Startups Are Risky
We all know that, but most entrepreneurs don’t know the first thing about how to manage risk. In fact, we wrongly assume important rules of risk management that it’s simply out of our control.
Traditional ideas and important rules of risk management make you think that it’s an unquantifiable quality of something that is mostly out of your control. For example, someone might call an investment “moderately risky”. But it’s something they don’t put a number on.
In this article, we will see the 6 important rules of risk management.
1. Risk Levels Generic Categories Like
- High Risk: Aggressive/Speculative
- Medium Risk: Moderate/Investment Grade
- Low risk: Conservative/Low Chances of Going to Zero
But what do these words actually mean? High risk of what, exactly? Is it a high risk of losing the majority of your investment? But how high is the risk? Is it 1%? 50%? 0.005%? And during what time period? A year? Ten years? The lottery is clearly high risk, but at least it is a quantified risk. You know going into it your chances of losing and in what time frame. This is one of the most important rules of risk management.
So why, when it comes to startups, is a risk such a hard thing to quantify? The only major statistic that is well known is that 9 in 10 startups fail. The reason risk is so hard to put your finger on is that managing risks in a startup is the founder’s responsibility. Said another way, the amount of risk and speculation in a startup is based NOT on the nature of the business, but on the nature of the founder’s attitude towards the business and risk management. It’s impossible to put a number on startup risk since the custodian of the business and risk management is always a variable in the risk factor.
2. How Do You Manage Risk in General?
Let’s look at the simplest form of a high-risk scenario (as defined by the ability to lose your entire investment): a simple coin flip.
What are your chances of bankruptcy in a coin flip? Well, it depends.
- Worst case: If you bet all your money on a single flip, your chance of bankruptcy in one flip is 50%.
- Best case: If you only bet 1% of your money at a time, your chance of bankruptcy in one flip is 0%.
- Conclusion: Managing the risk of a coin flip is the responsibility of the bettor.
Statisticians can even show you an optimal strategy if you are trying to maximize your expected outcome in a series of coin flip bets while minimizing your chances of going broke. If you bet 25% of your money on each bet, that’s the magic number for a coin-flipping scenario. It’s the number that is most likely to get you the largest payout balanced with the risk of going bankrupt. This is one of the most important rules of risk management.
In high-risk situations, nobody can predict the future. Nobody knows if the coin is going to go heads or tails next. Nobody knows if you have discovered the next Facebook idea or if it is going to fail like 9 in 10 other startups. But in the face of uncertainty, you can apply strategies that take this lack of knowledge into account. This is one of the important rules of risk management.
The size of the bet is an enormous and often overlooked factor for important rules of risk management. It is also completely in the control of the person embarking on the high-risk management.
3. Another Risk Management Technique
Before I apply these important rules of risk management concepts directly to startups, I want to explain one more tool that risk managers have in their toolbox: the stop-loss. In his amazing book What I Learned Losing a Million Dollars, Jim Paul tells us how he was so certain that soy beans were going to go up in price that he kept holding on to them until not only his million dollars was gone, but until he was half a million dollars in debt and went bankrupt.
What did Jim learn from this hair-raising experience? He learned that although many speculators (and make no mistake, all startup founders are speculators) find great success with no risk management strategies, you will with certainty go bankrupt at some point if you don’t manage your risks. The stop-loss is one of those techniques. In the stock market or futures trading, a stop-loss is a price at which you sell your investment… NO MATTER WHAT. This is one of the most important rules of risk management.
For example, let’s say you buy soybeans at $100 per share, you can put a stop loss in at $90 per share and it will automatically sell your investment when it drops to $90. You can also use a trailing percent, like 10%. If soybeans go up to $120 and then drop 10% to $108, they will sell automatically. You could apply a tighter stop loss of say 5% and it would sell at $114 instead of $108. There are two big advantages to using a trailing stop-loss while speculating. This is one of the important rules of risk management.
