Managing Business Risk is a Key Consideration for All Entrepreneurs
“A ship is always safe at the shore – but that is NOT what it is built for.” – Albert Einstein
So how do investors perceive business risk, and how should you look at business risk as an entrepreneur? Well, generally, investors want huge return with no risk. How is that possible? Well, it isn’t. So investors are willing to settle for a clear path on how you mitigate risk in your startup, and how that will drive the enormous returns that they seek. One example is that investors want to know that you can see the market before others do, and that you will have a product that uniquely addresses the market opportunity just as it is ready to explode!
When you talk with a lot of people, business risk has an inherently negative connotation in business, but you have to take more risk to get higher returns, right? True, but you have to take the right kinds of risk, and even then, you need to mitigate those risks over time.
As an entrepreneur, it is important to understand where investors get their tools for assessing risk and understanding risk. Most VCs are MBA, and they have taken finance courses that include Modern Portfolio Theory, or MPT. In this theory, you want to eliminate “Unsystematic Risk”, where you don’t get a reward, and only expose yourself to “Systematic Risk”. You do this by managing your investments in diversified portfolios. However, an underlying assumption in MPT, is that markets are efficient. This is not necessarily a good assumption, even in the public markets, especially for small cap stock. In the private equity markets, it is a terrible assumption. So how should you look at risk then? Good investors, just like great entrepreneurs, need to take calculated risk exposure, and have a superior ability to assess risk-return. The entrepreneur also must have a strategy to mitigate risk as he or she builds her business. Now, as a VC or Angel investor, you should still diversify. As an entrepreneur, you don’t have that luxury, so you have to put “all of your eggs in one basket”. You are taking a more concentrated bet, but you are betting on yourself.
A great entrepreneur needs to assess the likelihood and potential negative impact or all significant risks, and mitigate or eliminate these risks whenever possible. Sadly for all of us, in order to drive exceptional returns, you must have risk exposure. As an entrepreneur, you’ll need to have a plan and path to assess and then mitigate risk through the accomplishment of key milestones.
(1) The Basic Types of Risk for a Startup
Entrepreneurs need to understand the three basic types of risk in any new business venture and how they apply to their specific business. The first is “Technical Risk”, and it applies to the amount of breakthrough science or technology that is required to develop your product. The next is “Market Risk”, which is all about the likely existence, the size, and the potential growth of your target market. The third is “Execution Risk”, and it is not just about “Can it be done?”, it is more about “Can you and your team do it, and in a timeframe where you will be relevant, and ideally dominant?
(2) The Additional Types of Risk for a Startup
Some other key risks include: Litigation Risk (Will a competitor or partner sue you?), Employee Risk (Will an employee sue you?), Contract Risk (Will a customer or supplier sue you? You have to be aware of Supplier Risk), Intellectual Property, or IP Risk (Will you get sued for patent or trade secret infringement, or will someone rip-off your idea?), and Product-Market Risk (Even if the market is big and growing fast, do you have the best solution?) With supplier risk, you might want to look into security risk management to ensure that you and your business is protected.
Most of these risks can be significantly mitigated with a good legal support team and implementation of a strategy. As the CEO of a startup, you will need to make “judgment calls” based on your experience and knowledge. Your attorney is there to help point-out the risks. It is the businessperson’s job to make the decision about taking that risk.
Product-market risk cannot be mitigated through a solid legal strategy, but it can be mitigated through a good marketing strategy. You do this by testing your ideas with real customers, and refining your product strategy as you get feedback.
(3) Methods for Assessing Risk and Risk/Reward
As an entrepreneur, you need to be able to ask and answer two very important questions about any decision that involves risk, which is pretty much every decision that you make.
Question #1: If I don’t do this thing, will it cost me and how much?
Question#2: If I do this thing, and it doesn’t go the way that I want, how much will it cost me and my company, not only short term, but over the long term?
(4) Strategies for Risk Mitigation
Accomplishment of Key Milestones is how startups mitigate risk and how they drive step-function increases in valuation. This will always translate into either more business or more predictable business.
(5) Risk Avoidance is Key for Some Things
There are some risks that you just don’t want to take, and you should avoid taking these risks. Getting back to the two questions above, if not making the decision doesn’t cost you anything, and the risk/reward isn’t a lot greater than the downside risk, then you probably should avoid doing it.
(6) As You Mitigate Risk, the Valuation of the Company Will Increase
The reason that entrepreneurs should clearly outline key milestones and how they mitigate risk is that it drives valuation. I like to think about a startup’s financial value growing like bamboo. When you plant bamboo, it takes a number of years before it starts to really grow. But once is stars to grow, it shoots up several inches or even a foot at a time.
(7) The Inherent Nature of Risk in Any Business Venture
Entrepreneurs need to understand that starting a company is risky. You will likely be taking more personal financial risk by starting a company than you do by working for someone else. There is also an “opportunity cost” of starting a company, assuming you can be gainfully employed somewhere else. However, if you are honest with yourself, and you have an enhanced capability to assess risk-reward, then you could be a good candidate for entrepreneurship. After all, we all take a risk when we get out of bed in the morning. We might as well take some risks that have the potential to create great value.
(8) Enterprise Risk Management (ERM) and “Risk Factors”
If you are very successful as an entrepreneur and you end up taking your company public, as the CEO of that company you will need to have a different understanding of assessing risk. As part of the SEC filing process, you will need to identify all the important “risk factors” for potential public investors in your company. If you don’t do a good job at this, then you expose yourself and your company to a significant amount of liability. In this case, it is really important to have an excellent corporate attorney that is familiar with this process, and a commitment from your management team to clearly articulate all the important risks for your company. The list needs to be comprehensive and cover all of the important “corner cases”. The focus is on “what can go wrong.”
As a public company, you will also be required to show that you are doing some level of Enterprise Risk Management, or ERM. If you do this right, you can focus on the key risk to the company without it being a lot of busy work on things that will likely never happen. One of the more popular processes used for this is the COSO ERM Framework. If you plan to take your company public, then you should familiarize yourself and your board with these things.
(9) Crisis Management is Inevitable in the Longer Term
If you run a company long enough, the proverbial “shit will hit the fan”, and you will need to have a plan to manage this. If not, it’s never too late to look into finding agency crisis help to prepare your company for any unexpected situation that can harm the organisation. It is best to be safe than sorry. Not all crisis management situations are as challenging as the situation that Johnson & Johnson faced with the poisoning of Tylenol in the mid-1980s, but you will most certainly have crisis moments that you will need to navigate. As the captain of the ship, it is important that you don’t panic, that you don’t ignore the issue, and that you actively manage and address the issue, and have a policy of open and direct communication.
(10) Perception versus Reality: Both are Important
As an entrepreneur, you will need to understand that “perception is reality” is more than just a catch phrase. It is critically important that you understand how people assess, understand, and process risks. Many times, you can mitigate by using facts and data to more directly align perception with reality. However, sometimes this cannot be done, and you, as the leader, will need to be empathetic, while still drive the strategy and direction of the company.
What do you think are the most important things for entrepreneurs to understand about risk?
This is Patrick Henry, CEO of QuestFusion, with The Real Deal…What Matters.