Risk and risk tolerance are important concepts for entrepreneurs and investors. Many people believe early-stage investors, venture capitalists, and successful company founders are people willing to accept a high degree of risk. I’ve found this to be far from the truth and, in fact, most often value is created by those intensely focused on identifying and efficiently managing risk.
In this five-part series on managing risk in high-growth technology companies, we’ll cover:
The job of a CEO is to manage total risk.Vinod Khosla
Merriam Webster defines risk as “the possibility that something bad or unpleasant (such as an injury or a loss) will happen.”
This simple definition highlights the two ingredients that create risk, a probability of an event and a potentially bad outcome. I often hear people telling entrepreneurs the biggest risk you have is uncertainty. And while removing uncertainty is for any successful business and certainly critical for any high-growth company, removing uncertainty alone does nothing to change the undesirable outcome.
Risk: “A state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome.”
Uncertainty: “The lack of complete certainty, that is, the existence of more than one possibility. The “true” outcome/state/result/value is not known.”
By separating these two, you are better able to identify the information you need to make better decisions and the actions you take (Right Thing, Right Time, Right Way) to reduce your exposure to risk. By removing uncertainty, you better understand your risk exposure and can better allocate scarce resources on actions to manage risk. Through these actions you can reduce the likelihood of a bad outcome, you can lower the impact of a bad result, or you can shift the risk to another party.
Let’s begin by looking at the major risks companies face when starting out, launching new products, and bringing existing products and services to new markets. The risk which early stage and high growth companies spend most of their time addressing fall into four categories:
Product – Does the product or service solve the problem?
Market – Is there a sufficient addressable market of customers with this problem?
Execution – Can the company build, market, sell, and deliver this solution profitably to this market?
Scale – Is the company able to execute as it grows rapidly.
Product Risks – Does your solution solve a defined problem and will people use your solution to solve their problem?
Can you build it? Will they use it?
Historically, product risk focused on can you build and deliver your solution. This has dramatically changed over the last few decades. The uncertainty around the cost and time it takes to build a software product, to “make it work”, is a small fraction of what is was 20 or 30 years ago. Today, the question of can you cost-effectively write software for all but the most complex systems is a resounding, “Yes!”. The product question of today is can you build a product that people want to use to solve their problem.
Eric Ries in his seminal book, Lean Startup, and Ash Maurya in Running Lean provide excellent advice on how to identify, prioritize, and manage Product and Market risk. These techniques focus on learning as much as you can as quickly and cheaply as you can in order to reduce the likelihood that you will develop a solution that does not have “Product/Market Fit”.
Maurya suggests starting by ensuring you have a sound Product/Problem Fit and suggests entrepreneurs focus on answering two big questions. The first asks if you understand the problem and have a solution that effectively addresses the problem. This, of course, means nothing if people are unwilling to use your product in it’s current form, at the expected price, and via the proposed business model. So the second question asks are enough people willing to purchase your business solution in the way you are marketing it to them at the price you have set?” Yes, this includes evaluating price points very early in your discussions with potential customers.
Market Risks – Is the addressable market sufficient for success with your business model?
Market risks are the risks associated with finding, selling, and servicing a set of customers willing to use your solution to solve their problem. Key risks here include:
Is the addressable market large enough?
Can you cost-effectively reach your addressable market?
Will you convert and retain a large enough market share to support your business model?
Can you build and maintain a competitive advantage over existing and new competitors in this market?
It’s clearly not sufficient to know that a large number of potential customers want a product, it’s not sufficient to know that a significant percentage of these customers are willing to pay your requested price for your product. You must have clarity around these two questions and a cost-effective way of finding, creating interest, and cultivating that interest into paying customers. Then you must meet or, better yet, exceed the customers’ expectations so they continue to use your product and help you secure other customers.
Dave McClure’s Pirate Metrics are a great way to evaluate the effectiveness of your ability to reach, convert, and grow your customer base. Separating the process into Acquisition, Activation, Retention, Revenue, and Referral (AARRR) along with metrics for each and then building a set of experiments to optimize each step has proved successful for many companies. Satisfying these items should lead you to have confidence that you have achieved Product/Market Fit.
Startup metrics information
For more information on metrics for early stage companies, see my post Knowing When You’re Ready to Scale
This is the first post in my Managing Risk for Success Series: Defining risks around Product/Market Fit. The next piece in this five-part series on managing risk in early stage and high-growth technology companies will be available soon.
Part 2: Business Model Risks
Part 3: Execution and Scaling Risks
Part 4: Identifying and quantifying risks
Part 5: Risks management strategies
Part 6: Prioritizing and optimizing risk exposure