1) You have quantified your maximum loss! Just like buying a lottery ticket, you now know with certainty how much you have put at risk. It doesn’t matter if the stock goes down 75%, the amount you can lose is now capped at your stop-loss.
2) You have locked in your profits! With a 10% trailing stop-loss, you don’t have to predict where the top of the market will be, because you know that you are going to be within 10% of a local maximum.
Professional risk managers use techniques like bet sizing and stop-losses all the time for risk management. And yet entrepreneurs rarely if ever talk about these things.
4. Applying Risk Management Concepts to Startup Ideas
Lean Startup techniques can be thought of as important rules of risk management techniques. Minimal Viable Products is just another way to make smaller bet sizes. Failing Fast is just another way to say that you should put tight stop-losses on your startup ideas. But what is failure? When do you know a startup idea has failed? When do you give up?
On the one hand, you don’t want to give up early. You want to give every great idea you have a fair chance. On the other hand, you don’t want to be like Jim Paul and hold on to your version of a soybean investment until you have more than one broke.
One of the most important lessons from What I Learned Losing a Million Dollars is that you must decide on your strategy before you make your bet. If you are already doing an activity, you are intrinsically biased to justify why you are doing that activity instead of determining objective rules for when you know it’s failed. This is one of the important rules of risk management for start-ups.
For ten years, I didn’t have any stop-loss failure criteria before embarking on new startup ideas. I would go into a new project and keep working on it long after I lost interest in it and my heart knew it was a failure. I would feel like I was too deep into it to quit. I had told too many people about it. I was too invested to let it go. Holding on too long to a losing idea is a surefire way of going broke.
5. When to Give Up
Setting a stop-loss is a very personal thing based on your own risk tolerance levels. In the stock market example, someone who isn’t worried about high volatility might make a trailing stop-loss of 10–15%. A more conservative person might put a trailing stop-loss of 3–5% or even less.
In coming up with startup ideas, you must also create stop-loss criteria based on your own risk management levels. My personal startup stop-loss strategy is based on my excitement about an idea. When choosing a startup idea, the most valuable currency isn’t money (like in the stock market), it is your time. So the startup idea of stop-loss is based on time. This is one of the important rules of risk management.
If a startup idea doesn’t have to pay customers before I lose personal interest in it, I will walk away from the idea without any hesitation. There is no debate and no exceptions. Sometimes this means an idea lives for just a few days or a few weeks. Other ideas might capture my excitement for months or longer. But when I am no longer excited, I walk away.
Does this mean that not all of my startup ideas will get as much attention as they might deserve? Maybe. That’s the inherent risk in using stop-losses. You might get stop-losses out right before things really take off.
But the alternative scenario is much worse. Worse than missing out on a great idea that needs more time is holding on to a bad idea for too long. Trying to turn bad ideas into good ideas by execution effort alone is one of the saddest and most common flaws I see entrepreneurs making every day. This is one of the important rules of risk management for start-ups.
Great ideas are like trains, there is always another one coming. Worse than missing the first one that passes you by is being so busy working on fixing a dead train that you miss the working one right behind you.
6. Success in Startups
A new trend among successful entrepreneurs like Ev Williams is to create their own personal entrepreneurial incubator systems like The Obvious Corporation. In his own words:
“We started investing, incubating, and experimenting to figure out what worked and what we wanted to do at this stage in our careers; we just knew we wanted to work together on stuff that mattered.” ~Ev Williams
Medium, the most successful experiment to come out of The Obvious Corporation, was a product of a highly planned risk management strategy. Do a few things not knowing which ones would turn out heads and which one would turn out tails. Once the coins landed, look at the results and double down on the one with the most traction. This is one of the important rules of risk management for start-ups.
History forgets most entrepreneurial mistakes. Speculating on business propositions is more about being in the game long enough for one of them to work than most people understand. Learning the craft of long-term speculation is what separates the great entrepreneurs from the forgotten ones.