I’ve heard “spend the fewest dollars to reduce the highest risk” so often from investors that it’s become a cliché. Often, however, just when we dismiss something like this as a cliché, further examination reveals important principles.
This is one of them.
The general idea of reducing risk with early stage money (whether an entrepreneur’s own funds or an investor’s) is a weapon that not enough of us use well enough. Put to work correctly, it adds immensely to our chances for success in our venture, as well as our ability as an entrepreneur to keep more of what we start.
How?
Risk in this context means those parts of the business plan that, if proven to be optimistic or unachievable for the costs or within the time specified, jeopardize the success of the business. Examples might include wildly optimistic sales projections, dramatically understated customer acquisition costs, or product features not validated by users. Also included might be understated expense levels, or profit margins not achieved by any company in the industry.
So, one way is to make sure that any information that can be obtained is obtained. This certainly includes publicly available data about competitors, financial results, product lines, and the like.
Figure out how to test the market for customer acceptance in both time and cost to acquire a customer. See The Cost To Acquire A Customer.
The reason to reduce risk is to increase the value of your company beyond the cost to reduce the risk.
For instance, a good idea that with only a cursory understanding of the market and no financial projections based on some comparable company might only be worth several hundred thousand dollars to an investor. An investment of $100,000 might "cost" the entrepreneur 35% of the company.
The same company with a thorough market map (see Competitive Market Mapping) and clear, comparable financial projections might be worth up to $1Million. The same $100,000 will "cost" less than 10% of the company.
If the product prototype is built, and market-tested, the value might jump to several million dollars.
Does it cost many hundreds of thousands to go from step one to step two to step three? No. The difference in the value is the benefit the entrepreneur gets for reducing risk for the investor - even if the investor is herself.
Conversely, it is important not to spend money that dopes not reduce risk. If the plan calls for a factory to be built when contract mfg is available is this risk worth reducing? Almost certainly not. (Later, when product volumes increase dramatically, internal manufacturing might be a consideration. But that is a long way from now.)
Risk is a function of the next funding source. What they consider to be risk reducing is more important than what you consider it to be.
Now if only weight loss were as easy as risk reduction!