Managing risk, conviction, and cognitive biases in a startup: thinking like an investor

Startups involve a lot of risk. Here's why adopting an investor mindset can help you remove risk from your startup.

The primary job of a founder of any new business is to remove risk.

That’s why funding comes in rounds and not a lump sum at the beginning. Every venture capital firm would love to get the best price for their share of equity in a business, which often comes at the earliest stages of the company.

That’s because early-stage startups are simply too risky for an investor to pour their entire fund into one bet. Investors prefer to spread their investment across a number of businesses that allow them to reduce the risk of their portfolio failing. Later on, many investors will opt to exercise their pro rata rights, which grants them the right to participate in future rounds of funding.

Risk is also why valuations change over time. Valuation is not simply based on a venture’s total addressable market or opportunity size. It is driven primarily by the likelihood (the degree of uncertainty) that the business will be able to capture part of that opportunity.

Whether you plan to raise venture funding or intend to bootstrap your business to a point where you can sustain growth on revenue alone, it is helpful to view your business with a similar perspective as an investor.

Why you should adopt an investor mindset

As a founder of a new business, it’s helpful to view your company’s decisions as “investments” into your portfolio’s (startup) future.

Instead of allocating capital toward specific businesses, you’re spending both time and money (but primarily time) on trying to prove the opportunity.

Understanding risk in a startup

New ventures are risky. But not all risk is created equal.

Before I continue, it’s important to distinguish a startup from a regular small business. While both are risky, they face vastly different types of risk.

How is a startup different than a small business? It matters when it comes to risk.

A startup is “an organization designed to look for a business model that is repeatable and scalable,” according to Stanford professor Steve Blank. By contrast, most small businesses focus on executing an existing business model by offering a well-defined product or service.

Small businesses offer services that are readily understood, even if they’re novel for a market. For example, if I open a Japanese-style ramen shop in a small town in rural Kansas, it may be unique and novel to that town, but it is built on a well-understood market of ramen shops.

Delicious. But not a startup.

That is to say: a niche product or novel offering does not equate to a startup. All restaurants within a market share the same tools and techniques for acquiring customers, monetizing those customers, and delivering their product.

Startups are less certain than that. They often involve risk around the product they offer, the market they exist in (assuming the market even exists yet), and how they’ll make money.

The differences can be nuanced, but let’s assume you’re building a startup and not a small business.

What risks do startups face?

Startups face a number of unique risks that small businesses do not. These risks fall into a number of categories, including:

1. Market risk
By far the greatest risk a startup faces is the possibility that what they’re building will have no market demand. While this is not unique to startups, it is more likely to occur in innovative new ventures. In fact, 47% of startups fail because of market-related risks, according to Fractl 1.

Market risk really boils down to one simple question: is what we’re offering valuable enough that people will pay us for it?

In other words, is there enough demand for what we’re offering to make a viable business around it? And can we charge our customers enough to make the economics of our business work?

2. Capital risk
Another major cause of startups failing is a lack of money. According to Wilburlabs, 37% of startups failed because they “ran out of money.” Running out of capital is rarely a simple issue to unpack.

Some startups run out of capital because they fail to raise enough funding to be successful. This happens in capital-intensive businesses, where you need to spend enough money to get to a point where your business starts to grow.

One case study of a capital-intensive startup that failed to raise enough money is Quincy Apparel. According to their founder Christina Wallace, the company failed because they didn’t raise enough capital to fully develop their clothing collection, which made it difficult for them to attract customers and grow.

There’s another type of startup, however, that is not capital intensive. These include software businesses and professional services businesses, which can be built inexpensively (except for talent).

In these types of businesses, endurance is key to success. Assuming you have a viable business model, a good product to offer, and a system for generating demand, it is possible to succeed solely by staying in the game longer.

That’s actually the situation behind Minsilo. A lot of the successes we’ve had as a business have come hard-earned. We’re not venture-backed. We don’t intend to raise capital (see the next section for why). We’re taking the slow route to get things right.

We’re committed to solving a massive problem that companies face with aligning their people and business at scale.

3. Investor risk
Running out of money is one risk startups face. Another is having investors.

While the right investors, at the right time, can be an invaluable ingredient for startup success, seeking capital from the wrong sources at the wrong time can prove fatal.

It’s not the fault of investors. Most institutional and professional investors have to deliver returns to their investors (called limited partners, or LPs) by a specific date. A venture fund typically lasts for 8-12 years, at which point the initial investors expect to have made an outsized return.

Investing in startups is highly risky. As the old saying goes, with “high risk comes [the potential for] high reward”. As a result, it makes no sense for an investor to take a lot of risk for an average-sized return.

The benchmark return for a venture fund is a 10X return on invested capital.

