Startup Risk Management & Next-Generation Business Models (1)

Although dealing with uncertainty is at the heart of the entrepreneurial method, “Risk Management” is not a term often heard amongst early-stage entrepreneurs.

This is not to say that entrepreneurs are ignorant about risk. In fact methodologies like Agile and the Lean Startup, with which many entrepreneurs (particularly “techpreneurs”) are intimately familiar, can be viewed as “risk-based” frameworks for business growth. Nonetheless, the entrepreneur will generally find a basic knowledge of traditional risk management to be a very useful addition to his mental toolkit. And the lingo of risk management tends to have a salutary effect on even the most world-weary investors.

Professional risk managers distinguish between four risk management techniques, collectively referred to as the “4 T’s”: Take (or Tolerate), Treat, Transfer, and Terminate.

· Take: Intentionally pursue the course of action and fully accept the risks;

· Treat: Carry out actions designed to modify the reality and reduce the risk. Actions may be focused on organisational, human, policy, operational, or supervisory factors.

· Transfer: Pass the risk to another party. Examples include insurance and outsourcing.

· Terminate: Don’t do it.

Glyn Holton argues eloquently for the inclusion of a fifth technique that he refers to as “Investigate”, but in one’s view investigation is something that should be done as part of “Treat”, and in one’s experience many organisations handle investigation as part of “Take”. And “4T + I” doesn’t sound neat.

Financial markets, starting in the early 70’s with the popularisation of the Capital Asset Pricing Model and the emergence of the Black-Scholes option pricing model (readers interested in the early history will find a very readable account by Robert Merton in his Nobel Lecture), have developed sophisticated vehicles for Treat-ing and Transfer-ing risk.

Many of these are financial derivatives, the most common being futures, forwards, options, and swaps. We will return to these in the next article.

So much for financial risk. Most “cash-light” startup entrepreneurs are not yet at the point where capital allocation is their most pressing headache. The more fundamental question is how to minimise the risk of wasting time and energy.Life is too short to build something nobody wants”, as Ash Maurya says.

For the purposes of this article we shall refer to time/energy wastage as “friction”. What can startup entrepreneurs learn from risk managers about minimising frictional losses generally, and from the financial markets about minimising friction specifically through Treatment or Transfer?

The emerging lexicon on the startup method (heavily influenced by the contributions of Frank Robinson, steve blank , Eric Ries, Ash Maurya, Marc Andreessen et al) identifies the first two key phases/challenges of building a startup as: achieving Problem-Solution Fit (“PS Fit”) and then achieving Product-Market Fit (“PM Fit”).

In these early stages, minimising the frictional component inherent in learning from potential customers while fine-tuning the product tends to be the big challenge (even when it comes disguised as a “burn rate” issue, complete with a dismal-looking cashflow forecast).

According to Eric Ries: “Startups that succeed are those that manage to iterate enough times before running out of resources”. Unfortunately many entrepreneurs focus on the “resources” which are finite and over which they (usually) have less control, instead of on the “iterations” which they can learn to accelerate by following processes that manage risk and reduce friction.

The major frictional components that will be encountered in the journey from Idea to PM Fit can be summarised thus:

PS Fit

1. Defining a low-risk way to prove the idea will work before committing fully.

2. Finding early adopters.

3. Using feedback from early adopters to refine early-stage product design;

PM Fit

4. Establish a team and processes to support continuous improvement ;

5. Progressively iterating towards “PM Fit”, however defined.

Having laid out these five “high friction” challenges, what do the 4 T’s have to say about them?

We apply the model to the five challenges in the table below. “Terminate” has not been given any treatment, as it is trivial for our purposes.

Frictional Challenge #1: Low-risk initiation

TAKE:

Just do it. Work harder. Think smarter.

TREAT:

Apply Lean Startup principles and develop an MVP. Note that identifying whether this is truly the “minimum” MVP is left to the entrepreneur’s abilities and creativity.

TRANSFER:

There is currently no formal risk management solution for the transfer of this type of risk. Getting a client to pay for the MVP (as often proposed) is a good thing, but it amounts to a point solution and doesn’t in itself achieve the objective of market testing.

Frictional Challenge #2: Find early adopters

TAKE:

Just do it. Hit the streets, work your contacts, and find prospects with the right characteristics.

TREAT:

Specifically look for Earlyvangelists. Nonetheless there is no sufficiently formalised process around this that would qualify as a “risk management solution”.

TRANSFER:

There is currently no formal risk management solution for the transfer of this type of risk.

Frictional Challenge #3: Establish the Feedback Loop from early adopters to early product definition/refinement

TAKE:

Just do it. Engage continuously with early adopters and incorporate features into product.

TREAT:

Adopt Customer Development and Lean Startup practices. Focus on earlyvangelists and validated learning.

TRANSFER:

Still nascent. In theory one should be able to hire a “market research” consultant with extensive lean startup experience, but these are very few and far between, and the risk of an unsatisfactory outcome is significant.

Frictional Challenge #4: Team & Process for continuous improvement

TAKE:

Just do it. Build the team and establish the processes, fine-tuning as you go along.

TREAT:

Adopt Agile. Adopt Lean Sprints. The detailed process for actual team building is not yet highly formalised, although a few rules of thumb regarding general structure have emerged e.g. “problem team + solution team”.

TRANSFER:

There is currently no formal risk management solution for the transfer of this type of risk.

Frictional Challenge #5: Iterating to PM Fit

TAKE:

Just do it. Work harder. Think smarter.

TREAT:

Adopt innovation accounting. Set specific metrics for PM fit using a combination of throughput and retention.

TRANSFER:

There is currently no formal risk management solution for the transfer of this type of risk.

So What?

From the above it is obvious that the entrepreneurial method has not yet matured to the point of developing solutions that can seamlessly or automatically Treat or Transfer startup-related risks using standardised and systematic mechanisms. Entrepreneurial risk management appears to be where financial risk management was about 40 years ago…

This highlights a number of opportunities for innovative new business models. We explore these in the next article.