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High Risk ≠ Innovation

My friend, Chris, sent me a link to Why Venture Capitalists Avoid Innovation: They Like Making Money, written by Andy Singleton.  It was interesting reading, but I don't agree with many of the conclusions. 

One of the author's complaints is that VCs "claim to be in the business of innovation, but they also talk constantly, often in the same paragraph, about how much they want to avoid innovation."  However, Singleton is confusing 'innovation' with 'risk.'  There are lots of types of risk with any new venture:  technology risk, team risk, market risk, competitive risk, development risk, sales and marketing execution risk, financing risk, etc.  A brief word on each:

  • Technology risk -- The risk that some fundamental new innovation just won't work.  This tends to come up more often with 'hard' technologies like semiconductors, energy, drug development.  This is different from development risk.
  • Team risk -- The risk that you either can't build a team with suitable skills or that the team you build won't work effectively together.
  • Market risk -- The risk that the market for your product won't appear.  Perhaps you are counting on some market shift in the future.  If it happens, you'll be the big winner because you saw it first.  If it doesn't, you may be dead.
  • Competitive risk -- The risk that existing competitors in your market can fill the need that you are trying to fill more quickly than you can.
  • Development risk -- The risk that your development team will be ineffective and fail to build a product that works well and/or is done on schedule.
  • Sales and Marketing Execution risk --A set of risks ranging from getting the product requirements correct so that engineering builds the right thing to the ability to generate sufficient awareness and demand for the product to the ability to actually get customers to part with their cash in exchange for the product.
  • Financing risk -- The risk that you can convince investors, now and/or in the future, to invest in the company in light of all these risks.

There are probably other risks (add in the comments), but these are the main ones I think about.  One problem in Singleton's post is that he equates innovation to risk, and most likely technology risk.  I look at it differently.  I think that an investor looks at any early-stage company and weighs the risks versus the potential upside.  If they can mitigate the risks and the upside is big enough, they invest.  If the risks look too big and the upside doesn't justify them, they pass.

How would you mitigate some of these categories of risk?

  • Technology risk -- Is there a proof of concept or prototype that demonstrates the technological achievement?  Has the team demonstrated the ability to project the technology advance in the past?  Is there independent diligence that validates the planned technological advance?
  • Team risk -- Have you worked with the team before?  Have some of them worked together before?  Does that validated track record give you the confidence that they can execute the plan?
  • Market risk -- Are there early market trends that will tell you if the market is shifting in the direction you are hoping for?  Is there a fallback or interim plan that will keep the company going if the market shift happens later than you predict?
  • Competitive risk -- Can you gather some competitive intelligence that will give you a hint of what the competitors' plans are?
  • Development risk -- Similar to team risk: Does the technical team have a validated track record of developing similar projects with high quality and on time?
  • Sales and Marketing Execution risk -- Another team risk:  Does the Sales and Marketing team have a validated track record in specifying the product correctly, building awareness and demand, and closing profitable business?
  • Financing risk -- Does the plan give the company sufficient cushion to ensure that they can get far enough to attract additional investment?  Will an objective new investor be attracted to this opportunity?  Is there room for a reasonable valuation step up in valuation while still leaving room for a new investor to make sufficient money?

From my experience, the most common reason why a venture-backed IT company fails isn't technology risk but sales and marketing execution risk.  Products are poorly specified, requirements aren't honed sufficently, products are positioned poorly and undifferentiated, sales teams are ineffective, etc.  It's hard getting all this right.  If you don't, even the best product won't sell.  In fact, great sales and marketing execution can make a success out of a mediocre product.

The second most common reason is market risk.  Oftentimes start-ups are projecting that a new market segment will open up that they can capture.  If it doesn't happen, or doesn't happen before the start-up runs out of money, you are in trouble.  Hopefully, there is some sort of fallback plan.  If not, you are probably dead in the water.

Most VCs take on some level of technology and development risk as history shows that many times these can be overcome.  In fact, the first thing I read after reading Singleton's post was about Bloom Energy.  If that's not VCs backing innovation, to the tune of $400M, I don't know what is.  Of course, I am sure that these VCs see gigantic potential upside and had plans on how to mitigate the risks before they invested.  And, there are many others in clean tech, drug discovery, etc.

Some of Singleton's comments on the state of the VC business are accurate, but don't impact the calculus around these risks.  Some firms are more risk averse, but they still evaluate deals along all these axes.  An innovator has creative ways to mitigate these risks.  That's the type of innovation that VCs are looking for.  There are very few deals with no risks and big upside.  Instead, most VCs are looking at how some or most of these risks can be overcome.  It may be a high bar and may not always sound reasonable.  Perhaps they are looking for business innovation rather than just technological innovation.

Before you present your company to an investor, make sure you have thought through all these risks and what you would do to mitigate them.

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