How to De-Risk a Startup
In a previous post, I wrote that startups are collections of risks, and that the best way to make progress on a company (and to get higher valuations from investors) is to address the biggest risks as quickly and thoroughly as possible. But how do you actually mitigate different types of risk? How do you convince yourself that you have product/market fit? How do you persuade investors and employees that you can build a lasting company? How do you demonstrate to early adopters that you're good at building products?
This post contains a (non-exhaustive) list of common startup-related risks, the spectra along which those risks might be classified, and some tips and heuristics for mitigation. The further you move from "high risk" to "low risk" along each spectrum, the stronger your valuation, perceived progress, and likelihood of success will become.
The entries on each risk spectrum are rated from 1 (high risk) to 5 (low risk). Your goal is to move away from the 1's and toward the 5's. For example, if you were trying to prove to a friend that you could bake a great cake, then the risk spectrum might look like this:
-  You've never baked a cake before, but you're sure you could do a good job.
-  You show your friend a picture of a nice cake you made in the past.
-  You introduce your friend to people who have previously tasted your cakes and loved them.
-  You let your friend taste an amazing cake that you just made.
Most of the example risk spectra that follow can be summarized by three core principles:
Principle #1: showing is better than telling.
-  You think you can do XYZ.
-  You've done XYZ in the past.
-  You're currently doing XYZ, and doing it well.
Principle #2: external validation is stronger than your personal opinion.
-  You claim XYZ.
-  Numerous people who are affiliated with you (friends/accelerator batchmates/etc.) claim XYZ.
-  Numerous people who are completely unaffiliated with you claim XYZ.
Principle #3: more data is better.
-  Your product has 0 sales.
-  Your product has 5 sales.
-  Your product has 50 sales.
9 Risk Spectrum Examples
As a caveat, the following are based on my personal risk "ratings." Other people might look for different proof points or have different ratings for the same proof points.
1. Product/Market Fit Risk
Goal: prove that you're actually building something that people want.
-  You think people will want to use your product.
-  You talked to potential customers, and they said they wanted to try the product once it was built.
-  You have LOIs (letters of intent).
-  You have unpaid pilots.
-  You have paid pilots.
-  You have paid contracts. Ideally prepaid.
-  You think people will want to use your product.
-  You have some early users, but they're all affiliated with you (friends, family members, etc).
-  You have some early unaffiliated users, but user acquisition economics aren't great.
-  Your user base is growing organically at a moderate rate.
-  Your user base is growing quickly through affordable paid acquisition.
-  Your user base is exploding through referrals and word of mouth.
-  Engagement is very low, churn is very high.
-  Engagement and churn are both moderate.
-  Engagement is very high, churn is very low.
2. Product Quality Risk
Goal: prove that you can build a great, high-quality product.
-  You are sure you can build a great product, but haven't built one before.
-  You plan to outsource product development.
-  You have a prototype, and it's very mediocre.
-  You've previously been on a team that built great products.
-  You previously led a team that built a great product.
-  You have a prototype, and it's good.
-  You have a live, fully-functioning product and it's amazing.
3. Team Risk
Goal: prove that you've assembled a great team for achieving your vision.
Your product requires strong execution across many functional areas (eng, sales, UX design, etc.) and...
-  ...your full-time team only covers 1-2 of those areas.
-  ...your full-time team only covers 1-2 of those areas, but investors and advisors fill in most of the gaps.
-  ...your full-time team covers most of those areas.
-  ...your full-time team covers all of those areas.
4. Recruiting Risk
Goal: prove that you will be able to grow your team effectively. (This is a very real risk in Silicon Valley, where demand for good engineers is much higher than supply.)
-  You've never hired anyone before.
-  You're not someone people would want to work with. (E.g. you're a jerk.)
-  You have some interviewing experience.
-  You have prior recruiting and management experience.
-  You've built very strong teams in the past.
-  Your team already includes several great hires.
-  You're currently able to reliably recruit in-demand candidates through personal charisma, a strong company mission, an amazing company culture, or something similar.
5. Sales Risk
Goal: prove that your team can sell the product effectively.
-  No one on your team has any sales experience.
-  You've done sales, but not much or not recently or not of the same flavor that you'll need for your company.
-  You're successfully selling you product, but it's significantly underpriced and/or sales are taking much longer than expected.
-  You've done a lot of sales work that's similar to what you'll be doing at your startup.
-  You've built and led successful sales teams in the past.
-  You have a strong, experienced sales team.
-  You're successfully selling you product at a good price and with reasonable sales cycles.
