Understanding Risk in the Context of the High Impact Startup: The Playing Field

By definition, high impact entrepreneurs tackle opportunities with high risk/reward profiles.  Most entrepreneurs – being optimists by nature – are more excited about the potential for outsized rewards than the challenges of dealing with outsized risks.  Most investors, on the other hand, focus more attention on risks of the new venture.  In fact, investors commonly look at risk reduction, rather than reward capture, as the key valuation driver for the venture, particularly in the development stage.  Today, I want to focus on how, in my diverse experience as a venture backed entrepreneur, angel and institutional early stage venture investor, and counselor to dozens of high impact entrepreneurs and investors, I think development stage venture investors think about risk at the 30,000 foot level.  

Market Risk.  Market risk has multiple facets, the more subtle of which are often overlooked.  The “big question” of course is whether there is a suitably attractive (size and/or growth potential) market for a new product or service.  The first, pretty straightforward if not always easy to answer but critical “next question” is the nature of the competitive – current and potential future – environment..  One of the biggest turn-offs for investors is the “we don’t have any competition” assertion that so many entrepreneurs (particularly rookies) include in their business plans and presentations.  There is always competition: it may not be “good competition” and/or it may not be available today, but it is out there.  It’s trite but largely true that any entrepreneur with a really good idea for a new product or service can be certain that they have company in terms of other bright folks thinking about the same market opportunity. 

The second subtle and even more often overlooked market risk is whether there is a realistic and attractive business model for the new product or service.  Can the market be accessed in a way that both delivers on the value proposition from the buyer’s perspective and is profitable for the producer?  The analysis here includes relatively simple enquiries – what, for example, the regulatory requirements are that might impede the business model – to rather more complex – whether, for example, a competitor with a sub-standard competitive product or service might have broader relationships with the target customer base that would make unseating it for the particular product or service impractical.” 

The bottom line on market risk is simple: do the basic “is there an attractive market” analysis but make sure you go beyond that and be sure to understand the competition (current and emerging) and to establish that there is an attractive and market-feasible business model. 

Technology Risk.   As most, but by no means all, high impact entrepreneurs are either technology-driven (say a biopharma startup developing a novel new class of antibiotic compounds) or technology-centric (say a company developing a new SaaS business model for a business process that has historically been done on a customer’s internal computer systems) many entrepreneurs approach risk primarily as a question of whether the technology “works.”  And technology risk in the basic will it work sense is an important (if often over-emphasized) component of the risk analysis of these ventures.  Unfortunately, while technology risk is often, relative to other risk components, easier to get a feel for, it is just as often misunderstood by entrepreneurs, particularly those coming from technical, as opposed to business, backgrounds. 

“Does it work?” may seem like a simple question, but it is in fact more subtle than many less experienced entrepreneurs appreciate, and it is the subtleties that drive the way investors tend to think about technology risk.  That is because the question is really not “does it work?” but rather consists of two related and more specific questions: (i) “does it work in a commercially relevant way?” and (ii) “are there more commercially relevant alternative technologies out there?”  A new antibiotic compound may work, in all the right clinical models, extremely well, but still not be commercially relevant because it simply costs too much to produce, on the one hand, or works for a range of infections that are already sufficiently controlled by other antibiotics with well-established market positions. 

In broad terms, the key to understanding technology risk begins with the “does it work” analysis (which itself may involve substantial capital and time investments), but is not complete with out the two-part commercial relevance analysis.  Tip for entrepreneurs: the commercial relevance analysis is not something you do after the “does it work” analysis.  You must address commercial analysis at the front end and throughout the life of the project, or risk the all too common mistake of investing time and money in proving out the technical feasibility of a project that, with a little commercial viability analysis, you should have killed off early on. 

Intellectual Property Risk.  Intellectual property risks (and rights, for that matter) are one of the most misunderstood parts of the risk puzzle.  First, many entrepreneurs (and more than a few investors) think that the commonly heard refrain that a new high impact business must have a “sustainable unfair competitive advantage” to merit investment means that such a firm must have some sort of magic bullet that no one else has access to.  The fact is, that while “magic bullets” do exist – for example the patent on aspartame (long expired) – that give their owners serious market power for some period of time, magic bullets are seldom as magic as they seem – saccharin, after all, lost sales to aspartame but remained (and remains) a significant player in the alternative sweetener market.  So, even if a startup has a “magic bullet” it will pay to thoroughly assess just how magic the bullet really is.

