What do we mean by risks in a startup and do they ripple?
Over the years I have seen many business plans and in the startup world we often speak of calculated risks (see my entrepreneurship simulation).
Risk is divided into impact and likelihood of the occurrence of an event. Essentially every assumption in the business plan is a risk, the management team, the price charged to the customer, etc. Creating a risk score of business plan has some value, but more so is understanding where the risk of the business plan is and working to reduce it, for example, we know that the management team is a risk area of concern, a high quality management team tends to have an overall impact of reducing risk.
A calculated risk means we have minimized impact and likelihood of each risk. Part of this process is to reduce the number of assumptions by validating them, ie, will customers pay money for this product? We can reduce risk associated with the assumption about customers by finding someone(s) willing to commit to purchasing the product prior to its completion i.e. advance sales.
A startup is set of risks of different impact and likelihood and thus different significance. I have seen investors who will not invest in any company where the management team is unproven which suggests that the team is one of the highest impact risks.
We could develop a 2 dimensional impact v.s. likelihood chart and assign values to each resulting area on the chart to derive an overall risk score. While the term impact could be interpreted broadly, its typically interpreted to mean an immediate impact such as an angel investor doesn’t invest or a particular partner doesn’t align with the company.
This narrow interpretation fails to capture a more strategic impact such as the integrated nature and the system wide impact of some risk items.
If the team is of poor quality then the ripple effects can be broad and deep, if a particular customer doesn’t buy then the impact might be short lived.
Generally, the advice around startups is to reduce risk as much as possible and then proceed with launch. But this advice is too coarse.
The advice should be tailored to say something more, along the lines of reducing the risk items that have the largest ripple effect across other risk items. In other words, cause and effect linking of risk items i.e. one risk item could increase the likelihood or impact on another risk item(s). Items that ripple include the management team, barriers against competition and shortage of financing.
So when devising a risk plan:
– understand that assumptions are risks
– that some risks have a ripple effect due to their systematic and integrated nature
– investors tend to dislike ripple risks
– understand ripple risks by considering their impact on other risk items
– reduce ripple risks impact by figuring out a way to decouple them from other risks, for example, adviser teams for a weak management team.