6. Market Risk
Goal: prove that if you execute well, you can make enough money to become a huge company (e.g. $1b+ exit potential).
-  Your target market is small and unlikely to grow quickly.
-  You have no idea how large your target market might be.
-  You found a Gartner report that gives an estimate of market size.
-  You have a plausible top-down analysis of market size ("People spend $X per year on this problem, and we think we can capture 15% of that with our solution.")
-  You have a plausible bottom-up analysis of market size ("We think we can capture 10% of users in group A and 20% of users in group B, and we plan to charge those users $X and $Y, respectively.")
-  You have a plausible bottom-up analysis, backed by experiments and data. ("There are X million potential users for our product, and we've done some tests that show each user would be willing to pay $Y/month")
-  Incumbent companies are huge and demonstrate that there's a big market for what you're doing.
7. Funding Risk
Goals: prove that you have enough capital to reach the milestones needed to raise more money on better terms (if you want to), and that you have a viable back-up plan if you can't raise money on your ideal timeline.
-  Your business will not be self-sustaining for a long time, and you're completely dependent on raising many rounds of venture funding.
-  You have multiple well-funded competitors and will need tons of capital to compete with them.
-  There's no cushion between when you expect to have enough momentum to raise your next round and when your current cash balance will force you to try raising another round. (E.g. you think you'll need 12 months to get to $1m in revenue and 3 months to raise a Series A, and you have exactly 15 months of runway in the bank.)
-  You've successfully raised some venture capital before.
-  You've successfully raised tons of venture capital before.
-  You have good funds investing in your current round, and they will help guide you to your next round.
-  You have good funds with deep pockets investing in your current round. (That is, funds that could lead your future rounds if they wanted to.)
-  With some effort and sacrifices, you would be able to get to break-even without any additional capital.
-  You're not dependent on additional capital because you can easily become break-even or profitable at any time.
8. Short-Term Competition Risk
Goal: prove that you're differentiated from existing players in the market.
-  There are many competitors of all sizes (huge incumbents, young startups, well-funded startups, etc). These companies are attacking your target market from many directions.
-  There are many competitors, but they are ineffective legacy players or poorly-funded startups.
-  There are very few competitors, but no strong differentiation between you and them.
-  There are very few competitors, and strong differentiation between you and them.
-  There are no competitors and there's a high barrier to entry (which you have crossed).
9. Long-Term Competition Risk
Goal: prove that as you become successful and other companies try to copy you, you will be able to maintain your strong position.
-  You're not the first mover and you don't have a real competitive advantage.
-  You don't have a real competitive advantage, but at least you're the first mover.
-  You have weak competitive advantages: a few small patents, slightly better unit economics than new entrants, etc.
-  You have moderate competitive advantages: good brand perception among your customers, significantly better unit economics, a strong patent portfolio, etc.
-  You have strong competitive advantages, like network effects or a proprietary datasets, that get stronger as you grow
How to De-Risk
Step 1: Do an honest self-assessment of your company's major risk areas.
Step 2: List ways to move from high risk to low risk along each risk spectrum. If you're not sure what you can do, ask investors, advisors, or other founders.
Step 3: Create short-term and long-term risk mitigation plans for your company. Some of the action items might be small and easy, like running an AdWords test to estimate customer demand and market size. Other actions will take time, like figuring out an elegant way to bake network effects into your product or finding a good VP of Sales when no one on your team has sales experience.
- If there's little remaining risk in an area, focus on other areas. It is usually better to turn a few 1's into 3's than it is to turn a 4.5 into a 5.
- Good investors and advisors are an effective way of moving from a 1 to a 2 or 3. Maybe you don't know how to hire a VP of Marketing, but if one of your investors or advisors does then at least that's something.
Corollary #1: a great complementary founder can take you from a 1 straight to a 4 or 5 in some areas. That's a great way to boost your seed round valuation.
Corollary #2: pick your investors and advisors deliberately. People who can help in areas where you're lacking are more valuable than people with the same strengths as you.
- Get external feedback. Self-awareness is hard. Soliciting risk assessments from people you trust who will be honest with you is a great exercise.
- Try to address risks before you have to face them head-on. If you've never done sales, you can practice as soon as your product is ready. But you can also start practicing pre-launch, or even on a hobby project before you start your company in the first place.
Ultimately, addressing risks is not something you should do for investors, it's something you should do for yourself. If you're thinking of dedicating years or even decades of your life to something, it's worth understanding where your biggest challenges will be and how your can incrementally address those challenges.