Removing Technical Risk

September 9, 2003

By Steve Mezak

If you seek funding for your startup, you will eventually face the challenging review of your company known as “due diligence”. Venture capitalists look at many things during the due diligence process to make sure they were not completely fooled by your sizzling presentations and demos that lead to you receiving a term sheet. The term sheet outlines the terms of the investment including how much money they will invest and how much of your company they will own afterward. It is NOT a guarantee they will invest. Even if you pass the due diligence process with flying colors, the investor can still back out of the deal.

At one of my successful startups, I participated in multiple meetings with several venture capitalists. We had been in business for about a year and were raising our second or “B” round of funding. Happily, we received a term sheet from two major VCs that wanted to do the deal. Then I learned it was to be my responsibility to shepherd the VCs through a technical due diligence.

Are you prepared for a technical due diligence? What do VCs look for? In my case the VCs hired a technical consultant to examine our software. He interview senior members of the engineering team and reviewed our software development, QA and release process. We weren’t perfect, but our problems were minor and the deal went through.

VCs look at these five things during technical due diligence :

  1. Your Idea – does it make technical sense, can it be done?
  2. Your Team – your competence, experience, ability to execute?
  3. Your Technology – appropriate for the product, efficient, scalable, etc.?
  4. Your Process - do you have one, is it documented, does it work?
  5. Your Code – is it readable, well-structured, maintainable, organized?

VCs are also concerned about the market risks of your startup. VCs think of each startup as being in one of two slightly poetic categories: “Better, Faster, Cheaper” or “Brave New World”. In other words, “Better, Faster, Cheaper” means an evolutionary and beneficial improvement to what your prospective customers are doing now. Generally, these are less risky startups but the reward may be less and competition is more likely. A “Brave New World” startup wants their customers to do things in a completely different, revolutionary and better way. Requiring your customers to make significant changes in behavior can be very risky!

VCs want to see how well you reduce both the both technical and market risks over time. You can ask for a higher valuation if you demonstrate how you have reduced the risks of investing in your company. But what specific risks should be looked at?

I recently found report on the Internet that can help. It summarizes research funded by the US Department of Commerce on evaluating the risks associated with bringing new technologies to market. The full title and on-line link is below in the Compile Time section. Of particular interest is an article contributed to this report by George C. Hartmann and Mark B. Myers entitled “Technical Risk, Product Specifications and Market Risk”

The article includes a slightly more complex model used to evaluate the risks of a startup, as shown in the following four quadrant diagram:

Quadrants of Risk
Quadrants of Risk

The diagram shows the higher risks encountered when breaking new ground in either technical and/or market areas. Evolutionary products use existing technology and are sold into existing markets. These are usually not the kind of products created by startup companies. Other products leverage a base of existing technology and are sold into new markets. Sometimes the market opportunity is large enough, and situation right to justify starting a new company to deal with the increased market risks.

When a new technology is applied to an existing market, a discontinuity occurs between ending the use of old products and methods and using the new product. It carries a higher technical risk. The highest risk occurs when new technology is used to create products for new markets.

Hartmann & Myers identify three independent elements of the Technology risk and assign probabilities of their contribution to the success of a product. The probabilities are dependent on the completeness of the risk element.

Technology Risk Elements
Probability of Success
(for each element)
Technical Risk (P1)
Availability of Competencies & Complementary Technologies (P2)
Specification
Achievability (P3)
Incremental extension of existing in-house technology Technology & advanced development competencies are available,
complementary technologies exist.
Modest extension of existing specifications & performance requirements

0.9

Incremental extension of outside technology Technology competency not available. Advanced development competency & complementary technologies are available. Major extension of specifications / performance
0.7
New technology, feasibility demonstrated Technology competency & complementary technologies are available.
Advanced development competency is not.
New specification in a new domain
0.5
New technology, feasibility NOT demonstrated Technology or advanced development competencies are available elsewhere.
Complementary technologies not available.
Some specifications unknown or unknowable
0.3
New invention, not reduced to practice Neither technology & advanced development competencies nor
complementary technologies are available anywhere.
No specification known
0.1

The Technical Risk column describes the risk of resolving remaining technical problems as your product is developed. In the second column, competencies include the people, skills, tools and processes necessary to create your product. It is the programmers, compilers, interactive development environments and a software development process that all give reliable results when applied.

