How smart entrepreneurs manage risk and uncertainty

Data from the U.S. Census Bureau reveal that, aggregated across all sectors, 55% of new ventures die within the first five years. Of the remaining, 35% fail during the next five.

While data for VC-backed ventures are spotty, we estimate that failure rates are even higher for such startups. These ventures tend to be much better funded and thus run a much greater risk of not being able to return even the principal amount to the investors. A dry-cleaning shop can continue to survive as a low-profit no-growth lifestyle business for years. This would be impossible for any VC-backed venture.

Take the case of companies that have gone through the celebrated Y Combinator program, one of the most selective and best-known incubators in Silicon Valley. Even for these ventures, failure rates are estimated to be as high as 80–90%. This is true also for companies backed by VCs in Silicon Valley and Cambridge/Boston. Clearly, a new venture is almost always a high risk endeavor.

Counterintuitively, however, smart entrepreneurs (i.e., those whose success cannot be attributed to mere luck) are anything but gamblers. On the contrary, they tend to be somewhat risk-averse. Smart entrepreneurs are like experienced mountaineers. Climbing Mt. Everest is risky business. However, the last thing an experienced mountaineer wants to do is roll the dice and leave his/her survival to fate. Aside from an element of sheer luck, the difference between those who make it and those who don’t lies in the effectiveness with which any of them anticipates and manages the underlying risk and uncertainty.

Technology ventures, typically backed by external investors and almost always aiming for high growth, face five major sources of risk and uncertainty:

Market Uncertainty: Two years from now, will there really be a market for our products and services? Even if there is, are our assumptions about market size valid?

Technological Uncertainty: Have we made the right bets in terms of the technologies to develop and/or the platforms to use for our products and services?

Competitive Uncertainty: Even if our assumptions regarding the market and technologies are on the mark, will we reach the goal-post before our competitors do? Beyond the initial product/service launch, can we survive and win the ensuing competitive battle?

Organizational Uncertainty: Do we have the right leadership and the right team to execute on our plans? Have we preserved the needed flexibility to make changes if the venture pivots and needs different types of skills and mindsets?

Financial Uncertainty: Will we have the capital needed to meet our needs until a successful exit? Alternatively, have we raised too much capital too early and thus will face the pressure to scale up prematurely? Have we raised capital from the “right” investors and at the “right” cost of capital?

While all entrepreneurs face these types of risk and uncertainty, smart entrepreneurs are exceptionally effective at taking calculated risks and at transforming more risky contexts into less risky ones. Based on our experience as investors, advisers, directors, and scholars, we summarize below nine strategies that can go a long way towards significantly reducing the inherent risks underlying any technology startup.

1. Pick an opportunity with asymmetric barriers to entry. One of the worst things an entrepreneur can do is to follow the herd because it seems like an obviously good opportunity to everybody. Instead, look for opportunities with asymmetric barriers to entry i.e., where the entry barriers are low for you but high for others. This could be because you have unique and early insights into the market opportunity (e.g.,  Facebook), unique technological capabilities (e.g.,  Google), or simply an early mover advantage that enables you to scale up faster than copycats who enter the market after you (e.g.,  Amazon).
2. In the early stages, minimize complexity. Focus on a carefully selected niche and keep the early business model simple. At the time of founding, the new venture is desperately short of resources and managerial bandwidth. Starting out with too complex a business model is almost always the “kiss of death.” Look at Amazon. Jeff Bezos has said that he picked the name “Amazon” because, eventually, he wanted to sell anything and everything. However, his first move was to focus only on books and nothing else. In eCommerce, selling books requires the least complex business model.
3. Never ignore an economic analysis of your business model. Even in the beginning, you need to have at least some clarity about your eventual path to profitability. What factors will determine your prices? Your cost structure? And, your return on investment? Take the case of a Silicon Valley microprocessor company that is currently among the “walking dead.” When we interviewed him, the CEO noted that all he needed was a 10% market share in his target segment to start generating profits. He overlooked, however, that competitors with 30–60% market share would have bigger scale and lower cost structure than his company’s. In this type of a scale-driven business, there is no chance for a company with a 10% market share to survive profitably.
4. Have a bias for conducting multiple low-cost experiments. Given uncertainties on all fronts, one of the fastest ways to achieve more clarity is to conduct multiple low-cost experiments, ideally in parallel. Perhaps you can segment the customer base geographically (or, on some other basis). For each segment, can you experiment with different product/service features, different pricing structures, and so forth? Such experimentation is the core idea behind the concept of “lean startups.”
5. Reduce cash burn without slowing down the business. Never buy new if you can buy second-hand; this applies to everything — from computers to furniture. In fact, never buy if you can lease. Never sign a long-term lease if you do a shorter-term rental. Never rent if you can borrow. Might a bigger company have extra space that they may be willing to let you borrow, at least on a short-term basis? How about incubators or science parks? And, of course, never borrow, if you can salvage. Is some other company trying to get rid of excess stuff? Might they be happy to have you just solve their problem?
6. Convert fixed costs into variable costs. The goal here is to retain flexibility in case your business model changes or you start running into financial difficulty. Variable costs help you pivot faster than fixed costs. For example, until you have traction and more confidence in your business model, it may better to rely on subcontract manufacturing rather than build your own plant. Similarly, it may be better to rely on independent sales reps rather than create your own sales force.
7. Build a balanced team of complementary people. Make sure that your leadership team includes people with the necessary — but different and complementary — capabilities. In the case of technology ventures, these often include (a) technology development, (b) operations, (c) marketing and sales, (d) finance and accounting, and (e) people management. It is very difficult for a “jack of all trades” to excel at any of these important tasks. Also, if too many people excel at the same task, the risk of blind-spots in other weakly-managed areas goes up significantly. This often happens because people feel comfortable with others like themselves and thus look for similar (rather than different yet complementary) partners.
8. Leverage selected customers, suppliers, and complementors. Every company is embedded in a broader ecosystem. Can you identify which customers, which suppliers, which technology partners, which channel partners and the like will benefit from your venture’s success? As with employees who hold stock options, these companies have a stake in helping you succeed. This makes them your “natural” partners today. Think of how you can leverage them to get early feedback on various aspects of your business model, give you endorsements, reduce your cost structure, and reduce your cash burn.
9. Look for “smart” money rather than just money (or, worse, “dumb” money). Last but not least, be neither too stingy nor too greedy in raising capital. Raising too much capital too early can force the venture to start scaling up before key uncertainties in the business model have been resolved or key capabilities built. Research studies indicate that premature scaling is one of the biggest factors behind the failure of VC-backed technology ventures. Also, as much as possible, avoid “dumb” money i.e., funding from investors who will interfere too much and give you bad advice to boot.

In sum, you can never eliminate risk. Like smart entrepreneurs, however, you can systematically reduce the risks for your venture and let your competitors be the dumb ones. It is far better to be smart and a bit risk-averse than to be dumb and a gambler.

Haiyan Wang is Managing Partner, China India Institute, a Washington DC based research and advisory organization. Anil K. Gupta is the Michael Dingman Chair in Strategy, Globalization and Entrepreneurship at the Smith School of Business, The University of Maryland at College Park. They are the co-authors of The Quest for Global Dominance, Getting China and India Right, and The Silk Road Rediscovered.

A condensed version of this piece appeared in https://hbr.org/2016/11/how-chinas-government-helps-and-hinders-innovation