Updated: May 20, 2020
Many founders and funders think of risk as a bad thing, but risk is a reality for a company or investment at every stage of development. Accepting risk as a reality, and developing mindset of seeking risk out can be a long-term competitive advantage.
By developing a culture that rewards surfacing and dealing with risk, you ensure that as you grow beyond the initial founding team, you can trust your team members to surface and mitigate risk, which adds value to your company even when you’re not in the room.
Communicating risk to investors to build trust
Many founders want to appear that they have it all figured out, and that investing in them is a safe bet, but investors know better. They have either run their own businesses or seen thousands of companies in your stage of development. They know that risk and uncertainty are always present. Hiding your risks makes their job harder, and making their job harder means they are less likely to invest.
Founders can delight investors (or advisors or partners) and build immense trust if they are authentic about the risks they face. As Paul Graham points out in How to Convince Investors:
“[Founders] think they're trying to convince investors of something very uncertain — that their startup will be huge — and convincing anyone of something like that must obviously entail some wild feat of salesmanship… [but] here's the recipe for impressing investors:
Make something worth investing in.
Understand why it's worth investing in.
Explain that clearly to investors.
If you're saying something you know is true, you'll seem confident when you're saying it. Conversely, never let pitching draw you into bullshitting. As long as you stay on the territory of truth, you're strong. Make the truth good, then just tell it.”
One easy way to be authentic with investors is to simply be honest about the stage your company is in. As Martin Casado points out in Aligning Startup Metrics with Stage of Maturity,
“My experience is that most pitches go sideways because the investor is led to believe there is more maturity in a company than there is.”
Using your fundraise to add value to your company
This authenticity will not only build trust, but can turn your fundraise into a process that actually adds value to your business. Authenticity signals to the investor that you are coachable, and open to learning from their experience.
This elevates the conversation from “what is the founder hiding?” to “how can I help?” This is the type of conversation that can lead to a valuable financial partnership.
Common mistakes when assessing and mitigating risk
Risk can be scary, but it is inevitable. Knowing common mistakes founders make when addressing risk—and the cognitive biases that often cause these mistakes—is crucial to reduce risk. Effectively reducing risk can help you build a durable venture, navigate uncertainty, or more easily secure funding. Here are some common mistakes in risk assessment and mitigation.
Not articulating your core assumptions
As Ann Winblad points out in Keep Testing Your Core Assumptions, one of the most common mistakes founders make is making decisions without articulating their core assumptions. If you don’t identify and regularly talk about which assumptions matter the most, you risk spending valuable time and resources on activities that don’t add value to your company.
Articulating your core assumptions means you can design experiments to turn these assumptions into facts, and de-risk your company. Tomasz Tunguz points out in Bounding the Unknown Unknowns that although business plans have “gone out of style”, they can be valuable precisely because they make you think carefully about your assumptions.
Not seeking outside perspectives on your company and its risks
Many founders, and founding teams, become so busy with their project that they forget to step out of their day-to-day operations and engage people outside their business to look at their business from an aerial view. This is a mistake, because stepping back from your venture and enrolling others in looking at it can help you avoid costly mistakes that others have made or experienced. As Satya Patel says in The Value of a Board at the Seed Stage,
“...As an entrepreneur, it’s easy to spend all of your time firefighting. A board meeting offers a fantastic opportunity to escape the day-to-day and spend some time thinking about the company’s overall goals and primary strategic issues...We’ve found that actually having time scheduled with someone to whom you feel responsible provides an opportunity to step back from the business and leads to regular and thoughtful conversations about issues that are critical to the business long term.”
Enrolling people not in the trenches of your business can help you with availability bias (a mental shortcut that relies on immediate examples that come to your mind when evaluating a specific topic). Other people have different experiences and skill sets, and will surface risks and assumptions that you may not even see.
Relying too much on outside perspectives on your company and its risks
Conversely, many founders rely too much on their observations of other companies or advice from people outside the company.
An example of this is seeing every other startup doing digital marketing, and becoming convinced that you should do digital marketing. Blindly copying a strategy that works for a different company ignores that your company is not that other company. Borrowing from Richard Feynman’s Cargo Cult Science, Leo Polovetz calls this phenomenon Startup Cargo Cults:
“Everyone in the startup ecosystem, from investors to founders to employees, is prone to Cargo Cult thinking. People try to extract lessons from the successes of others, but fall prey to numerous biases and fallacies. Our brains are wired to take examples of success and extract “lessons” from them, but these lessons often range between innocuously wrong and dangerously wrong.”
Even raising money is a behavior that many startups blindly copy from other companies. Most successful founders have realized that they don’t need to raise money, but that capital is just one of many resources they can choose to use or not. Raising money can add value, but it’s not required. Facebook “worked” ($600M raised), and so did Mailchimp ($0 raised).
There are also many “mentors” that will try to help you on your journey as a founder, and many founders treat successful mentors’ advice as “the right way” to build their company. Getting advice is worthwhile, but as Brad Feld points out in his post The Benefit of Mentor Whiplash:
“As the business grows, there are more points of stimuli, more agendas, more exogenous factors, and more potential whiplash. If you don’t build your own muscle around collecting, synthesizing, dealing with, and deciding what to do with all the data that is coming at you, then you are going to have massive problems as your company scales up. So learning how to do this early on your journey is very powerful.”
Validating assumptions that don’t matter (yet)
Every assumption you have about how to develop your company is a risk, but some assumptions are much less risky than others in the stage you are in right now. Founders often spend valuable time and resources on low-risk assumptions, or on risks that might someday be a risk, but don’t matter now.
