Start-ups see volume & variety of investors in the early stages.
The early stage start-ups are faced with may many challenges and as investors the due diligence process must enable identification of these risks and investors must proceed
with investment only if they have sufficient data and actionable strategies for the risk mitigation.
Researchers have identified various factors due to which the start-ups fail in delivering their promises.
Not all the risks can be identified early and mitigated, but some prominent risk parameters can be identified with the associated business model and the industry.
Careful consideration of these risks would enable:
- Better decision making at the time of investment
- Better portfolio management post investment
- Provide exit indicators
Thus 6 key risk parameters have been identified which work well in most of the businesses and industries.
- Product risk: Entrepreneurs love their product. One way for entrepreneurs to mitigate product risk is to avoid perfection. It’s a fallacy to think that any product will ever be “finished” in the sense that it will make all users completely happy. When the product becomes good enough to make some customers reasonably happy, it must be introduced in the market where it can start generating cash flow and feedback.
Market Risk: Market risks refer to whether or not there is sufficient demand for the offerings at the price set.
- This is where from the investors’ lens the observations & data regarding the market validation/Product Market Fit/Beta launch become crucial. It is important to not only know that the above were done but to carefully study the process, outcomes and observations.
- As Steve Jobs put it, “Real artists ship.” Until real customers start using and talking about the actual product there is no real way of knowing what is being done right and what is wrong.
Team risk: It’s important to have a great team and a personal sounding board -- a mentor, advisor, confidante or even a start-up incubator to help prepare for each challenge.
- There is no easy way to know how the market will receive any new product.
- Feedback from friends, surveys of potential customers, focus group testing, and beta testing are all useful techniques for helping to gauge market acceptance. But the real test of market risk is when people spend money on the solution available for sale.
- From the investors’ lens one needs to ensure the product addresses a big enough market, and the right opportunity within that market, at the right time.
Competitive risk: Every venture has more competitors and fewer competitive advantages than it thinks.
- Having a good team is also great for bouncing around ideas, build a product, bring it to market and maintain successful growth.
- Inability to build & maintain a strong team is a negative indicator towards the operations and scalability of the business. Entrepreneurs must invest early in people who believe in the product and instill a sense of confidence that can get the company across the finish line.
Financial Risks: The end of the road for any business is running out of cash. For start-ups, the biggest financial risk stems from not having a Plan B in case investors and lenders say no (or don’t say yes quickly enough).
- Competitive mapping (link to previous blog) about the number and clout of competitors & SWOT Analysis helps significantly in mitigating this risk.
- Having no competitor is a red flag (may mean no market) but having more than a couple of large ones may mean this is a crowded space. In such cases, intellectual properties contribute to keeping potential competitors from overrunning.
Legal & Regulatory Risks: Possible problems with legal or regulatory roots is almost endless: tax complications; disputes arising from poorly structured agreements; lawsuits filed by a competitor or trade regulatory inquiries.
- It may be more prudent to have two separate business plans: one for growing the business at finding an investor, and one for executing the business otherwise.
- Financial risks don’t disappear on fund raise and investors must factor other financial risks in the due course of the business before investing. Namely,
- Credit risk (default from customers)
- Price risk (increased cost of inputs)
- Exchange rate risk (variation in currency exchange rate)
- Interest rate risk (increased cost of capital)
- One way to mitigate financial risks for entrepreneurs is to take funding when available and keeping it in reserve for a rainy day.
The first step towards mitigating legal and regulatory risk is to learn enough about the subject. The second step is to onboard mentors, counsellors, or attorneys.
Investors must evaluate the regulatory and compliance framework of the industry and the business prior to investing and must evaluate the same with the expertise and capabilities to handle them both internal & external to the team.
Conclusion: Taking the above 6 major risks and other
Business/industry specific risks investors can lay out a competitive mapping which could enable in better decision making and close monitoring of the business growth.