We all know that every startup is risky. No risk means no reward. Yet every investor has his own “rules of thumb” on what makes a specific startup too high a risk for his investment taste. You need to know these guidelines to set your expectations on funding.
Of course, if you intend to fund the business yourself, or have a rich uncle, external investment funding concerns are not a problem. Yet, it’s still worthwhile to understand the issues so you can minimize your own risk of failure. Here is a summary of the “big picture” high risk considerations:
- Inexperienced team. I’ve said many times that investors fund people, not ideas. They look for people with real experience in the business domain of the startup, and people with real experience running a startup. An expert in software is considered high risk in manufacturing, and a Fortune 100 executive running a startup is high risk.
- Historically high failure rate category. Certain business sectors have historical high failure rates and are routinely avoided by investors. These include food service, retail, consulting, work at home, and telemarketing. On the Internet, I would add new social networking sites, and new matchmaking sites.
- Dependent on government regulations. If your business model is dependent on government approvals, that can take a long time, or require political connections. All new medicines, for example, require expensive and extensive testing for side effects before FDA approval. Of course, successful approvals may also mean high returns.
- Large initial investment required. If your startup involves new electronic chips, that may require a huge investment (more than $1B) to ramp-up manufacturing. By definition, all but the largest investors will pass, and it becomes high-risk to all investors. New drugs often fall in this category, due to long clinical trials and FDA approvals required.
- Businesses with small return potential. Businesses with a low growth rate or a small opportunity (less than $1B) are considered high risk by investors, who get measured on portfolio return over time. That eliminates from consideration family businesses, small niches, and business areas with declining growth.
- Poor public image businesses. Most investors like to maintain a squeaky clean image, so would consider it high risk to invest in businesses on the margin of legality or social acceptability. Don’t expect investor enthusiasm for your gambling site, porn site, gaming, or debt collection business.
- Operations in another country. Investors in one country are generally reluctant to invest in a company outside their realm of operational knowledge. We all know that the success “rules” in Russia are different from the USA, so cross-boundary investments are considered high risk, even if you have operating experience there.
These rules of thumb should not be viewed as barriers, but just another factor that needs to be addressed specifically in your business case and investor presentation. It’s better to be proactive on these, rather than hope your investor is too naïve to notice. Your challenge, if your interest is in one of these areas, is to point out quickly why the high risk is mitigated in your case.
In summary, it pays to have some insight into how investors will likely see you, since this allows you to prepare the best case, both for your own decisions, and for approaching an investor. It’s never smart to switch your plans to a “less risky” business that you know nothing about, because your lack of experience there simply moves that alternative to the high risk category.
If you can’t handle risk, don’t do a startup. But even if the risk energizes you, do it with your eyes wide open. Even the best adventurers do their homework before starting down a new path. Known obstacles are a lot easier to overcome than surprises. Enjoy the challenge.