Assessing Startup Risk — A Methodology for a Phi Measure of Risk
This articles describes a methodology for systematically assessing risks in a high technology startup and then presenting the results in a simple risk contour profile and a single number, its Phi Risk.
The methodology described here is designed as adjunct to the Lean Canvas methodology. It extends that methodology by adding one further aspect — how to assess the risk side of the risk-reward tradeoff.
For anyone interested in a Phi Calculator that performs the calculations in this article and produces final graphs and risk numbers, please email me.
There are 11 risk parameters to assess. Each parameter is graded on a profile of 0 to 10. Low risk is ranked as 0, medium risk as 5 and high risk as 10. Finally the result is shown in a simple “Risk Contour Profile”.
Finally the resultant score is labelled as an opportunity’s Phi Risk Number — the average of the 11 scores, a number from 0 to 10.
“Technology Risk” is a measure of how risky it is to achieve the core technological breakthrough(s) that are necessary for an opportunity to be a success:
Startups need to deliver a Minimal Viable Product (MVP) that reduces the scope of a product to one that is just sufficient to deliver a product that customers want and will purchase.
Then the startup can enter an iterative learning cycle to maximum effect.
However often the scope of an MVP is expanded drastically due to “edge cases” — all the little things that a customer wants in its MVP. Some products have few edge cases — they are easy to deliver as self-contained value propositions. They have low “Edge Case Risk”. Others have an enormous number of edge cases — very large numbers of little things that need to be delivered before a customer finds the product “acceptable”. Often in these latter cases customers become annoyed to the point of dismissal if any one of these “little things” are missing or don’t work. They have “High Edge Case Risk”:
The Market Timing Risk is an assessment of the extent to which the success of the product is predicated on assumptions regarding the behaviour of the wider market and/or also on the trajectory of the economic market cycle.
The Monolithic Customer Risk is an assessment of the extent to which the opportunity is contingent on supplying a small set of customers (or a group of customers that perform as if they were a cartel or a monopoly).
Single customers or small groups can act with some impunity in negotiating conditions of supply, including price and volume. The lack of diversity also exposes the opportunity to the problem of solving the MVP problem for one (potentially very demanding) customer. This can be linked to Platform Risk and Scale Risk.
The Scale Risk is an assessment as to whether or not returns rise linearly (approximately) with scale, or whether the Opportunity requires a substantive threshold scale before it becomes viable. The larger this threshold the larger the capital required to get there.
Another form of Scale Risk is if there are increasing returns to scale. This implies that there will be a natural monopoly in the opportunity which in turn necessitates that the opportunity spend very heavily to ensure its dominant position in what is effectively a race.
Execution Risk is an assessment as to how difficult the opportunity is to operationalize and execute. In particular if a large number of even slightly risky things have to all work in serial to make the opportunity function then the probability of failure escalates dramatically (the ‘line of ducks problem’).
Gorilla Incumbent Risk is an assessment as to the size of a direct competitor who is occupying the same segment or a materially close segment, even if they could change to being a customer or potentially being a great trade sale candidate.
Legal Risk is an assessment as to the extent to which the opportunity may encroach on either patent or intellectual property areas of a large existing company, or butt up against legally defined jurisdictional restrictions.
Capital Intensity Risk is an assessment of the downside case of how much capital it will take to achieve a cashflow positive status and how long this process will take. Some opportunities require several iterations where each iteration requires a large capital injection. This can be linked to other parameter risks (such as scale risks).
Platform Risk is an assessment of two issues. The first is an assessment of how reliant the opportunity is on the continuing behaviour of a very large company via its platform or its services. Complete reliance runs the risk that a shift in direction by that company can eliminate the opportunity. The second assessment is how reliant the opportunity is on being a part of an existing structure, partially removed from the value proposition to the end customer. For example being in the middle of a long OEM supply chain. In such cases any high profitability in one part of the segment can be commoditized or squeezed from either side of the segment. This is related to, but subtly different from issues of Monolithic Customer Risk and Gorilla Incumbent Risk.
A successful company needs a great company culture and a smoothly integrated team — a group of skilled individuals who work well together under stress to achieve a goal.
Personnel Risk can occur through a mismatch in the initial group (an indication that there is not a natural synergy amongst the core founders or specific skills are missing).
Risk can also occur if the skills and personalities that are necessary to form a team are hard to source (or very expensive to source) — either because of regional issues in recruitment or because there is a general shortage of such skills in the market.
To achieve a quick snapshot view of the risk profile we can plot the measures as shown in the diagram examples below.
After viewing these profiles certain patterns emerge (which will be discussed in a later article).
We can also generate the two core Phi measures of risk — the Phi and the Max Phi.
The basic Phi measure is simply the average of the Risk Parameters and is a number between 0 and 10.
Most opportunities will have medium Phi numbers as they will have a mix of risks.
Opportunities that have a high Phi are indicative of a very risky opportunity.
The second Phi risk measure is the Max Phi — this is the sum of any parameter above a score of 7.5. It is essentially a measure of the size of the risk outliers.
The example at the left shows a Phi value of 5 (a medium overall risk) and a max Phi of 9 (indicating only one outlier).
The big picture is an opportunity of modest risk with one area of concern. If this one area of risk can be mitigated, the general picture is an opportunity of medium risk.
The example at the left also shows an opportunity with a medium general risk with a Phi value of 4.7.
However the Max Phi is 25, indicating that there is significant outlier risk.
To achieve an overall risk commensurate with the medium Phi requires mitigation across three critical areas, indicating a much higher risk profile than the first example.
The example profile at left is a high risk profile with a Phi of 7 and a Max Phi of 61.
It is indicative of an opportunity with broad systemic risk that would need to have commensurately very high potential returns to offset its risk profile.
Assessing Startup Risk — A Methodology for a Phi Measure of Risk
Research & References of Assessing Startup Risk — A Methodology for a Phi Measure of Risk|A&C Accounting And Tax Services
Source
0 Comments