Remember the “Matching your message and metrics to your stage” section of our essay on Investment Thesis and Value Drivers? The bets you are asking investors to make in each stage are highly correlated with the most-risky assumptions.
Team: Pre-product in market. The investor is betting on the team. Show why the team is right for the opportunity.
Examples of important assumptions: I’ve found a valuable problem. I understand my customer and can make something they want. I have people on my team that can help me achieve product-market fit.
Product: Post-product creation. The investor is betting that you have found product-market fit. Show real adoption/traction metrics, not one-off customer quotes.
Examples of important assumptions: I have a solution that customers will pay for. I can organize a team and company to deliver my solution.
Repeatable sales: Many similar customers are purchasing. The investor is betting that you have a large pipeline, and can grow the pipeline. Show sales cycle, and your sales pipeline or revenue backlog. Show that you have a playbook for creating revenue.
Examples of important assumptions: I can find and sell new customers. I have several sources of customers, that I can intentionally grow.
Unit economics: Widespread product traction. The investor is betting that you have a good gross margin and can scale profit/EBITDA. Show that your revenue can go up faster than your costs.
Examples of important assumptions: I can turn demand into revenue, and revenue into profit. I have a supply chain that can scale with my company. I can defend myself against competition.
This is not a comprehensive list of assumptions. The point is that any effort not spent turning the highest-risk assumptions into facts is a waste of time and puts your company at risk.
Only dealing with familiar or comfortable risks (known unknowns)
Many founders focus on solving the risks they feel comfortable with. For example, a technical founder might focus their time and resources on patenting their technology or building a great product, because that is an activity they know and understand. A sales-savvy founder might focus their time and resources on finding and acquiring customers or building a sales team. The problem is that the most important risks are often the risks you are least comfortable with.
This behavior may come from a combination of risk aversion (the behavior of humans, who, when exposed to uncertainty, attempt to lower that uncertainty) and the law of triviality (the tendency of people to spend a majority of their time on relatively minor but easy-to-grasp issues).
Effectively dealing with the uncertainty inherent in building a company starts with knowing the difference between the elements of the knowledge pie:
Things/risks you know you know (known knowns),
Things/risks you know you don’t know (known unknowns),
Things/risks you think you know that you don’t know (unknown knowns)
Things/risks you don’t know you don’t know (unknown unknowns or blindspots)
In early-stage ventures, there is a much greater number of unknowns than knowns. Arguably, a founder should be most worried about #3 and #4, but these are often the most uncomfortable risks to talk about or deal with.
Using resources to solve minor / low-priority risks
Unfortunately, the uncomfortable risks are generally the most important risks. As Leo Polovetz points out in Startups Are Risk Bundles:
“All progress is not created equal… If investors are not worried about X, then seed capital should not be spent proving that they’re right not to worry. One common example of this mistake is a very strong technical founder spending all of their seed capital on writing code and building a product, but not launching or getting any customer feedback.”
The most important risks are the existential risks, i.e. if they come to pass, they will cause your company to fail. The problem is, existential risks are scary, complex, or don’t have a known solution. This leads to another mistake.
Confusing risk with uncertainty
One of the most challenging aspects of building a new venture is extreme uncertainty. When you start a business, whether you know it or not, you are
Making a prediction about the future (market need),
Making a prediction that you can create and capture value (product-market fit), and
Making a prediction that other people aren’t making the same prediction (competition)
Businesses are run on predictions (i.e. forecasts), but the world is a complicated place. Let’s say you started a real estate investment firm in 2007. How much would your forecast have mattered to your success? Probably not much.
This problem arises because people often confuse risk with uncertainty, but they are not the same thing. As Frank Knight points out in his seminal book Risk, Uncertainty, and Profit, there is a massive difference:
Risk is present when future events occur with measurable probability
Uncertainty is present when the likelihood of future events is indefinite or incalculable
Many of the core assumptions in a new business are uncertain (they are incalculable or unknowable). Businesses do not exist in a vacuum (remember our fictional 2007 real estate investment firm). They are at the epicenter of social, political, economic, business, and consumer trends (see The Inevitability of Uncertainty for more detail).
Assuming most of the risk exists outside the company
When asked about risk, many founders may point to patents, competition, or market size as their biggest risks, ignoring that the biggest risks are associated with the founders themselves. As Paul Graham points out in The Hardest Lessons for Startups to Learn:
“...competitors are not the biggest threat. Way more startups hose themselves than get crushed by competitors. There are a lot of ways to do it, but the three main ones are internal disputes, inertia, and ignoring users.”
Over a decade, Noam Wasserman conducted research on 10,000 founders (see takeaways from The Founder’s Dilemmas) to understand the most common causes of startup failure, and found that 65% of startup failures were due to “people problems” such as relationship (interpersonal) problems, role and decision-making problems (control), and reward problems (incentives or equity splits).
In addition to “people problems”, many startups fail simply because they can’t execute, or can’t execute quickly enough to reach escape velocity (a viable product with paying customers and profitable unit economics). These risks often seem so simple that they are discounted by founders, and even scholars who study business strategy. However, as Raffaella Sadun, Nicholas Bloom, and John Van Reenen have found over 15 years of researching 12,000 companies, ability to execute can be a huge competitive advantage:
“To stay ahead, the thinking goes, a company must stake out a distinctive strategic position—doing something different than its rivals, [but]...If you look at the data...There are vast differences in how well companies execute basic tasks like setting targets and grooming talent, and those differences matter: Firms with strong managerial processes perform significantly better on high-level metrics such as productivity, profitability, growth, and longevity.”
As you can see, there are a myriad of mistakes you can make when trying to assess your company’s risks. This is why having a structured process is important.