Alas, most startups do not, in fact, have magic bullets, at least not at the startup stage.  The more important IP risk question for most startups is not “does the entrepreneur have a magic bullet” but rather “does the entrepreneur have a feasible path to developing an important, if not magical, intellectual property moat around the business?”  Brands, for example, can be extraordinarily valuable IP assets: but almost by definition they have little or no value when the business is launched but rather become valuable if the business successfully nurtures them as it grows.  Too many entrepreneurs (and too many less experienced investors) think of IP risk solely in terms of magic bullets when, in fact, most startups rely more on IP assets they create on the fly than IP assets they start out with. 

Execution Risk.  Most entrepreneurs and investors, if asked to think of startup risk in terms of four elements, would include “the team” as one of the risks.  As it turns out, so would I – except that I think that the term “team” rather begs the real question: to wit, can this team execute on the (almost always evolving) opportunity.    The question is not “are these all good people” but rather are these the right good people to execute this opportunity.  

The best entrepreneurs and investors understand that building a team is not about drafting the best players (to use a football analogy) but rather about drafting the players best suited to manage through the particular technology, market and intellectual property risks that face the new business.  If the technology risk, for example, is more about transitioning a business process to an SaaS environment, you want a CTO with commercial development strengths, not a CTO commonly recognized as the brightest bulb on the theoretical bleeding edge of the computing-in-the-cloud universe.  If your ultimate IP moat is going to be your consumer brand, you want business development folks with consumer brand-building bona fides, not business-to-business strengths.  If your developing software for managing drug discovery and development processes, you want people with first-hand knowledge of that market, as opposed to people who, say, have been successful marketing administrative software to law firms. 

Conclusion.  As noted, the above is my personal take on a 30,000 foot view of how to understand risk in the start-up high impact business environment.  I have doubtless glossed over (or missed entirely) issues that some entrepreneurs and investors would think deserve at least a sentence or two even in such a short essay.  That said, I think that an entrepreneur who understands the “big picture” of risk analysis as outlined above will be well on her way to assessing her own startup’s risk, which is the first step to developing a plan that will convince investors that she can manage those risks.

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About Paul A. Jones

Serial venture capital backed entrepreneur, angel investor and venture capital investor; Co-chair of the VentureBest team at Michael Best & Friedrich, LLP.
This entry was posted in Entrepreneurship, Venture Captal and Angel Investing. Bookmark the permalink.

One Response to Understanding Risk in the Context of the High Impact Startup: The Playing Field

  1. Andy Reuland says:

    Great overview Paul,

    A question that I’m curious about is why don’t investors or startup blogs and networks talk about why the risks are actually important to making the venture highly valuable?

    I feel that the risks (or hurdles the entrepeneur has to conquer) are often what makes the venture a high reward opportunity if solved. If their are not challenges (and I’m not talking about the general ones all companies have to deal with) then it makes the venture too easy to copy or indefensible.

    Obviously to raise money and execute on a venture you have to show that you can overcome these risks, but often investors only focus on the negative aspect of this, and not that it’s a two sided coin. For example:

    I tell investor I will create the first company to overcome a major legal or industry barrier, and show that I have a plan and team to accomplish this. Most investors I believe would just say “find a venture that doesn’t have to solve this”, or “Can you just avoid this issue by changing your business model, or something else”.

    Now it’s great when you find alternative paths, and I’m all for the path of least resistance when it’s in the venture’s best interest, but often it’s the companies that figure out and solve these initial risks or challenges that become very successful.

    Any thoughts on the investor view on this, and why entrepreneurs can’t try to show that some risks are a good thing, rather than how we will avoid or find a space that minimizes them?

    I fell right now, if your an entrepeneur you have to play to the investor (and you should if you need their money!) on these topics, and often may change your company to something that even if funded because you avoided the risk, don’t reach optimal results.

    Great blog, keep the conversation and topics coming…

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