Technology Start-up Risks: Looking through the investor's eyes
Alnoor Bhimani, author of Financial Management for Technology Start-Ups, discusses the unique risk assessments these businesses must carry out to attract investors
Assessing risk is a conditioned reflex for most people. Deciding on a course of action usually involves looking at the value of the desired outcome and weighing it against the costs of the action, as well as looking for possible unintended effects. We usually make financial decisions with a view that the rewards should account for the risks we absorb: an outcome that is certain carries little risk, so the payoff should be smaller than those we’d expect from a risky proposition, where there’s a chance of low returns or even losses.
For technology start-ups, two broad categories of risk exist. The first is the business risk around the product, the technology or the market. There could be issues with the product if its quality, features or delivery preferences aren’t up to scratch. There might be technological failings when it comes to development, provision or servicing of the product. Perhaps your intended customers aren’t receptive to the product concept. The market could be too small, or shifting too fast towards other solutions.
The other risk category relates to the financial risk of the start-up. How the business funds itself, and the form of its cost structure, will affect the risks that a start-up faces. Over the past decade, both types of risks have altered businesses across all markets, industries and platforms – new and old. As a result, opportunities for tech start-ups to create value have expanded very quickly, but so have the challenges and risks. Still, pegging risk to the level of expected returns is what always underpins investment decisions.
An investor considering funding a tech start-up will check that the risk-return relationships are balanced. Investors will look at how viable a concept is at the outset, and how well the start-up can sustain successful operations in the long run. There will be an assessment of a tech start-up’s idea, the market and the team in particular for the investor to be confident that it can deliver. In terms of the product concept and market, an investor will look for a competitive differentiating feature. Perhaps the start-up can better execute something that already has an existing market. Or it might offer an entirely new business model or market to be developed. Perhaps the product has lock-in capability where, as we saw earlier, there is resistance for a customer to move away once they’ve adopted a product in terms of effort and time. If the concept enjoys network effects, this could be a very attractive opportunity, where fast business development and growth become important.
The investor will also want to see whether there is uniqueness in the technology, and how far the concept has been developed by the time they step in. Part of investor concern will be with the founders. The team needs to have solid technical expertise and sales orientation. It also needs to be comfortable with acting on advice and be flexible around inventors’ executive approach and decision making, i.e. when the investors signal a need to advance the business along a new trajectory. Investors won’t want a team to show emotional resistance to evolving their product concept or business hypothesis. A founder who only wants to stay with the start-up short-term, or wants to stay in a specific role long-term, won’t impress an investor.
All this analysis comes down to assessing risk and return potential. Tech start-ups tend to have a low chance of high payoffs in the long term, but a high chance of large immediate cash needs. This isn’t a problem – in fact it’s what makes them attractive to investors. If the payoffs are likely to be positive but not very high, this wouldn’t excite tech investors. And if a start-up’s funding needs are low where there are high expected returns, it’s likely the funding will have been met through other means. Looking purely at the risk-return dimension of an investment, investors will seek high risk/high return characteristics, which are generally what a tech start-up has. Tech business founders need to understand risk with the eyes of the investor.