The third column is Specification Achievability. It combines two closely related risk: being able to implement the product to meet specified requirements and also the risk of not being able to specify exactly what the product should do. It assumes there is a specification with clearly identified customer needs and market requirements identified.

What is the technical risk of your product? The table can be used to calculate a number. For each column, decide which row reflects your level of risk. Then multiply the three numbers representing the corresponding probability of success together, and subtract the result from one to get a measure of technology risk.

For example, suppose you have lots of experience with the programming technologies you are using to build your product (P 1 = 0.9), and you are completely familiar with the programming tools and software development process required (P 2 = 0.9), and you are applying the technology and development process to a major new application, well specified but significantly different than anything done before (P 3 = 0.5). Then your technology risk is

Technology Risk = 1 – (P 1 x P 2 x P 3 )

= 1 – (0.9 x 0.9 x 0.5) = 1 – 0.405 = 0.595

Lets look at a few more examples.

  • Suppose you have very limited specifications – a situation typical of many startups. Then P 3 = 0.3 and your technology risk increases to 0.757. Pretty risky.
  • What if you have good specs like before ( P 3 = 0.5) but you decide to use outsourced development (P 1 = 0.7)? Then the technology risk is 0.685. Slightly more technology risk, but perhaps justified considering the cost savings, and the reduced risk of running out of money.
  • How about crappy specs combined with outsourcing? P 1 = 0.7 , P 2 = 0.9 and P 3 = 0.3 lead to a technology risk of 0.811. In addition, if you are not exactly sure of how to develop software (P 2 = 0.5) then your technology risk is:
    1 – (0.7 x 0.5 x 0.3) = 0.895 only 0.105 away from total doom !

Are these numbers meaningful? Maybe. They are inexact estimates of your technical risks encountered in creating your product. More importantly, you can identify areas where you should remove risk to improve your chances of success.

But wait, there are more risks! Hartmann & Myers describe three potential market risks in the table below.

Market Risk Elements
Probability of Success
(for each element)
Availability of Value Chain Elements (P4)
Product Differentiation (P5)
Market Acceptance & Business Model (P6)
Value chain is available within the company Product is best in class for all attributes Company is currently in the market

0.9

Major elements of the company’s value chain must be developed Product is best for some attributes, but not all Company has contact with customers, but is not in the market
0.7
Company value chain is broken, many elements not available Product offers advantages in one or two attributes Company is active in a closely related market
0.5
No value chain elements exist within the company Product has same profile as competitors Market exists, but only as a “niche” market. Business model not established
0.3
Critical value chain elements do not exist anywhere Product offers advantages in one or two attributes, but is worse in all others Market & business model do not exist
0.1

The market risk calculation is similar to technology risk:

Market Risk = 1 – ( P 4 x P 5 x P 6 )

Your Value Chain means the internal organization required to perform engineering, marketing & sales. If your company has only hired engineers, you are probably at P 4 = 0.5. Most startups should have both P 5 and P 6 >= 0.7.

Finally, you can combine all the technology and market probabilities for your product to calculate your chance for overall success with the simple formula:

Overall Probability of Success = P 1 x P 2 x P 3 x P 4 x P 5 x P 6

VCs do not like to invest until many risks are removed. They may not use a calculator, but technology and market risks will be estimated as they consider investing in your company. Even without trying to impress investors, you should start your company with an understanding of the potential risks. Then you should work diligently to reduce these risks as quickly as possible.

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