Why five risks?
In the creation of a young company, there are five principal risks to be addressed by the entrepreneur. Professional investors will probe these five risk areas and make the decision to invest based upon comfort with each. So, it is important for the entrepreneur to identify, address and mitigate each of these in order to increase valuation and decrease the risk of ultimate loss of the business.
First: Product risk.
Is the product or service possible to produce at all, let alone economically enough to
compete in the marketplace? One way to mitigate this is by using early money to create a prototype, to perform market research, to complete the first generation of the product, or to deliver the service to a satisfied customer.
Second: Market risk.
Are you ahead or behind the market with your product or service? Will the public respond in numbers to buy, license or rent your offering? This risk can be mitigated by finding a customer willing to purchase as soon as a proven model is completed, and willing to state this in writing. Another is to gain the support of a core vendor who is willing to offer special extended terms to the company as its investment in creating the product in a finished state. A third demonstration of overcoming market risk is by holding controlled focus groups and gathering information from unbiased potential customers supporting the acceptance of the product or service.
Third: Management risk.
[Email readers, continue here…] A great idea often fails from the inexperience or inability of management to bring the idea to market. Similarly, great management often can manipulate an original idea or business plan into one much more attuned to the market, adding tremendous value that might have been lost sticking to the original plan. This is sometimes labeled “execution risk” addressing whether management can create and run the company producing the product acceptable to the marketplace.
Fourth: Financial risk.
Any new enterprise is at risk if there are not enough resources to get the company to breakeven, which is a proxy for stability. If a company truly needs five million dollars to get to breakeven, investors that provide the first million are greatly at risk of the company failing to raise the remaining capital or of subsequent investors valuing the company at a lower price than the first investors, causing a “down round” in which the early investors are punished for taking the first risk.
And fifth: Competitive risk.
If there are high barriers to entry with such protections as patents, long development time already spent or contracts with the major potential customers, then the risk of a competitor with more resources jumping into the frothy pool and taking advantage of the demand created by the company is minimized.
Reduction or elimination of one or more of these risks increases the valuation of the company and certainly improves its chances of survival and growth.
You may recognize these five as a slight variation on the “Berkus Method” which is often published and used by investors when valuing pre-revenue businesses. Here we expand the definitions a bit to encompass businesses that are still early stage, but perhaps beyond startup.