3 Types of Start-up Risk: Market, Product & Execution Risk

I’ve been looking at a bunch of very (very!) early stage start-ups for the Capital Factory over the past two weeks. It’s interesting how most start-ups don’t consider their idea/start-up in terms of the three standard types of risk: market risk, product risk and execution risk. Taking the time to think through how to mitigate such risk over the course of a start-up’s life is critical because of the ever-evolving complexity between things a start-up can control and those it can not.  Of course, the other side of the risk “coin” is opportunity and potentially reward. As cliche as that sounds, it’s the truth, which of course is how all good cliches are born.

It’s always fun to google around and see how others have covered this topic; sometimes in similar ways and sometimes in very different ways. As with all these inherently subjective posts, this blog is based on my experience and my opinion.

Market Risk

Market risk is simply the risk (and therefore opportunity) of an idea within a particular market. It’s the obligation of the start-up to answer the question: “Why should my idea and my team exist in this market at this time?”

Very common things to talk about in this category of risk are “market entry strategy” and “market readiness” for a particular product or service. Market Risk assessment should take the “time-to-market” into consideration as well:  bringing a new semiconductor to market takes much longer than launching a bit of software or an iPhone app. What might happen in terms of competition, pricing, and market health by the time this product/service comes to this market?

Market risk, by definition, is one of the first types of risk that start-ups must consider as it represents the context for their product, team, and business in general.

Example

A contemporary example of “market risk” for a start-up would be a dependency on the shift of traditional advertising dollars to the digital realm, and in particular, ad dollars being disproportionately targeted at that start-up’s business.  Depending on how one counts, the traditional media (Viacom, News Corp, NBC-Universal, etc) and traditional advertising (Omnicom, WPP, Interpublic) industry is about a HALF TRILLION dollar industry.  That’s an enormous market and it is easy to see why hundreds of start-ups and hundreds of millions of dollars of investment are chasing opportunities in that market.  That said, the traditional media & advertising market is a peculiar one:  deeply adverse to change, commonly technologically challenged, highly insular, and very service/relationship oriented.  For even the best web application, a business model that rounds off to simply “we will make money from on-line advertising” is basically (a) not thoroughly thought out; and (b) crippled by market risk in today’s environment:  said plainly: there is significant “market risk” for this businesses compared to one that has a viable, alternative (freemium or subscription model, for example) path to revenue.

Another example of market risk is an idea that is significantly ahead of its time (or too late) for a particular market.  The broadband infrastructure market (DSLAMs and Cable Data type products) had a narrow, 3-year market window: 1996-1999, for the most part.  Trying to enter the broadband infrastructure market much before 1996, when dial-up Internet access was growing quickly and wildly dominant, would have been significantly risky.  Trying to start a new broadband infrastructure company after 1998-1999, when the major telcos and cable companies (and vendors like Alcatel and Cisco) had made their decisions, was equally risky if not impossible.

Next time (or very soon): Product and Execution risk discussions…

life-style businesses versus high-growth businesses

In 1998, after having worked at a number of start-ups, I started my first company (BroadJump; with 3 co-founders).  You could fill an ocean with all the things we didn’t know about start-ups, business plans, venture capital, and so on.  One thing we did know, because our investors made sure we understood, was the difference between a life-style business and a high-growth, venture-backed business.  The difference was spelled out primarily in terms of returns:  it was typical for high-growth / venture backed companies to gun for a 10x return or better on an investor’s capital. While the goal is much the same today, the “10x return” is increasingly rare in either acquisitions or IPOs and what makes a good return is up for discussion.

Let’s define what “life-style business” means (to me, in any case):

  1. it’s short hand for a business that, in general, does not REQUIRE or USE professional investors (venture capital) money to finance operations. When a business uses OPM (other people’s money), the explicit (or in many cases implicit) agreement is to accept the investor’s expectations around outcome and business’s performance.  Not using OPM means that life-style businesses typically are not obligated to growth / performance goals beyond “making ends meet” sort of profitability. If they happen to exceed such goals, fantastic.
  2. As a consequence of #1, life-style businesses are sink-or-swim operations for founders/principles who typically have much greater control, ownership, and accountability (fewer boards, fewer executives).
  3. “business sustainability” is significantly prioritized over “growth and scale” – this is inclusive of the notion that a life-style business is not built for a certain type of exit within a certain time frame

Here’s the point: a blind “swing for the fences, get a 10x return or die trying” approach to starting and growing a business is simply not realistic in today’s environment.  I’ll be the first person jumping for joy if those days return but I don’t see a reason to believe that they’ll be back any time in the next 3 years, if ever.  Some market segments are worse off than others, but every segment has been negatively affected to some degree.

For start-ups, especially web/software/SaaS start-ups, I believe the following is a time-and-place appropriate approach to growth:

  1. a highly-efficient, life-style business approach from seed-stage through profitability (or very close)
  2. an openness to positive exits at any stage (this has implications on control and ownership)
  3. balanced analysis ahead of using OPM to enter “high-growth” mode – but not losing the highly efficient heritage

UPDATE: March 28th:

There’s an interesting post at Techcrunch on the topic of risk aversion and selling early that makes sense to comment on given #2 above.  In short, the article makes two arguments for why companies sell early instead of swinging for the fences: after-the-fact risk aversion where companies sell as soon as a viable offer comes in rather than double-down and go for a much bigger return.

