will the technology scale when the business scales?
In most startups, different people work on these risk sources. The lack of integration might be considered a risk in itself. Cooperating as marketers and developers will help you to analyze startup risk as an integrated exercise, and set priorities correctly across disciplines.
5 steps in de-risking your Startup
Key to the success in our approach is taking the steps as a team. Getting the best result is a joint effort by business people and engineers. To de-risk your startup you need to go through the following five steps:
1. Outlining your idea
First, you need to clarify your idea. There are several tools around to do this. In most cases, it starts with the solution. The Value Proposition canvas can be a useful tool for this. This can be extended into a full Business Model canvas. You don’t have to write down your whole startup in a business plan, but you need to have at least a solid understanding of the main components.
2. Identifying risks
In the next step you try to identify as many risks as possible, going back and forth through the canvases. You can do this the Customer Development way, by using hypotheses and assumptions. We normally like to focus on risks, since that makes it a bit more pragmatic.
3. Ranking the risks
The next exercise is to estimate and rank the risks. You do this using impact and probability occurrence as the dimensions.
4. Risk mitigation strategy
Next, you look at risk mitigation. What measures can you take to mitigate the risks? Lean Startup focuses on experiments, but we think mitigation strategies don’t always have to be experiments.
You start with the biggest risks and execute your mitigation strategy. In terms of Lean Startup, this would be the experiment that has the highest priority. You focus your efforts here. If you are not able to mitigate this risk, the other risks don’t matter.
The Startup Risk Management Sheet
We’ve developed a Startup Risk Management Sheet that helps you in the process. You can download it from our website, and use it to de-risk your startup (check the instruction video). You can also join us for a workshop “De-risking Your Startup”. Remember, investors don’t like to take risks. The outcomes of the workshop are therefore key in landing investment for your startup. Also, mitigating as much risk as possible, early in the process, proves to be very good for your personal health as an entrepreneur.