Managing Startup Risks – An Entrepreneur’s Guide
At its core, running any business is a task in risk management. The risks arise from uncertainty about various aspects of the business – what will the customer preferences in the future be, will the firm’s technology succeed, how will be overall economy perform, what will the firm’s competitors do in the future, etc. It is important for the entrepreneur to be aware of the risk that she confronts in her business and prioritize them appropriately since some level of risk is inherent in every business. The typical entrepreneurial personality is less averse to risk and often ignores them. In the early stages, this is often a good thing because an over-focus on the risks can paralyze the entrepreneur to inaction. But as the business matures, the entrepreneur should adapt and be cognizant of the risks that the business confronts. Rather than attempting to bring these risks to zero, entrepreneurs should make a judgement call about which risks need to be mitigated (and to what extent) for their specific context. This article provides a general framework for assessing and managing the risks that confront most startups.
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Risk and opportunity are complementary – they are two sides of the same coin. Our markets work on the assumption that there is a direct relationship between risk and reward – the greater the potential upside, the higher the risks involved. However the converse is not necessarily true: situations that involve great risk sometimes have little or no upside; these are not smart risks to take. The successful entrepreneur understands these subtleties and is able to judiciously pick which risks to take and which ones to avoid. The entrepreneur achieves through a keen awareness and management of risks. Risk is an integral part of entrepreneurship, it should not overwhelm you.
An entrepreneur needs to identify the various risks that confront the venture and make an assessment of their importance to his or her specific situation. The act of starting a business is inherently risky:
- There is no guarantee that customers will like your products or services enough to purchase them.
- Entrepreneurs frequently borrow money to finance their venture in its earliest stages; there is a chance that they will not make sufficient profits to be able to pay these loans back.
- As a business expands, the founders will invariably have to delegate responsibility for certain tasks to employees whom they do not know well. The employees bring uncertainty and risk related to their skills and performance.
- Entrepreneurs do not know the correct price for their product at the beginning; they may have to raise prices or change their business model, running the risk of alienating customers.
- Whenever a business ventures into a new market or launches a new product line, there are risk involved with the logistics and geography.
- Business owners also have to face risks that are external to the day-to-day operations of their companies. These risks include natural disasters (earthquakes, tsunamis, volcanos), freak accidents (plane crashes, car accidents) and long-term environmental changes (global warming, freshwater depletion, etc).
Entrepreneurship involves accepting those risks that are necessary or unavoidable, while taking steps to mitigate those that can be controlled. Given that reducing down to zero is impossible (or extremely expensive), individual entrepreneurs must decide where on the spectrum of risk-taking they stand. What kind and how much risk are you prepared to accept? The answer to this question will depend on your specific situation; good entrepreneurs are the ones who can successfully answer it. In the rest of this article, we will outline the risks faced by most businesses and offer some strategies for mitigating them.
There are two major risks that every startup confronts regarding its team: (a) the risk of hiring the wrong team members and (b) the risk of losing good team members. These impact of these risks to the business are highest during the early stages of the company when it is dependent on a small core team; as the firm grows and is able to hire more staff, these risks get diversified and are reduced. However, there are good mitigation strategies in place to manage them.
During the early stages, the survival of a startup rests to a large extent on the industriousness and talents of the founding team. Risks include unskilled co-founders, disagreement amongst founders over money or direction of the business, and the departure of a talented founder. One good way to mitigate these risks is by choosing someone you already know well as a co-founder, as opposed to rushing into an ad hoc arrangement with someone you meet online or at a Meetup. To reduce the chances of knowledge gaps, make sure that you choose co-founders with skills complementary to your own. Think about drawing up a written founders’ agreement to minimize the probability of disputes about ownership and responsibility for individual aspects of the business. Once you have a good team, you can reduce the risk of losing them by providing them equity that vests over time. In other words, tie the individual success of your team members with the success of your business.
As your business grows and you delegate responsibility to employees, part of the success of your venture will rest in their hands. The earlier the hire, the more critical an individual is to the success of your company. To minimize the risk of working with the wrong person, hire slowly and fire fast. Multiple interviews with core team members are useful for getting a second or even third opinion on the hiring decision. Give applicants practice assignments as part of your recruitment process; those that are successful should be placed on a trial period as a further way of testing their suitability. Employees who do not perform as expected, who are persistently negative, critical or abusive are a threat to your business and should be let go as quickly as possible. Assuming the employee has a good attitude, some knowledge deficits are inevitable; you should cultivate such employees and provide them training to overcome any skill gaps. In general, a smart and hard-working employee should be retained even if there is a gap between his or her specific skills and your needs.
