Business Crimes

What-Kills-Startups1.pdf

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What Kills Startups? Sooner or later, disaster will strike. A disciplined approach to iden fying and mi ga ng risks can help you beat the odds. Will you be ready?

We’ve all heard the sta s c that half of all startups fail within their first five years. The actual number is even bleaker. In a study of firms formed in 1998, only 44% were s ll around only four years later, according to the Small Business Administra on.

In any given year, among firms with employees, almost as many firms close or go bankrupt, as there are new startups:

e=es mate Sources: U.S. Dept. of Commerce, Bureau of the Census; Administra ve Office of the U.S. Courts; U.S. Dept of Labor, Employment and Training Administra on.

Some firms close by choice: the owner elects to re re or move on to something new, for example, and decides that it is easier to shut down the business than it is to try to sell it.

Most closures, however – even those that do not end in bankruptcy – are the result of unforeseen circumstances. It seems that Murphy’s Law affects entrepreneurs dispropor onately. O en, these disasters could have been avoided if company management had paid more heed to the principles of risk management.

Risk and Reward

What do we mean when we talk about risk? Simply stated, risk exists in any situa on where there is a possibility of an outcome that we would rather avoid.

Unforeseen circumstances and their nega ve consequences are the very essence of risk. If we could predict the future, there would be no uncertainty, and there would be no risk.

Starts and Closures of Employer Firms, 2003‐2007

Category 2003 2004 2005 2006 2007

New Firms 612,296 628,917 644,122 640,800e 637,100e

Closures 540,658 541,047 565,745 587,800e 560,300e

Bankruptcies 35,037 34,317 39,201 19,695 28,322

About The Author

Akira Hirai is the founder and CEO of Cayenne Consul ng, a firm that has helped hundreds of entrepreneurs prepare for the fund raising process by cra ing strategies, business plans, financial forecasts, and pitch decks.

Akira started two technology companies in Silicon Valley during the dot com bubble. His previous experience has spanned investment banking, management consul ng, so ware engineering, and sales management. He earned his A.B. in Engineering Sciences at Harvard University.

Akira Hirai Cayenne Consul ng 714.TOP.PLAN [email protected] @akira_hirai www.caycon.com

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Risk surrounds us. With plumme ng home values, sinking stock prices, and frozen credit markets, that fact is surely more evident today than ever before.

The flip side of risk is opportunity. There is a direct rela onship between risk and reward: the greater the poten al upside, the greater the risks involved. (As an aside, it’s worth no ng that the converse is not necessarily true: situa ons that involve great risk some mes have li le or no upside. These are stupid risks to take.)

For entrepreneurs, this means that if you want to have a chance at success, you have to take significant risks. Entrepreneurship is neither easy nor risk free. And that’s exactly why more than half of all startups fail within a few years.

While risk is an integral part of entrepreneurship, it doesn’t have to get the be er of you. Great entrepreneurs achieve success through keen awareness and management of risks.

The Risk Management Framework

“Risk Management” is the art and science of thinking about what could go wrong, and what should be done to mi gate those risks in a cost‐effec ve manner.

In order to iden fy risks and figure out how best to mi gate them, we first need a framework for classifying risks.

All risks have two dimensions to them: likelihood of occurrence, and severity of the poten al consequences. These two dimensions form four quadrants, which in turn suggest how we might a empt to mi gate those risks:

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Once we know the severity and likelihood of a given risk, we can answer the ques on: Does the benefit of mi ga ng a risk outweigh the cost of doing so?

Quadrant A: Ignorable Risks

Cost effec veness is an important considera on in deciding how we face up to risks. Risks with rela vely minor consequences and a rela vely low likelihood of occurring – those in Quadrant A of our framework – obviously aren’t worth spending a lot of me worrying about.

An example of a low‐likelihood, minor‐consequence risk might be the possibility of ge ng a flat re on your way to a rou ne mee ng. Assuming you service your car regularly and you drive on maintained roads, a flat re might cause you to be late to a mee ng once every ten years. It’s not a big deal.

Quadrant B: Nuisance Risks

The next category of risks are those we call “nuisance risks” – li le things that o en seem to go wrong, but whose impacts are easy enough to minimize through straigh orward changes in behavior. There are countless examples of nuisance risks and simple solu ons:

The printer runs out of toner while you’re preparing the proposal for the customer mee ng that starts in 30 minutes. Solu ons: don’t wait un l the last minute, and always keep extra toner on hand.

Your lead engineer gets the flu three days before the scheduled release date of your first customer beta. Solu ons: create a development process free of dependencies on any one person, and build in con ngencies for the fact that almost everything seems to take twice as long and cost twice as much as you originally expect.

You knock a mug of coffee into your laptop keyboard and coat your hard drive in cream and sugar, making your marke ng plan inaccessible. Solu on: use so ware to perform automated daily backups so that you’ll lose, at most, a day of work if you destroy your computer.