Therefore, investors expect their investments to grow rapidly and work to quickly raise subsequent rounds of funding until they reach some form of exit, namely either through acquisition or IPO.

If your timeline is not aligned with your investors’, it can become problematic for your business.

If you’ve seen the TV show Silicon Valley, you probably remember the insanity surrounding the growth of Pied Piper. Venture-backed firms are not expected to grow sustainably or slowly: they’re expected to grow at breakneck speed (called blitzscaling by Reed Hoffman) in order to gain dominance in a winner-take-all or winner-take-most market.

There’s nothing wrong with this approach, but few businesses (and founders) are truly suited to this type of rapid growth. Before seeking this type of funding, you and your co-founder(s) should ask yourselves: does this model suit the business you are building?

3. Technology risk
Technology risk is multi-dimensional and can be difficult to analyze. For simplicity sake, there are three major types of technology risk:

  • Technical risk (e.g. can we build it?)
  • Design risk (e.g. will our users want to use it?)
  • Product risk (e.g. can we solve our customer’s needs with our product?)

For non-technical founders, technology risk is often the first to come to mind. After all, if you cannot build the product yourself, the uncertainty of the process of building product can seem like an insurmountable challenge.

Some businesses face genuine technical risk. These are often hard technology businesses: companies that rely on cutting-edge research in math, chemistry, biology, or physics. Companies like Tesla, SpaceX, Moderna, and OpenAI all have substantial technical risks.

Fortunately, most tech products are straightforward to build. It may take a lot of developer time, but many of the apps startups build follow well-known design patterns. This means that it’s not a question of whether it can be built: it can. It’s a question of how long it will take to build.

Another facet of technology risk is design risk.

Design involves both the appearance of the app (user interface or UI) and the user experience (UX). While it’s easy to laugh at seemingly “ugly” user interfaces of the past (think Windows 95), many of these now dated products were still designed with a user in mind.

Windows still has the start menu, cascading menus, and more.

In fact, many of these early interfaces were designed as a response to the notoriously difficult to use software that came before it.

They may have been unpleasant to look at, but they follow many of the design principles that modern software is built on. The classic book “Universal Principles of Design,” is as relevant in 2021 as it was in 2003. Ditto for the 1988 book “The Design of Everyday Things” by Don Norman.

Observing your users is key to eliminating product risk

Bad design impairs your product’s ability to solve your customer’s problems. It’s important to both provide the functionality that your customers need and make that functionality usable through good great design.

Product risk is the third category that should be considered.

Many early-stage ventures correctly identify a painpoint in the market but deliver a product that doesn’t meet the needs of the people with those problems.

These businesses do not struggle to gain interest or initiate a sales conversation. Instead, they lack the ability to close deals because customers quickly realize the product they built won’t actually solve their problem.

The primary job of a product manager is to clearly articulate your ideal customer profile (ICP), develop a persona around them, analyze their needs, and then work with your prospective customers to develop a product that truly solves their needs (hint: through user testing).

4. People risk
People risks abound in startups. Like technology and capital risk, it’s multidimensional. But startup expert and author Jim Collins puts it best in his 2001 blog post (which summarizes his book “Good to Great”):

The executives who ignited the transformations from good to great… got the right people on the bus (and the wrong people off the bus) and then figured out where to drive it.

Jim Collins (2001)

In summary, your job as a founder is to find the right people to work in your startup in order to make it successful. You have to find, attract and retain the right people.

For cash-constrained businesses, this can be a bit difficult. You might find that you need the right people to raise capital to hire the right people. This catch-22 is more common than you might think.

While investors will call this lack of ability to attract talent a negative indicator of a founder’s ability, it can be a reality for first-time founders. Regardless of their ability.

The question then becomes: how will you address this situation as a founder? Will you spend the time to learn the skills you need (perhaps even learning how to code or build a product) and work to overcome your weaknesses? Or will you pass on this opportunity?

There is no right answer. Unlike an established business, there’s no way to take a stance of “that’s not my job” and work to find someone else. Founding teams either do all of the work that needs to be done or they don’t. And those who don’t often fail.

5. Founder risk
Similar to people risk, founding teams also present risk to a new business. Founder conflict is a killer of many startups, and it often comes when a startup is at its most vulnerable.

There unfortunately is no silver bullet to eliminating founder risk.

Solopreneurship is one option. It’s difficult, lonely, and all-consuming. It requires considerable fortitude and discipline. As such, it’s not usually the recommended path for startups.

Going solo prevents founder conflicts, but who will drive the business forward if something happens to you? And will you be able to actually execute successfully on all of the jobs that a startup needs to be done?

I recommend finding a co-founder. Especially if you plan to bring in outside capital.

