Risky Business: Understanding Risk In The Startup World

Risk is inherent in everything we do. But what are we actually saying when we talk about “risk” in the context of a startup company? Is the accepted assumption that entrepreneurs have a high tolerance for risk accurate? Can the risk be defined? Is it the risk of the business failing, or the founders failing? What informs how we think about risk, and how can we better manage it?

We have embraced the myth that entrepreneurs need to have a high tolerance for risk. This is a simplistic way of thinking about entrepreneurship and perpetuates the acceptance that early-stage companies are risky, while simultaneously ignoring that because the risk is present, entrepreneurs aren’t simply required to accept risk, the real responsibility is to manage risk.

As a lifelong entrepreneur, I have lived through what happens when risks are unknown, unidentified, and become too great to overcome. As an investor, I have had to develop ways to perceive risk in companies as an indicator of future success or failure and attempt to assign metrics to articulate perceived risks. 

Risk Tolerance

Simply saying that entrepreneurs have a high tolerance for risk, is not only inaccurate, it perpetuates the self-fulfilling prophecy of failure. It is a simplistic catch-all that covers up errors in judgment and reinforces the belief in “opportunity” over execution.         

Founders are far more successful when they have a realistic perspective on the risks their business faces. A key characteristic of the most successful founders I have worked with is that they have almost unhealthy anxiety about their business and a fear of failure. They are constantly stressed testing their businesses for unforeseen events and are the prototypical laying-awake-at-night entrepreneurs. 

More times than not, their fears of what will sink their businesses never come to fruition. However, when a serious threat they didn’t anticipate challenges their teams, they react quickly, already have contingency systems in place, and are able to move quickly from reacting to the problem to executing a solution. 

I used to talk about having a high tolerance for risk prior to unpacking this statement to better understand it. I now believe that entrepreneurship is both a tolerance for risk and uncertainty, while also building the tools and skills needed to be successful at managing risk mitigation.

What is Risk?

One of the riskiest endeavors I can think of is rock climbing. The smallest single error can be fatal. Successful climbers are not the ones who run up the mountain in search of the rush and thrill, but rather the ones who spend a lifetime understanding how to identify hazards in their chosen sport and make micro-adjustments when the unforeseen happens. When climbers talk about risk, they speak about the level of exposure they are creating to these hazards.

Are you putting your business in the direct path of fatal hazards? Have you spent considerable time and effort paying attention to all the little details in your business? It’s no longer okay to just say that you can accept risk as part of being an entrepreneur. It’s your responsibility to obsess over the company you are building and plan the ways to navigate threats and hazards that are sure to develop along your route.

Risk in the Context of Entrepreneurship

Risk can be defined as the possibility of loss. Therefore, there must be some probability that the company will fail and any investment will lose value. A risky company can therefore be perceived as having more headwinds working against the management team which in turn has a compounding effect on the amount and frequency of the hazards that threaten the ability of the business to continue as a going concern.

Examples of Company Risk

• Management team risk (pervasive across all businesses and industries)
• Market risk
• Product or Service risk
• Execution risk
• Operations risk
• Financial risk
• Balance sheet risk (lack of assets, expanding liabilities)
• Technology risk

The relationship between risk and return that investors seek is referred to as a “risk-adjusted return” whereby the greater the risk of the company and potential loss of the investment, the higher the return must be to accept those risks. How the parties value a company becomes the direct articulation of reperceived (and agreed) risks.

Examples of Investor Risk

• Duration -how long will it take to create a suitable return?
• Liquidity - How readily can I get my money out? 
• Are there assets that can be liquidated to pay me back in bankruptcy?
• Can I influence the governance (and spending) of the company?
• Is there security in the investment to protect my downside?

Cognitive Bias in Entrepreneurship

How can we adapt our thinking to be more attuned to managing risk? We can start by understanding that our actions, driven by our thinking and cognitive abilities are predisposed to work against us. This is referred to as cognitive bias, whereby we as humans seek confirming evidence for beliefs we already hold. This is most clearly present when founders spend a disproportionate amount of effort talking about the market opportunity. They see opportunity and look for all shreds of evidence that reaffirm that belief. This however is conflicting with the reality that execution trumps opportunity and in order to manage risk, founders must be looking for evidence that contradicts their beliefs. Which is in turn is not how we are hard-wired as we naturally look for confirming data that distort our judgment.

Heuristic thinking such as making “gut” decisions or relying on “rules of thumb”, tends to be far more prevalent in entrepreneurs. The research indicates entrepreneurs rely more on these types of heuristic decisions in part because we operate in a condition of high levels of uncertainty. 

Most pernicious is that the research also indicates that entrepreneurs are a group that ranks very high in optimism and positive effect. We not only believe that events will only generate positive outcomes (every company has a hockey stick of revenue growth in their projections), entrepreneurs prone to these cognitive biases, also more readily believe they are capable decision-makers.

Conclusion

All too often founders see materially less risk in their companies today because they are so convinced that their vision of the future will unfold as they see it. This can become a fatal blind spot and lead to misrepresenting and how great the risk of failure is weighed against the probability of success. When all your efforts and projections are only pointing in one direction, it’s easy to lose sight of the downside and work to mitigate risk in parallel with all the exciting growth initiatives you and your team are most focused on. 

Accepting that hazards are most definitely along the road ahead, founders can shift their methods of thinking by being open-minded and pessimistic as a counterbalance to our predisposition for optimism. If you spend equal effort dreaming about how your company will fail, as much about dreaming of all the trappings of future success, you would already be a step ahead of your natural tendencies and most founders.