With a li le common sense, nuisance risks shouldn’t cause any lost sleep.

Quadrant C: Insurable Risks

Risks that could have major consequences but are rela vely unlikely to happen are o en insurable. Insurance is the prac ce of spreading the cost of an improbable loss across a group,

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so that no single individual bears the en re cost of a disaster. Everybody pays a premium to the insurance company, and the insurance company pays claim benefits when one of its customers experiences an insured loss.

Here are a few common forms of insurance and the risks they cover:

Property & Casualty Insurance can mi gate losses from fire, the , and natural disasters;

Key Execu ve Insurance can mi gate losses from the death or incapacita on of a management team member;

Liability Insurance can mi gate lawsuits resul ng from product defects or on‐site injuries to visitors;

Errors & Omissions Insurance can mi gate lawsuits from disgruntled customers; and

Directors & Officers Insurance can mi gate lawsuits in cases of negligence, harassment, or discrimina on.

Even uncommon risks are o en insurable. Some underwriters specialize in wri ng unusual policies: event cancella ons due to adverse weather; or injury to specific body parts (early examples include Jimmy Durante, who insured his nose for $50,000, and Fred Astaire, who insured his legs for $75,000).

Quadrant D: The Company Killers

Now we come to the Company Killers: the risks with both a rela vely high likelihood of occurrence and major consequences. These risks can sink startups and Fortune 500 companies alike. The survival of your venture depends on your ability to iden fy and mi gate the company killers.

The thing that makes company killers so deadly is that there are so many of them. Individually, they may seem manageable, but collec vely, they represent a true challenge for any entrepreneur.

For example, suppose you manage to dis ll your world down to just ten company killers and you think you’ve eliminated 90% of the risk in each category:

1. There’s a 90% chance that you’ve iden fied a genuine market need;

2. There’s a 90% chance that your addressable market is as big as you think it is;

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3. There’s a 90% chance that you can actually implement your innova on;

4. There’s a 90% chance that you can figure out how to sell it for more than it costs you to make it;

5. There’s a 90% chance that you have assembled the right management team to do the job;

6. There’s a 90% chance that you manage to stay one step ahead of the compe on;

7. There’s a 90% chance that you don’t get sued into bankruptcy;

8. There’s a 90% chance that you won’t get buried in regulatory red tape;

9. There’s a 90% chance that you don’t run out of money; and

10. There’s a 90% chance that nothing else goes wrong.

You might take comfort in the fact that any one of these risk factors presents only a 10% chance of sinking the company.

However, the probability of surviving all ten risk factors (making a technical assump on that the ten risk factors are sta s cally independent of each other1) is:

90% × 90% × 90% × 90% × 90% × 90% × 90% × 90% × 90% × 90% = 35%

The key insight here is that a company that is reasonably good at managing individual risks might have a marginal chance of surviving overall. That’s why “reasonably good” isn’t good enough – risk management must be among the entrepreneur’s core competencies.

1In reality, these factors are not sta s cally independent and there’s probably some overlap among these factors – I’m just using this to illustrate a point,

so don’t take these numbers literally.

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Iden fying & Mi ga ng the Company Killers

Companies flatline when the cash runs out and total current liabili es (i.e., bills due now) exceed total liquid assets. Risk management is all about iden fying and mi ga ng the uncertain es – especially the company killers – that surround cash flows.

Uncertainty plagues businesses in countless ways, but we can group most company killers into the following categories:

Market Risks

Compe ve Risks

Technology & Opera onal Risks

Financial Risks

People Risks

Legal & Regulatory Risks

Systemic Risks

These categories are neither exhaus ve nor mutually exclusive. Some risks span several categories. Let’s look at some examples.

Market Risks

Market risks refer to whether or not there is sufficient demand for what you have to offer at the price you set. Many inventors have died penniless, clinging to the belief that the market would beat a path to his door if he designed the be er mousetrap.

Fortune 500 companies spend billions on market research, and every year, they introduce products that are an instant flop. On the other hand, in 1943, the president of IBM allegedly predicted, “I think there is a world market for maybe five computers.”

Unless what you sell is a commodity, there is no easy way to know how the market will receive any new product. Feedback from friends, surveys of poten al customers, focus group tes ng, and beta tes ng are all useful techniques for helping to gauge market acceptance. However, nobody – not you, not your best friend, not your venture capitalist – can know for sure whether people will spend money on your solu on un l you actually try to sell it.

Entrepreneurs are, by defini on, risk takers. Strong risk management is an important source of compe ve advantage.

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One way for entrepreneurs to mi gate market risk is to avoid perfec on. It’s a fallacy to think that any product will ever be “finished” in the sense that it will make all users completely happy. When your product becomes good enough to make some customers reasonably happy, get it into the market where it can start genera ng cash flow and feedback.

