The following outlines the most common risks that venture capitalists (VCs) look at during due diligence. The best pitch to VCs will include a presentation on the risks involved. Keep in mind, however, that thousands of other risks may be important to your business. You may have environmental risks, for example, which you would want to address.
The main thing is to think comprehensively about what could go wrong and to develop a strategy around each issue that your company faces or is likely to face.
Each milestone is a separate project and has its own risk profile. An early-stage technology company, for example, has lots of technology risk early on, but then these shift to market risks after the product is complete and sales begin. (The market risk is always there, even from the beginning, of course, but it isn’t really experienced until the company starts selling its products.)
Sales and marketing risk
Sales and marketing are perhaps the biggest risks for many early-stage companies. Many tech companies, for example, spend a lot of time focusing on their technology and not enough time on how they are going to sell it.
When new products are introduced, gauging their reception can be difficult: How well will customers accept them? How much are they willing to pay? What will the sales cycle be? What competitive pressures exist? What will the sales costs be?
VCs like to see that you have talked to a lot of potential customers, that you have thoughtful and appropriate sales channels identified, that key relationships have been established, and that you have test marketed your product (if appropriate) to demonstrate market demand.
Technology risk
Technology risk is at its highest for early-stage companies where a high degree of uncertainty exists about whether the product will work or not. If you have developed a prototype, you must still ask whether it will work when manufactured in quantity, or whether it can be scaled up in size for commercial and industrial applications.
Later stage companies also face technology risk in the form of data security issues, continuity concerns, Internet hacking risks, and other technology risks that impact large volumes of data, customer credit card records, HIPAA medical information, or even simply the ability to provide service if your e-commerce site crashes.
Manufacturing risk
Regardless of whether you make things in your own factory or outsource your manufacturing elsewhere, you have risks related with the production, storage, and delivery of physical goods. These risks range from labor practices in foreign operations to safety issues, perishability of products, breakdowns in supply chains, labor strikes, materials availability, quality management, freight and logistics interruptions, currency fluctuations, and more.
Management risk
Several types of management risk exist. The first risk is departures of key personnel. When your company has 100 or more people, losing people may not be a big problem, but when you’re a start-up with a team of four, the departure of key personnel can be critical. VCs will want to know
That you have developed a vesting program that provides incentives for key personnel to stay with the company.
That you have key man insurance, which ensures that funds are available to buy out the equity of a key management team member who is killed or incapacitated so that you can recruit a replacement team member.
Financing risk
Risks related to financing include the following:
Funding risk: If your plan includes multiple rounds of funding, then the overall risk of your company is higher than if you could reach your exit with just one round. Going through three, four, or five rounds before an exit isn’t uncommon.
Exit risk: Exit risk is important because if you can’t execute on your exit plan, then the VC won’t be able to return capital to his LPs. Understand the macro trends in your industry so that you can anticipate what might make acquisitions more or less attractive a few years down the road.
Economic risk: Economic risk refers to a macro trend that is possibly equally impactful for all businesses in your industry. What if the value of the dollar drops or goes up? Currency risks may be significant for your company if it does a lot of international business.
Legislative, regulatory, and political risk
Some companies have huge legislative and regulatory risks. Think about anything that has to do with healthcare. The FDA approval process can take decades and cost hundreds of millions of dollars without any guarantee of success. Some regulatory processes are expensive, time consuming, and seemingly capricious in their application. If your company faces these risks, your ability to raise venture capital will be impacted.
Political risk can be important for companies that depend on a certain party or local government official being in office. Changes in tax policy, employment law, or compliance with new securities regulations could all have an impact on your company.
Litigation risk
Litigation risk refers to how likely it is that your company will be the target of a litigation. This type of risk increases as your company grows bigger. Smaller companies may not be perceived as being worthwhile as a litigation target. But as your company grows and becomes either a threat to others or is perceived as having sufficient assets to justify a legal battle, then litigation risk increases.
Your industry also impacts litigation risk. A company that makes socks faces substantially less risk than a company that makes infant car seats. Food products can also have significant litigation risk, as does anything in the medical or transportation fields.
International risk
International risk applies to all companies in some way or another, but it is especially important to those companies that have a direct link with international business, including imports and exports. Currency risk is an example of international risk.
If your currency drops by 20 percent and you are buying on a fixed contract, then your cost of goods just went up by 20 percent. If this amount represents your entire net profit margin, your company is at risk. Other international risks include wars, protectionist barriers, tariffs, international regulatory risks, problems with international distributors, shippers, and more.