Over the years, I have seen my share of business plans, and in startup-speak, we often talk about calculated risks. (See my entrepreneurship simulation.)
Weighing risk requires asking two questions: 1) what might the impact of X be? 2) What is the likelihood of X occurring? Necessarily, every assumption in a business plan is one of risk; who will comprise the management, team? What will the pricing model be? Etc.
The creation of a business plan risk score has some value, but more significant value arises from understanding where within the business plan risk resides and then working to reduce it. For example, the selection of a management team is a risk, but hiring a high-quality management team tends to have an overall impact on reducing risk.
A calculated risk entails minimizing impact and the likelihood of each risk. How is this accomplished? Startups reduce the number of assumptions by putting them to the test, i.e., will customers pay X amount of money for this product? In this case, the entrepreneurs can reduce the risk associated with pricing assumptions by finding a sample of potential customers who are willing to commit to purchasing the product before its completion, i.e., advance sales.
A startup, therefore, is a set of risks differing in impact and likelihood, each with unique significance. I have seen investors who refuse to invest in any company where the management team is unproven. Why? The selection of the management team is one of the highest-impact risks a startup can take.
What if a startup develops a two-dimensional impact versus likelihood chart and assigns values to each to derive an overall risk score? While the term impact could be interpreted broadly, it is typically understood to mean an immediate impact, such as an angel investor who decides not to invest, or a particular partner who does not align with the overall vision of the company.
This narrow interpretation fails to capture a more strategic impact such as the integrated nature and the system-wide impact of some risk items.
Returning to the example of selecting a management team and developing a pricing model, if the team is of poor quality then the ripple effects can be broad and deep, if a particular customer chooses not to buy the product, then the impact might be short-lived.
Generally, the guidance around startups is to reduce risk as much as possible and then proceed with launch. However, this advice is too coarse.
The recommendation should be more along the lines of focusing on and reducing the risk items that have the most significant ripple effect across other risk items within the business plan. In other words, startups need to consider the cause and effect of linked risks items. One risk item could increase the likelihood and impact on another risk item(s). Risks that ripple include management team selection, barriers against competition, and the shortage of financing.
To wrap this all up in four bullet points, here are the items to consider when devising a risk plan:
- Understand that assumptions are risks.
- Some risks have a ripple effect due to their systematic and integrated nature.
- Identify ripple risks by considering their impact on other risk items.
- Potential investors who spot ripple risks tend to shy away from financing, so reducing or eliminating them early on is in a startup’s best interest.
Reduce ripple risks impact by figuring out a way to decouple them from other risks; for example, create advisory panels for an unproven management team.
Do you see ripple risks in your organization? Share your experiences in the comments below.
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