As Steve Jobs put it, “Real ar sts ship.” Un l real customers start using and talking about your actual product – as opposed to some mock‐up you test in a focus group – you have no real way of knowing what you are doing right and what you are doing wrong. Release – observe – improve – repeat.

Compe ve Risks

Every venture has more compe tors and fewer compe ve advantages than it thinks. If there is money to be made by sa sfying a pressing need in the marketplace (is there any other way to make money?), you can be sure that plenty of others are gunning for that same consumer dollar.

Business is a contact sport, and some of your compe tors will play rough. They’ll copy your business model. They’ll try to out‐innovate you. They’ll try to out‐spend you on marke ng. They’ll start price wars. They’ll start rumors about your product. They’ll try to do an end‐run around your patents. They’ll try to steal your trade secrets. They‘ll try to poach your best people. Just because you’re paranoid, it doesn’t mean they’re not out to get you.

To stay ahead of your compe on, you must con nuously ask yourself – and your trusted advisors – what others might do to try to beat you, and then develop appropriate defenses. Know your Strengths, Weaknesses, Opportuni es, and Threats – S.W.O.T analysis isn’t just a business school exercise. Figure out what you do be er than all of your compe tors – whether it be price, features, quality, or some other advantage – and focus on maintaining your leadership in that category.

Technology & Opera onal Risks

It’s one thing to say you’re going into the business of making and selling widgets. It’s quite another thing to master the actual mechanics of making and selling widgets.

Technology and opera onal risks broadly cover everything having to do with execu on: Can

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your team finalize the product design on a limited R&D budget? Will your product work as intended? Can you find reliable vendors? Can you manufacture it? Can you op mize the logis cs of product distribu on? Can you create an effec ve product support infrastructure? Will your firewall prevent hackers from stealing customer credit card numbers? Do you have a backup plan to keep your company running when an accident destroys some key equipment in your data center?

When it comes to execu on, there’s no subs tute for experience. It’s all about careful planning and watchful management by people who know what they’re doing. Businesses started by rookie entrepreneurs blow up dispropor onately because they don’t know how to avoid even some more obvious land mines.

Mistakes are inevitable; we all learn from our mistakes and become be er over me. However, research by Gompers, Kovner, Lerner, and Scharfstein (Performance Persistence in Entrepreneurship, Harvard University, 2008) suggests that entrepreneurs with a track record of success have a much higher probability of future success (30%) than first‐ me entrepreneurs (18%). (The paper studied entrepreneurs who raised venture capital, and defined “success” as having or registering for an IPO.) Learning from past mistakes is important, but if you really want to increase your chances of success, then find some co‐ founders who have succeeded in the past.

Financial Risks

The end of the road for any business is running out of cash. Some days, when you’re an entrepreneur, it seems like all roads lead there.

For startups, the biggest financial risk stems from not having a Plan B in case investors and lenders say no (or don’t say yes quickly enough). Many entrepreneurs fail because they make the mistake of be ng everything on being able to secure outside financing.

It’s true that many types of capital‐intensive businesses do require significant startup funding. But if you’re a rookie entrepreneur, the odds of finding an investor willing to take a huge risk on you are slim. It may be more prudent to start a business that requires a more modest amount of ini al funding. You’ll also want to have two separate business plans: one for growing the business if you happen to succeed at finding an investor, and one for bootstrapping the business if you have to go it alone.

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If you do succeed at raising capital, the next trick is to figure out how to start genera ng enough revenues to cover your costs before you run out of money. If you thought raising capital was tough, you’re in for a surprise.

Financial risks don’t disappear once your business is up and running. Any number of things can adversely affect the cash flows of opera ng ventures: Customers can default on your invoices (credit risk). The cost of your raw materials could skyrocket (commodity price risk). A strengthening dollar can reduce the net profits from your interna onal customers, or a weakening dollar can jack up the cost of your offshore manufacturing opera ons (exchange rate risk). A spike in interest rates could raise the cost of your working capital (interest rate risk). A plunge in the value of stocks or real estate you pledged as collateral could cause your bank to cut your credit lines (asset price risk).

Entrepreneurs quickly discover that it’s impossible to raise money when you need it, and everybody wants to give you money when you don’t need it. One way to mi gate financial and other risks is to take funding when it’s available and keeping it in reserve for a rainy day.

People Risks

People are, at the same me, the most crucial and least predictable element of any business.

The right combina on of experience, contacts, and temperament among the founding team can vastly increase a venture’s odds of success. Failure to recruit, mo vate, and retain the right partners can spell doom.

Companies fall apart when it develops major ri s: when one fac on wants to move one way, while others seek a different result.

