Market Risk

In a previous blog I pointed out three major risks a startup company faces: Management Risk, Technical Risk and Market Risk. I want to dig a little deeper into those risks and have selected Market Risk to start with. I further divided the Market Risk into three risk categories:

1. high risk market
2. lower risk market
3. transitional market

The high risk market would be a poor choice to enter unless there were changes in the market. The lower risk market mainly requires a marketing campaign to get the word out on the product. The transitional market would be a poor choice to enter unless modifications were made to the new product thereby transitioning the market from high to lower risk.

This outline was originally created with a software product in mind but other products may fit the same pattern.

1. It would be very difficult to enter a market with a new product if:

• An existing product meets the needs of the customers.
• Customers do not currently do what the new product does.
• The new product does not provide sufficient value to the customers for them to buy it.
• Customers find that building their own product to do what the new product does is more cost effective.
• There are not sufficient numbers of paying customers to make the new product commercially viable.

2. The new product can be successfully introduced to the market if:

• The new product will help customers but they do not understand the product.
• The new product will help customers with a task that customers are not aware of doing.
• Customers are not aware of the new product.
• Customers have invested in another product that does an inadequate job of satisfying them.
• Customers perceive that the new product won't help them.
• The new product will help customers but they have higher priority issues.
• The new product is not in use by a sufficiently large community.

3. The new product should be modified before it can be successfully introduced to the market if:

• There are regulations that the new product must meet.
• There are administration issues that the new product must overcome.
• There are integration issues that the new product must overcome.
• There are technology issues that prevent the new product from being used.
• The new product has not reached a sufficient level of development.
• The new product does not satisfy a sufficient number of the customer's requirements.

Three Risks of a Startup

In a conversation with Duane Knight the CFO of Denver Biomedical, recently acquired by Cardinal Health, he mentioned the three main risks of a startup company. Although you may be saying "just three?" I thought these summed up the topic, I like lists of three and no one would read this blog if I listed fourteen. So here goes:

1. Management Risk
2. Technical Risk
3. Market Risk

Management risk encompasses all the risks involved with the management team: do they have experience, can they execute the business plan, can they work together and can you even round up the right people. Startups are especially difficult because highly qualified people may not be available or may not want to quit more stable jobs for the volatile environment of a startup.

Technical risk is the risk involved with the product or service the startup intends to sell. A startup by its very nature is usually trying to do something that hasn't been done before whether that's a new drug compound or new food product. New drugs have especially high technical risks due to the uncertainties when administered to humans. In comparison, software is relatively low risk. That may come as a surprise to those organizations that have pumped millions into IT systems only to have them scrapped. But software is more adaptable and, when managed properly, most IT projects eventually hit their targets.

Market risk is the risk associated with all those things concerned with selling the product/service: does the market need such a product, are there competing products, will the market buy enough for the company to eventually make a profit?

The startup company must deal with each risk and develop ways to reduce these risks in order to build value in the company; the lower the risk, the greater the value. Eventually, with enough work, patience, money and luck, the risk can be managed to the point where the company can actually forecast their revenues and profits a month, quarter or even a year in advance. A sure sign that the company's ready to go public.

A Blessing for Angels

The Access to Capital for Entrepreneurs Act of 2007, (H.R. 578) was introduced to congress last January. This bill would provide a 25% tax credit on up to $500,000 in investments per year in start-up businesses. So far the bill has received favorable response from the Kauffman Foundation, the Angel Capital Association, Women Impacting Public Policy and the National Association for the Self-Employed.

The beauty of this bill is that it provides tax incentive at the front end of the investment, where the incentive is sorely needed, rather than the partial capital gains exclusion given investors now. The Wall Street Journal quoted Susan Preston of the Kauffman Foundation as saying that the bill would double the number of angel investors.

Will this type of incentive cause investors to throw caution, and cash, to the wind? Does spending $500,000 to buy $125,000 in tax credits sounds like a good deal to you? Although the tax incentive reduces the upfront risk, getting a return on the investment is still essential. But with the reduced risk, maybe more investors would be willing to pull their money out of CD's and invest in the next Google.