This post is by Continuations by Albert Wenger from Continuations by Albert Wenger
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After an excursion for the last few Uncertainty Wednesdays into the topic of intelligence, I want to return to how to think about risk. In a post about a decade ago I wrote that it is possible for a startup to be too innovative by trying too many new things at one. Here is the key line from that post:
If you innovate along too many dimensions at once you are multiplying risk (as startup risk is multiplicative, not additive).
So what does it mean for startup risk to be multiplicative and not additive? The simplest way to think about it is that as a startup you need to succeed at say five different things and if any one of them fails, the whole endeavor fails. What are those five things? Finding at least some degree of product market fit (in a sufficiently large market), having enough capital, building organization that can execute, actually delivering your product and building sustainable competitive advantage.
Another way to write this list is that startups take risk in at least five categories: market risk, financing risk, organizational risk, technology risk and competitive risk. Those risks are multiplicative. Imagine for a moment that perfect execution in any of the five categories earns you a 10 in that category and a total mess up gives you a 0. That means the range of outcomes goes from 0 to 10^5 = 100,000 (should have made it six categories, oh well). The key thing is if you get a 0 on one of the categories, it doesn’t matter if you get a 10 elsewhere, the combined outcome will still be 0 * 10 * 10 * 10 * 10 * 10 = 0. For example, if you run out of cash hard (e.g. in the middle of a financial crisis when everyone else is scrambling) you can wind up with a 0 even if everything else is going great.
Obviously this scale is not meant to be taken literally. But it gets the idea of a multiplicative risk structure across. From an investor’s perspective it means that if you are considering a startup that has big question marks in more than one of the five categories you are taking a lot more risk of a bad outcome.
Are there investing risks that are additive instead of multiplicative? Well, investing in multiple companies as you build a portfolio. The companies can succeed or fail independently of each other. If one company succeeds you add that to the total outcome. Conversely a company failing can be thought of as subtraction from the total outcome. Of course how independent they truly are depends on how well diversified a portfolio you are building.
So whether it is startups or some other decision, always think about whether the risk structure is additive or multiplicative. How much care you take and whether you get benefits of diversification depends massively on that fundamental structure.