Managing Risk in a New Venture
Most definitions of entrepreneurs that I have seen include something along the lines of "someone who takes risks." While there is certainly some level of risk in every new firm, the process of starting a business should not be about taking risks; rather, it should be about managing the risk that is involved. There are two main sources of risk in a new venture: the risk due to uncertainty surrounding the business and the risk due to what is at stake if the business should fail. You can't get rid of all risk from either source, but there are steps you can take to mitigate it.
Risk Due to Uncertainty Surrounding the Business. No business is a sure thing, but much of the uncertainty can be resolved through analysis of three of its sources: the market, the operational model, and the financial model. Market risk is a result of many factors, including whether the market is large enough to support your business, whether the market is growing, what trends exist in the industry, how the competition is structured, and how distribution works. If industry trends are moving away from your product or service or if potential customers are already locked up by competitors, it will be difficult to gain customer momentum. The issue of market size is also important in feasibility analysis. For instance, if you are starting a microbrewery, it is important to understand that your market likely is not the nationwide microbrew market, nor the local beer market. It is more than likely the local microbrew market, which is much smaller. Additionally, you should understand what regulatory trends are occurring: If you want to open a cigar shop and lounge, for instance, you would be wise to consider the potential impact of anti-smoking laws. Again, though you cannot get rid of all of the risk in entering a particular market, you can reduce your margin for error by understanding the nature of the market and customer buying behaviors. As a mentor of mine likes to say, "Become a student of your industry."
Operational risk deals with whether the business can set up internally to deliver goods and services to customers effectively. For product-related companies, this will include manufacturing and assembly of goods, which is often difficult to set up in terms of cost and quality control. This is even true if outsourcing to experienced firms. For instance, your manufacturer in Asia may ship you goods that have the logos sewed on upside-down -- a simple mistake but significant problem (This happened to a start-up I know in the Twin Cities). Operational risk will also include logistical issues with delivery and returns and effective use of service staff. Remember that your ability to execute internally and keep costs under control will be essential to business success.
Financial model risk refers to the risk that the business won't work due to the numbers. For any business, you should generate financial projections to get a picture of where breakeven will occur and what will drive the business financially. In other words, make sure to understand what revenues and costs must be in order to make the business financially viable and what factors impact revenues and costs the most. This will tell you your critical factors for success and provide you with tools for managing the business. For instance, if your main cost drivers are labor and materials, then you should concentrate on methods that ensure efficient use of labor and lower input costs. Remember that the financial model paints the picture of all aspects of the business and that the business cannot be successful if it is not economically viable.
Risk Due to What is at Stake. There are really two aspects to consider here, opportunity risk and financial risk, and you should be sure that the upside of the business is worth the risk in both areas. Opportunity risk comes from the fact that if the business fails, you could have been doing something else with your time and money. There is not a lot you can do about this risk except to weigh the merits of all opportunities you have before making a decision on starting a particular venture.
The more important source of risk for most entrepreneurs is financial risk -- the tangible value that you and your investors lose when the business fails. One of the most significant strategies you can take to manage this risk is turning as many fixed costs to variable costs as possible. For instance, rather than investing money in a sales force and manufacturing facility, consider hiring sales representatives and outsourcing production. You also may be able to tie some product development or other initial costs to sales rather than paying for them all upfront. In addition to keeping initial investments lower, turning fixed costs to variable will also lower your breakeven point and reduce the likelihood of failure due to lower-than-anticipated sales. This will help to deal with some of the uncertainty about sales levels early on.
Of course, these concepts work together: In a venture where there is more at stake if the business fails, it is in the entrepreneur's best interest to spend more time reducing uncertainty surrounding the business. However, do not get caught in what is called paralysis by analysis: don't spend so much time doing research that you miss the market opportunity. The key is to do enough research that you feel the opportunity is right, take steps to limit the downside risk, and then execute your plan!