Both startup entrepreneurs and investors want to avoid failure. But more important than avoiding failure is avoiding the trap of “playing it safe,” which means they need to take risks.
For entrepreneurs, making marginal improvements in industries ripe for major overhauls doesn’t cut it. They’ll simply be outmaneuvered by “braver” and “more disruptive” startups that are better equipped to attract customers.
And early-stage investors are after the kinds of returns that no longer exist in the public markets. They like investing in companies that think BIG. Those are the kinds of companies that make startup portfolios extremely profitable. But it’s a balancing act. Because those ambitious companies are also more likely to fail.
The investors and entrepreneurs most likely to succeed can manage this balance. They know the difference between calculated risks and reckless risks.
Take a look at your own portfolio. If it doesn’t have any failures, you’re simply playing it too safe. So how do you find the startups that are taking the right kinds of risks? The kind that are on track to become the next Google or Amazon?
The first step is to learn the three biggest risks ambitious companies must take in order to succeed.
They must expand geographically. Before companies go global, they have to venture beyond the borders of their home state.
When making that first move, most companies (I’d estimate 60% to 70%) expand to adjacent states. And this presents a major risk. Many companies make the move before they’re ready, stumbling badly in their initial attempt to launch multistate operations.
Investors should be particularly wary if the company is based in San Francisco. Consumers in the Bay Area are fast adopters of new technology and products. But what works there may not work elsewhere. And companies unable to grow beyond their local confines will never get big.
They must consider their own experiences, not just those of their customers. Once founders envision the product that will conquer the world, they sometimes forget the basic rule of “never ignore your customers.” And I love founders who start a company based on their own experience of not getting what they want from legacy companies. But there’s a risk that founders can take it too far. To avoid that, they need to maintain a constant feedback loop with their customers.
In this age of social media, it’s easy to do this. One up-and-coming company, Iron & Sprout, doesn’t introduce a new product without soliciting feedback from its community and getting 200 to 300 responses. Another company, Digital Brands Group (DBG), uses the constant stream of data it collects on its customers to determine its next product offerings.
They must pursue hypergrowth. Big venture capital (VC) checks can juice a startup’s hypergrowth. Take Uber, for example. It used VC money to grow rapidly and bludgeon its competition. But the risk here is if VCs pressure startups to grow at all costs, other problems (like pricing) can fall through the cracks. And if all that VC money and advice doesn’t result in rapid growth, startups can stall… and lose their ability to raise money in the future.
For some founders, that risk is too great. In describing his previous startup, one founder told me he’d be extremely reluctant to take VC money again. “They pressure you to spend a ridiculous amount to force-feed growth. It’s not efficient. And it substantially delays profitability,” he said.
Assessing Risk
Even at the early stages, investors can assess these risks. If a company is already operating in more than one state, you can examine how successful its geographical expansion has been. If it isn’t, you can usually get information on the timing and selection of states the company is targeting for expansion. And then you can draw your own conclusions.
Assessing a company’s ability to reach out and respond to market feedback can be tricky. Some founders trumpet the fact that their product has gone through many revisions based on market feedback. Others don’t. One founder relied on third-party surveys to convince me his product will be playing into strong consumer trends. As an investor, you should grill the founder on how they’re listening to and responding to their customers. If the founder is reticent on this subject, you should find out why. It may not be a good sign.
I address the hypergrowth question by asking founders if they’ll be going after VC money and what their concerns are (if any) in doing so. Some will speak longingly of using VC money to juice growth. Others will talk about the “right kind of growth.” It’s worth using a startup portal’s Q&A section to delve into this important issue with founders. Most founders will welcome VC money. If that’s the case, your question needs to be this: What will happen after they receive it?
Taking big risks is integral to the early investing space. There’s no set answer as to when a big risk becomes too big. But with experience, you will develop your own “feel” for evaluating these risks.
Good investing,
Andy Gordon
Co-Founder, Early Investing