To prevent key employees from leaving, offer adequate financial compensation and add clauses to their contracts that prevent them from joining competitors. An options plan whereby employees are awarded equity that vests over time is also a strong mechanism to retain good employees. Similarly, spreading an annual bonus award over a period of time (such as four equal payments each quarter of the following year) is also a good strategy to retain good employees.
Below is a list of common legal risks that businesses face; successful management of these risks is essential to the long-term health and sustainability of the business.
Businesses that get on the wrong side of government regulations can face fines and even prosecution. To avoid this problem, companies should ensure that they comply with all the regulations that affect their business, including business licenses, employment laws, corporate governance, and tax compliance. Depending on your chosen industry and jurisdiction, compulsory insurance might be required for certain aspects of your business.
Errors & Omissions
Businesses run the risk of loss and legal liabilities resulting from inadequate or failed internal processes, fraud, human error in processing transactions, etc. These risks can be minimized by establishing standardized operating procedures and adding control steps at appropriate points in the process workflow. Furthermore, businesses should obtain a professional liability insurance that protects companies and individuals against claims made by clients for inadequate work or negligent actions.
To discourage competitors from stealing your innovation, consider investing in copyrights, trademarks and patents. Very small businesses should assess whether the costs of potential litigation (including opportunity costs) justify the expense of IP protection.
To protect your employees and avoid falling foul of Health and Safety legislation, entrepreneurs should formulate contingency plans for emergencies such as fires and explosions.
Running out of cash is often the end point in the life of any business. The managers of a business must ensure that they never get to this stage. However, there are many financial risks that can lead you to this stage:
- Customers can refuse to pay your invoices (credit risk).
- The cost of your raw materials or suppliers could rise suddenly.
- Customers may switch to a competing product and not buy your product or service any more.
- A strengthening local currency can reduce the net profits from your foreign customers, or a weak currency can increase the cost of running your foreign operations (exchange rate risk).
- A spike in interest rates could raise the cost of your working capital (interest rate risk).
- A plunge in the value of stocks or real estate you pledged as collateral could cause your bank to cut your credit lines (asset price risk).
- A slowing economy could reduce the demand for your firm’s product or service.
Not all of these risks are relevant for all businesses but an entrepreneur must know which ones may affect his or her venture. The best safeguard against running out of money is to have enough of it as invested capital. Entrepreneurs often find it difficult to raise money when they need it most; while everybody wants to give them money when they don’t need it. One way to minimize your financial risk and give yourself a long runway is to take funding when it is available and keeping it in reserve for a rainy day; this is the strategy that most “hot” startups take.
You can minimize your other financial risks by establishing a prudent cash management approach, A/R collection policy and proper budgeting.
Risk from Lack of Diversification
Reliance on any single factor (or a small group of factors) in any aspect of a business is a serious risk and should be carefully managed. This risk is often not recognized by entrepreneurs in the early stages of their business. But once this risk is identified, it can be managed by taking a proactive path to diversification.
Diversification is most often associated with financial portfolio management theory but entrepreneurs should realize that the general principles behind diversification also apply to running a business. The key insight of diversification is that you should not rely on a single (or small set of) factor(s) for any aspect of your business. Entrepreneurs should, therefore, prevent a concentration of risk in a small group of clients, vendors, products, employees, marketing channels or even geographies.
Small businesses that are financially dependent on one or two large clients run the risk that these contracts may fall apart or the key clients may run into difficulties of their own. To mitigate this risk, entrepreneurs should diversify their income stream and avoid having a majority of their revenue coming from a very small number of clients.
Marketing Channel Concentration
If you have a single marketing channel that is bringing most of your customers, what will happen to your business if that channel falters? A relevant example is the exclusive reliance on google ranking by several eCommerce websites. As a result of the changes to Google’s search engine algorithm, many websites saw a dramatic drop in their search results ranking with a concomitant negative impact on their business. You should consider how your business would be impacted if your principal channel disappeared overnight? The best way to avoid such a risk is to have diversified marketing channels.
Countries with political uncertainty, weak judicial systems, high rate of corruption, stifling bureaucracy, or high taxes can make it very difficult for entrepreneurs to launch and grow a startup. Entrepreneurs in such place end up spending majority of their time dealing with inefficient activities that do not create genuine value for their business.
To minimize the chances of falling prey to such bureaucracy, founders should consider setting up in a business-friendly jurisdiction that offers political stability, a rule of law, IP protection, no corruption, and low taxes.
Some risk is inevitable in business. To be successful, entrepreneurs must learn to accept those risks that are unavoidable and mitigate those that can be managed. The best safeguards against risk are a good core team, a business-friendly government, diversified marketing channels, and prudent financial management.