Is Your Startup Worth the Risk? 5 Questions You Need to Answer Use these simple steps to assess the strength of a startup.

By Martin Hoffmann

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Colin Anderson | Getty Images

The art of predicting the potential of an early-stage business lies in identifying which internal and external factors will have the biggest impact on its future performance. To narrow in on those essential factors we can first boil the assessment of a startup down to understanding the upside potential on the one side and uncovering the risks on the other.

Related: 5 Things Every Entrepreneur Should Know About Risk-Taking

While unicorns as the focal point of most startup conversations illustrate the upside potential, battles are more often won by reducing the downside risk. After all, very few unicorns are predicted to be so successful early on, as there are simply too many outside factors involved. But eliminating the risk of failure is something that can be accomplished far more easily.

So, here's a simple five-step framework to help you determine how likely a business plan is to materialize:

Will the team find product market fit?

When assessing a startup's risk, the first consideration should always be whether or not the startup's product will take a strong foothold in the market. According to data from CB Insights, the No. 1 reason startups fail is that there is no market need for their products -- a factor that accounts for the death of almost half of startups in total.

Alex Schultz, Facebook's VP of growth marketing, analytics, suggests that finding product market fit can be a challenging process: "No. 1 problem I've seen ... for startups I've advised is they don't actually have product market fit when they think they do," he said in a lecture at Stanford University. After all, you don't have a crystal ball, and sometimes, even a technologically interesting product can miss customer needs -- just think of Segway.

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To get a better understanding of whether a startup will achieve product market fit, ask yourself the following questions:

  • How well can the team describe the customer and his or her challenges? Getting to product market fit ultimately starts with a clear understanding of your customer profile, so the more specificity is involved in the description, the more likely the startup will ultimately achieve it.
  • Consider the founders' track record: Have they worked in the space and gained inside knowledge about customers' pains, or do they just have a sexy idea?
  • To round this up with numbers, look for organic growth rates. Does the product get adopted organically? Do recommendations of happy customers drive growth, or does the startup invest heavily to acquire each customer? Often, huge marketing investments lead to "acquired" growth, which actually feigns adoption of the product.

Related: The One Question You Must Be Prepared to Answer When Pitching Investors

Can the team implement and scale its solution?

Having product market fit is just the starting point. A startup still needs to be able to deliver on its promise to customers at scale. Most businesses do not fail because of a lack of great ideas; they fail because they don't implement them in the right way. Good execution of an idea requires building the product well, marketing it correctly, using the right distribution channels and scaling production while ensuring sufficient quality.

To get an idea of whether the team is up to this job, start by determining what the specific success factors are in your startup's industry. Each industry is different, but there are usually a few factors that determine whether a business can be successful in that particular industry.

For example, we know that "retail is detail," requiring an understanding and tracking of the relevant metrics, seeing what makes prospects convert and deciding which merchandise to offer. For productivity software, it's more likely to be about the user experience design, as Basecamp has successfully illustrated. And for consumer products, brand marketing and distribution are still key.

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As founders, take the time to do your homework. Read case studies about the space to find out exactly what drives success in the industry, and what has made some leaders succeed and caused others to fail. Founder biographies often provide the most detailed insights. Then, see how the track record of your startup's team fits within this environment. What were their previous positions? Have they performed the required tasks at scale?

How well does the team work together?

At the end of the day, implementing and scaling a solution hinges significantly on the team behind the startup. Not having the right team was listed as the third most common cause of startup failure, according to the above CB Insights data. As such, it is critical to assess how well the team works together.

Consider how long the team members have known each other professionally and personally, and how well they get along. Looking at the body language of founders when they communicate can reveal interesting insights.

Most important, ensure that the team members communicate their vision with one voice, and do not express diverging messages. People often express themselves differently under stressful situations, so also consider if you can trust the team to work together to find solutions in the midst of crisis.

For founders, the essential strategy that can help bring everyone's vision together is drawing a road map as a team. The road map should not only describe where the company would like to be in five years, but also the details of what everyone needs to do to get there.

Related: 5 Questions Investors Ask Themselves Before Putting Their Chips Into Your Startup

Can the team adapt?

While teams must have a unified vision, they must also be able to adapt in how they go about achieving that vision. This is the philosophy behind the infamous "pivot," as coined by Eric Ries, author of The Lean Startup, which he describes as "a change in strategy without a change in vision," in a video for Fast Company. As Ries describes in his book, startups should bring a sort of scientific process to their activities, starting with a hypothesis, testing, measuring and iterating with whatever adjustments needed.

Consider the examples of Slack and Flickr, both of which founder Stewart Butterfield originally intended to be video game companies. Or Groupon, which stemmed from a failed attempt at organizing social movements through petitions. Or even YouTube, which started out as a dating site. As these examples demonstrate, being able to adapt as the market changes greatly improves a startup's chance at success. For this reason, flexibility is a major quality to focus on when assessing a startup's potential.

Apart from the process of iteration, you must ask how flexible the business model is and how it can be adapted when things go wrong, or new opportunities arise. Different types of business models offer different levels of flexibility. Simply put, a hotel can't do much if its location suddenly loses popularity with tourists. But AirBnB can adjust its business model when travelers' preferences change.

It can be helpful to track how the teams and the business models adapt to change. We cannot track change itself, but we can track its impact. If we define the right metrics that monitor how well the product is perceived in the market, we can notice any changes in customer perceptions. Such metrics could be net promoter score, customer acquisition costs, churn rate and others. Once these metrics show that the market has lost interest in the product, the business needs to find out why through user research and adapt the product if necessary.

Related: 3 Crucial Questions to 'Fail Proof' Your New Business Idea

Is the idea defendable?

Looking to the future, a final factor to consider is whether -- and how fast -- competitors with deeper pockets could replicate the startup's offering, and whether the startup can build on resources or assets that would protect it from being overrun by the competition.

Lead time no longer ensures protection for startups. Andy Rachleff, co-founder and executive chairman of Wealthfront, goes so far as to say in a blog post, "In fact, first to market seldom matters. Rather, first to product/market fit is almost always the long-term winner." We all remember Yahoo being the first search engine and MySpace being the first social media platform ...

Today, defending your startup's idea is a multi-layered question. Facebook has shown that a network of users can provide protection from competitors. Netflix and Soundcloud have illustrated that data can provide protection through deeper knowledge of customers preferences. And consumer goods companies such as Moleskine have benefited from strong protection through their brands.

When it comes to assessing the potential of a startup, it can be a tireless and fruitless endeavor if you fail to focus on the essential factors. For startup founders and investors alike, focusing on these five elements can give you deeper insight into a company's potential without trying to boil the ocean, or drowning in detail.

Wavy Line
Martin Hoffmann

CEO of Business & Investor Labs

Martin Hoffmann is a former private equity professional turned founder and CEO of Business & Investor Labs, which maps the big shifts at the intersection of business, innovation and culture, helping decision makers uncover the transforming success factors of the Digital Age.

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