We’ve all heard the statistic that half of all startups fail within their first five years. The actual number is even bleaker. In a study of US firms formed in 1998, only 44% were still around only four years later, according to the Small Business Administration.
Risk and reward
What do we mean when we talk about risk? Simply stated, risk exists in any situation where there is a possibility of an outcome that we would rather avoid.
Unforeseen circumstances and their negative consequences are the very essence of risk. If we could predict the future, there would be no uncertainty, and there would be no risk.
Risk surrounds us. The flip side of risk is opportunity. There is a direct relationship between risk and reward: the greater the potential upside, the greater the risks involved. (As an aside, it’s worth noting that the converse is not necessarily true: situations that involve great risk sometimes have little or no upside. These are stupid risks to take.)
For entrepreneurs, this means that if you want to have a chance at success, you have to take significant risks. Entrepreneurship is neither easy nor risk free. And that’s exactly why more than half of all startups fail within a few years.
While risk is an integral part of entrepreneurship, it doesn’t have to get the better of you. Great entrepreneurs achieve success through keen awareness and management of risks.
The risk management framework
“Risk Management” is the art and science of thinking about what could go wrong, and what should be done to mitigate those risks in a cost-effective manner.
In order to identify risks and figure out how best to mitigate them, we first need a framework for classifying risks.
All risks have two dimensions to them: likelihood of occurrence, and severity of the potential consequences. These two dimensions form four quadrants, which in turn suggest how we might attempt to mitigate those risks:
Once we know the severity and likelihood of a given risk, we can answer the question: Does the benefit of mitigating a risk outweigh the cost of doing so?
Identifying & mitigating the Company killers
Companies flatline when the cash runs out and total current liabilities (i.e., bills due now) exceed total liquid assets. Risk management is all about identifying and mitigating the uncertainties – especially the company killers – that surround cash flows.
Uncertainty plagues businesses in countless ways, but we can group most company killers into the following categories:
These categories are neither exhaustive nor mutually exclusive. Some risks span several categories. Let’s look at some examples.
Market risks refer to whether or not there is sufficient demand for what you have to offer at the price you set. Many inventors have died penniless, clinging to the belief that the market would beat a path to his door if he designed the better mousetrap.
Fortune 500 companies spend billions on market research, and every year, they introduce products that are an instant flop. On the other hand, in 1943, the president of IBM allegedly predicted, “I think there is a world market for maybe five computers.”
Unless what you sell is a commodity, there is no easy way to know how the market will receive any new product. Feedback from friends, surveys of potential customers, focus group testing, and beta testing are all useful techniques for helping to gauge market acceptance. However, nobody – not you, not your best friend, not your venture capitalist – can know for sure whether people will spend money on your solution until you actually try to sell it.
One way for entrepreneurs to mitigate market risk is to avoid perfection. It’s a fallacy to think that any product will ever be “finished” in the sense that it will make all users completely happy. When your product becomes good enough to make some customers reasonably happy, get it into the market where it can start generating cash flow and feedback.
As Steve Jobs put it, “Real artists ship.” Until real customers start using and talking about your actual product – as opposed to some mock-up you test in a focus group – you have no real way of knowing what you are doing right and what you are doing wrong. Release – observe – improve – repeat.
Every venture has more competitors and fewer competitive advantages than it thinks. If there is money to be made by satisfying a pressing need in the marketplace (is there any other way to make money?), you can be sure that plenty of others are gunning for that same consumer dollar.
To stay ahead of your competition, you must continuously ask yourself – and your trusted advisors – what others might do to try to beat you, and then develop appropriate defenses. Know your Strengths, Weaknesses, Opportunities, and Threats – S.W.O.T analysis isn’t just a business school exercise. Figure out what you do better than all of your competitors – whether it be price, features, quality, or some other advantage – and focus on maintaining your leadership in that category.
Technology & operational risks
It’s one thing to say you’re going into the business of making and selling widgets. It’s quite another thing to master the actual mechanics of making and selling widgets.
Technology and operational risks broadly cover everything having to do with execution: Can your team finalize the product design on a limited R&D budget? Will your product work as intended? Can you find reliable vendors? Can you manufacture it? Can you optimize the logistics of product distribution? Can you create an effective product support infrastructure? Will your firewall prevent hackers from stealing customer credit card numbers? Do you have a backup plan to keep your company running when an accident destroys some key equipment in your data center?
Mistakes are inevitable; we all learn from our mistakes and become better over time. Learning from past mistakes is important, but if you really want to increase your chances of success, then find some co-founders who have succeeded in the past.
The end of the road for any business is running out of cash. Some days, when you’re an entrepreneur, it seems like all roads lead there.
For startups, the biggest financial risk stems from not having a Plan B in case investors and lenders say no (or don’t say yes quickly enough). Many entrepreneurs fail because they make the mistake of betting everything on being able to secure outside financing.
Financial risks don’t disappear once your business is up and running. Any number of things can adversely affect the cash flows of operating ventures: Customers can default on your invoices (credit risk). The cost of your raw materials could skyrocket (commodity price risk). A strengthening dollar can reduce the net profits from your international customers, or a weakening dollar can jack up the cost of your offshore manufacturing operations (exchange rate risk). A spike in interest rates could raise the cost of your working capital (interest rate risk). A plunge in the value of stocks or real estate you pledged as collateral could cause your bank to cut your credit lines (asset price risk).
People are, at the same time, the most crucial and least predictable element of any business.
The right combination of experience, contacts, and temperament among the founding team can vastly increase a venture’s odds of success. Failure to recruit, motivate, and retain the right partners can spell doom.
As an entrepreneur, one of your most important responsibilities is to establish a clear vision and culture that the entire team can rally behind. Everybody needs to row in the same direction. Everybody needs to be able to tolerate each other for eighty hours a week. You must manage strong egos, mediate personality clashes and disagreements, and rein in rogue team members.
A company is only as strong as its weakest link. Don’t let personal relationships cloud your judgment: your old college roommate might be a good marketer, but she may not be the best person to market your specific product to your specific target market. If you discover that a member of your team isn’t going to work out, you need to fix it quickly before the situation gets worse.
Legal & regulatory risks
The list of possible problems with legal or regulatory roots is almost endless: tax complications stemming from your choice of legal entity or state of incorporation; disputes arising from poorly structured agreements; lawsuits filed by a competitor alleging misappropriation of trade secrets by one of the hotshot programmers you recently recruited from them.
The first step towards mitigating legal and regulatory risk is to learn enough about the subject so that you can fully appreciate what you don’t know. The Entrepreneur’s Guide to Business Law by Constance Bagley and Craig Dauchy is a great place to start.
The second step is to retain the right attorneys – usually, one for corporate matters and another for intellectual property matters. You must manage them effectively and follow their counsel when it makes sense.
Systemic risks are those that threaten the viability of entire markets, not just a single firm within a market. For example, rising default rates in the subprime mortgage market, and the subsequent domino effect among financial institutions created by linkages embedded in mortgage-backed securities and credit default swaps, have had a profound impact on the global financial system.
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