As an entrepreneur, one of your most important responsibili es is to establish a clear vision and culture that the en re team can rally behind. Everybody needs to row in the same direc on. Everybody needs to be able to tolerate each other for eighty hours a week. You must manage strong egos, mediate personality clashes and disagreements, and rein in rogue team members.

A company is only as strong as its weakest link. Don’t let personal rela onships cloud your judgment: your old college roommate might be a good marketer, but she may not be the best person to market your specific product to your specific target market. If you discover that a member of your team isn’t going to work out, you need to fix it quickly before the situa on gets worse.

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Legal & Regulatory Risks

Lawyers get paid the big bucks to keep you out of trouble. So do other specialists, if you happen to be in a heavily regulated industry like pharmaceu cals or air travel.

The list of possible problems with legal or regulatory roots is almost endless: tax complica ons stemming from your choice of legal en ty or state of incorpora on; disputes arising from poorly structured agreements; lawsuits filed by a compe tor alleging misappropria on of trade secrets by one of the hotshot programmers you recently recruited from them.

The first step towards mi ga ng legal and regulatory risk is to learn enough about the subject so that you can fully appreciate what you don’t know. The Entrepreneur’s Guide to Business Law by Constance Bagley and Craig Dauchy is a great place to start.

The second step is to retain the right a orneys – usually, one for corporate ma ers and another for intellectual property ma ers. You must manage them effec vely and follow their counsel when it makes sense (many legal decisions come with degrees of risk and reward that you need to balance). Finally, you must keep your a orneys informed of what’s happening in the business so that they can address poten al problems before they get out of control.

Systemic Risks

Systemic risks are those that threaten the viability of en re markets, not just a single firm within a market.

For example, rising default rates in the subprime mortgage market, and the subsequent domino effect among financial ins tu ons created by linkages embedded in mortgage‐backed securi es and credit default swaps, have had a profound impact on the global financial system.

There are plenty of less widespread, but no less real, examples: A spike in the cost of fuel is squeezing the en re passenger airline industry. The availability of low‐cost skilled labor in emerging economies is challenging the viability of many domes c manufacturing businesses. A suspected case of mad cow disease can corral beef sales for months or years.

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Pragma c Risk Management

Crea ng a pragma c risk management plan is straigh orward in concept, if not in execu on. Prepare a table with the following seven columns:

1. Risk Factor: List anything you can think of that could cause substan al harm to your business.

2. Type: Assign the risk to one of the categories described above, e.g. market risk, com‐ pe ve risk, technology & opera onal risk, etc. Assigning a type can suggest who might be best qualified to manage that par cular risk (for example, your CFO might be responsible for looking a er your firm’s financial risks).

3. Likelihood: Think of the rela ve likelihood of manifes ng this par cular risk factor. Simple descriptors like high, medium, and low should be sufficient.

4. Consequences: Describe what would happen to the company if this risk factor mani‐ fests itself.

5. Mi ga on Tac cs: List the things you can do either reduce the likelihood or minimize the impact of the consequences if this risk factor manifests itself. Note that just be‐ cause a tac c is available, it doesn’t mean you should employ it.

6. Mi ga on Costs: For each mi ga on tac c, think about the implementa on cost.

7. Status: Once you have assembled the first six columns, you need to decide which mi ‐ ga ng tac cs, if any, you need to implement. Your choices will depend on your per‐ sonal risk tolerance – there’s no right or wrong answer. Whatever ac ons you do take, you should document them in the Status column of your risk management plan.

As you develop your risk management plan, you should obtain input from your en re senior management team, as well as from your advisors and board members. We’ve all made different mistakes and learned different lessons, so it will be helpful to obtain mul ple perspec ves. 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. An cipa ng every possible risk factor is neither possible nor prac cal. That’s because no ma er how smart we are, and no ma er how carefully we assess the situa on, we can’t think of everything.

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Consider the startups that manage to a ract venture capital: these are promising firms, flush with cash, opera ng in a “hot” and growing market, run by gi ed entrepreneurs, with a demonstrated ability to meet important milestones, carefully chosen through a highly compe ve selec on process by experienced venture capital investors, watched over and mentored by advisors and Board members who have “been there and done that.” With all of these factors going in their favor, the majority of VC‐backed firms s ll fail!

Pragma c risk management isn’t about trying to an cipate and mi gate every possible source of risk. It’s really about two things:

Engaging common sense to recognize and mi gate the most obvious risks in a cost effec ve manner, using some of the techniques described in this ar cle; and

Developing a culture of responding to unan cipated developments – that is, pu ng out fires – in a calm, ra onal way.

Don’t let risk paralyze you. Entrepreneurs are, by defini on, risk takers. Strong risk management is an important source of compe ve advantage. You can beat the odds and build a thriving and rewarding venture by learning to recognize and mi gate risks.

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