Manage Your Startups Risks: How to Use Lean Principles
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 or 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 Squads 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 statisticsIn 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 / InvestmentPainting 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 relationship between the investment and the success:
Success = Opportunity * InvestmentYou 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 = RiskThis 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. 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 an 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 riskStarting 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 and experience onboard? 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?