Most people in the world would take the certainty of $1 million over a chance they could make $30 million. I’m not knocking that. I’ll sell SarahLacy right now for $1 million. (Takers?) But I tend to think of people who make that decision as being risk-adverse. What was surprising to me, is that people who have a huge tolerance for risk on the front end– literally creating something out of nothing—become risk-adverse when they’ve proven that it’s actually worth something.

After-the-fact risk aversion is probably related to the second reason in the article: founder’s like solving the technical, early problem but not scaling and growing the company with discipline. The author also lumps Sarbanes-Oxley requirements of public companies into this category.

In other words, “the art of the hack.” Once it’s solved, managing the company, growing revenues, taking on HR problems—all of that is the boring part. He loves starting companies and has been successful at it, but he has zero desire to build one into the next Google. There are a lot of guys like that in the Valley, too, but they’ve also got a huge pool of experienced managers to hand the company off to.

I think both of these are true and worth assessing as any company grows. There will always be points in time and company scale where founders / managers fall out of their comfort zone – that’s one definition of success, by the way. That fact of start-up-dom is entirely distinct from how a company should execute:  you can always hire in experience scaling and growing a company at any stage; you can also find smaller parts of the larger problem to scratch the problem-solving itch that commonly excites early employees. Doing both could make sense if the decision is to double down and grow the company and its value to customers and the market – but make this last decision first, in the presence of as much data as possible; what to do about risk aversion and the love of problem solving will follow.

The Major-Indie Phenomenon: film, gaming & start-ups

In the not too distant past, the major film studios were on a big-star-big-budget path that targeted huge hits, big sequels and the mass-mass market.  Without going into the history of the independent (indie) film, this led to the advent of the “independent studio” that worked with much smaller budgets but also had the control and vision to create more interesting (and less mainstream) characters, stories, and movies in general.  Around the early 1990’s, Independent Film started to gain real commercial traction as actors and directors that were pining for more artful / character-based projects to display their talents and highlight their craft.  Realizing that there was a real (and valuable) market for more artful, less mainstream movies, the majors created or bought their way into the indie film market and today, most major studios have an “indie brand” that allows them to play in the indie space. It took a few clear success stories in the new, independent-film model to get them to pay attention to a different model than they were pursuing.

Hang in there; I promise I’m going somewhere with this….

It’s interesting that the above studio story could be applied almost exactly the same way to the gaming industry. In fact, the market for indie/casual games is probably at an all-time high today with the popularity of the iPhone, Nintendo DS, and web-based Flash games. The major studios in this market are folks like Electronic Arts, Nintendo, and Activision.  As the majors grew, they spent big bucks going after big hits with mass appeal…just like the majors in the film industry. The casual / indie game companies filled a void that the majors had a hard time focusing on because it didn’t fit their model. Of course, after a few success stories and a maturing market, the majors started to take notice and today all most major studios have a casual game strategy. Notice a trend forming here?

OK. So now I think there is a new version of this story just starting to play out.  Full disclosure: I’m working with the folks at CapitalFactory in Austin, Texas as a “mentor” for thier first go-round of the process . They’re similar to Y-Combinator and focused on helping start ups in a variety of ways, including early, limited funding outside the traditional Venture Captial system.

“Capital Factory is a seed stage mentoring program for startups that provides a small amount of seed capital and weekly mentoring sessions by entrepreneurs who have founded successful companies. Startup companies apply to participate in our 10 week summer program intended to get a startup pointed in the right direction with a clear path to profitability and growth. This year the program runs from May 22nd to August 7th. At the end of the program we’ll be hosting Demo Day and streaming it live over the Internet.”

Something interesting happened last week in this space:  Sequoia Capital, one of the best known Venture firms announced a $2m “investment” in Y-Combinator that will give them more capability to fund and help seed-stage start-up companies. You can get more information here, here, and here.  Y-Combinator funds about 40 companies per year and has launched or help launch over 100 companies to this point, including: Dropbox,  RedditInfogami, Kiko, Loopt, ClickFacts, TextPayMe, Snipshot, Inkling Markets, Flagr, Wufoo, YouOS, PollGround, LikeBetter, Thinkature, JamGlue, Shoutfit, Scribd, Weebly, Virtualmin, Buxfer, Octopart, Heysan, Justin.TV, OMGPOP, SocialMoth, Xobni, Zecter, Adpinion, and more.

What’s interesting is that early-stage start-up creation/funding/mentoring starts to map to the same major-indie phenomenon that we’ve seen in the film and gaming industries:

  1. In the presence of clear examples of success, major players in a mature market begin to notice real opportunity in a new (efficient, scalable) model within that industry
  2. The majors did not die off or get crippled because of the new model; their scale allow them adapt (build or buy) to the new model in their own way and timeframe
  3. The new-model folks found real, material success; further, new-model proponents & the new model itself was NOT crushed by participation from the majors (they co-exist)

Now the question becomes whether or not this trend contineus as macro-economic pressure makes early-early stage company dynamics less interesting to the major venture players. Time will tell but there is at least some history on the side of the trend.