The book “The Founder’s Dilemmas” provides an excellent starting point for conversations you and your cofounder should be having from day one. It also talks about some of the legal and structural options that founding teams should utilize to prevent total collapse if one of the founders leaves (or refuses to leave).

Other risks
While the 5 risks mentioned in this section are among the most common, many startups face other risks. For example, startups in the crypto space may be concerned about reputational risk and regulatory risk. Aviation-related startups might worry about the risk that climate change presents. Hardware startups may worry about supply chain and manufacturing risks.

Managing Risk

Let’s be clear: if you’re running or working at a startup, you’re participating in one of the riskiest asset classes. That doesn’t mean to run to the hills in fear, but rather to be realistic about your approach to risk.

There are two types of investors: those who seek to understand risk and those who avoid it. Smart investors typically want to peel back the layers on risk and understand the factors at play. Casual investors follow the herd and make decisions based on adages and conventional wisdom.

Savvy investors do not shy away from risk. They instead seek to understand and control those risks. It doesn’t mean that they take bigger risks – although this a common result – but rather that they take calculated risks.

They understand risk and what might make an investment sink or swim. They may not have all of the answers on how to address risk factors, but they’re thinking about them and always looking for an answer.

How much conviction do you have?

One thing I’ve learned as an investor in the stock market is the importance of calculating the level of conviction you have in an investment, and then using that calculation to decide how much money you’ll allocate towards it.

While most long-term investing is not gambling, it still involves taking an informed bet. There’s uncertainty and risk involved in every investment. Decisions you make in your startup work very much the same way.

Now, here’s where the analogy breaks down. In equity markets, all investors have access to the same set of financial statements — balance sheets and income statements — that can be used to calculate specific performance metrics (KPIs). A savvy investor can then use these calculations to benchmark companies (bets) against one another.

Decisions made in the earliest stages of a business do not have access to these types of insights. Even if you have revenue, you cannot rely on your financial projections until you at least have clear product-market fit. There are simply too many unknowns about your customer, market, and opportunity to rely on it.

Hypothesis testing is one way to measure the viability of a decision in a startup. It involves clearly articulating what you want to test, listing your assumptions, and developing a plan for testing the hypothesis. It is the preferred approach to proving a startup’s viability, according to the Lean Startup methodology.

Checking your biases

Cognitive biases are an investor’s worst enemy. In many areas of life, it is possible to BS your way through things. Investing in the stock market over the long haul and building startups is not one of those areas. If you’re making decisions that are not firmly rooted in reality, you’ll eventually fail — and perhaps spectacularly so.

There’s an axiom in investing that applies to both investing in the stock market and startups: “the market can remain irrational longer than you can remain solvent.”

One of the more pernicious problems startups face is founder delusion. It usually works like this: a high achiever starts a business, gets early confirmation that they’re onto something, and then they fall flat on their face.

Typically, founder delusion is driven by ego and combined with all sorts of cognitive biases

Delusion leads founders to make decisions that do not align with reality. There’s a fine line between having an insight that is akin to Henry Ford’s famous line, “if I had asked people what they wanted, they would have said faster horses,” and every founder who proclaimed a bold vision that never seemed to pan out.

As well-known investor Eric Paley points out:

Some startup founders are so enthusiastic that they dream of futures that are not credible; they dismiss the need for customer feedback to validate their view; and they have no indicators that suggest they can build what they imagine.

Eric Paley (2016)

Even founders with the best of intentions can fall victim to founder delusion. I’ve personally seen it happen in both non-profit and for-profit companies. An unfortunately common scenario is when a founder is a subject matter expert, and they assume that their expertise in a given field of work is sufficient to be successful in that business.

Or they’ve personally experienced some kind of hardship, so they immediately assume they understand how everybody experiences that hardship or pain.

It’s important to not confuse deeply understanding the inner workings of a business with understanding how to start, run and scale a business. Instead, founders are well-served to consistently adopt a beginner’s mindset, whereby they question and challenge their own assumptions about the world and work to disprove their own beliefs.

Humble and egoless action is critical to overcoming challenges and failure. Those who are always learning and adapting succeed long-term. If you’re not constantly learning and growing, you’re leaving valuable opportunities on the table.

As you go forward, expect your startup to fail. Many times. The question is not how many times you fail, it’s how quickly you fail and how quickly you learn from your failures.

Resources

Here are some books I recommend reading to become a better investor (and founder):

Footnotes

  1. I calculated 47% based on Fractl’s findings that: 26% of startups failed because their business model was not viable; 12% failed because of no market need and 9% failed because of customer development issues.

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Ryan Leaf

Ryan is the founder of Minsilo. He is passionate about autonomous teams, the future of work, and organizational alignment. In his free time, Ryan enjoys traveling, exploring cities, and learning to fly.