Communicating Risk to Investors

Risk Framework Template

Most seed-stage startups do not have a well-refined risk management framework. If you want to stand out from the crowd when fundraising, consider taking the time to curate a coherent risk management framework for your opportunity. The 3-step process outlined below can help you get started.

Risk Identification

For the purposes of risk assessment in an early-stage startup, it is most valuable to focus on your unvalidated assumptions – of which there are inevitably a lot. These are the same assumptions you should be working toward testing through a customer discovery process, which has been outlined in Steven G. Blank’s book, The Four Steps to the Epiphany. In general, these assumptions are across the following categories: product concept; customers and the problems they want to solve; distribution and pricing; demand creation; market type; and competition. Below are some example assumptions listed for each category:

Product concept

I can manufacture it
I can secure reliable vendors

Customers and the problem

My target customers are who I expect them to be
My customer agrees that there are no good solutions available to them
My customer does not have a ready substitute that satisfies their need

Demand creation

X is sufficient demand for my solution to achieve breakeven
x% of my ideal customers will use my product regularly
We can reach our customers through channel x without an internal sales force

Competition

Market leader will not initiate competitive response until I have >x% market share
Acquisition, not competition, is the likely competitive response
Barriers to entry prevent new entrants
I have a strong IP defensibility position

Distribution and pricing

I can make it for $x
I can sell it for $x
I can secure a distributor to access x% of customers in initial target region
I can secure cost-effective distribution logistics

Market type, trends and drivers

This is a new market / existing market / resegemented market

Legal & Regulatory

I have the correct regulatory / reimbursement strategy
I have freedom to operate

Operational

I can recruit / motivate / retain top talent

With your entire team, get together and do a sticky-note brainstorming session considering risk factors and unproven assumptions that could cause substantial harm to realising your opportunity.

Risk Assessment

You could spend a lot of time worrying about the many risks that are possible. At this stage, it is most helpful to think about risks that are potential ‘company killers’, falling in the quadrants of high likelihood and major consequence.

Create a spreadsheet that assigns a score to the possibility of a wrong assumption and the level of impact if you are wrong. Multiply the likelihood score (from 1-5) and severity of impact (from 1-5) to get a risk score.

Scores that place that risk factor into an ‘Extremely High Risk’ or ‘High Risk’ classification you should be able to discuss a detailed risk mitigation strategy with potential investors. You certainly would not want them to raise a potential risk in this category that you had not considered.

Risk Mitigation

You can mitigate risk through insurance, risk sharing, or actions to minimise harm. There are three core principles of risk mitigation (borrowed from How to De-Risk a Startup, from Coding VC):

Showing is better than telling

You think you can do XYZ

You’ve done XYZ in the past

You’re currently doing XYZ and doing it well

External validation is stronger than personal opinion

You claim XYZ

Numerous people who are affiliated with you claim XYZ

Numerous people who are completely unaffiliated with you claim XYZ

More data is better

You have 0 data points

You have 5 data points

You have 50 data points

For each of your most critical risk factors identified previously, craft a mitigation tactic that can step down that risk using the principles above. For example:

You think people will want to use your product (unvalidated product/market fit assumption)
You talked to potential customers, they said they were interested
You have LOIs (letters of intent)
You have unpaid pilots
You have paid pilots
You have executed contracts
You have executed long-term contracts

It is also helpful to consider the cost of mitigation – an effective risk strategy weighs the benefit of mitigating the risk against the cost of doing so. One way of communicating the risks you are actively managing and monitoring is with a simple risk register table.

Summary

Like your business plan, your risk management plan is a living document. You should review and revise it regularly as your circumstances evolve.

Finally, although it’s important to develop a risk management plan, you shouldn’t obsess over it. Anticipating every possible risk factor is neither possible, nor practical. That’s because no matter how smart we are, and no matter how carefully we assess the situation, we can’t think of everything. What an investor wants to see is that you are thinking about risk and that you have a credible strategy for monitoring, assessing and managing risk.