In my earlier post, I noted that converting uncertainty to known-unknowns requires thinking hard about the potential things that can go wrong and having a good risk identification search process. I broke risk down into true risks, which are insurable at some level (known frequency and severity) and uncertainty, which could be hard uncertainty (can’t be known at a reasonable cost) and soft uncertainty (can be known relatively cost effectively).
Many firms do a poor job of searching for problems. I have found several styles of management teams that struggle dealing with risk.
- Insular management teams are prone to very large areas of soft uncertainty. Home grown executives are often dealing with problems for the first time. Unaware of problems at other firms they repeat mistakes long solved elsewhere. A diverse management team of backgrounds, industry and experience is just a better management team.
- Management teams that are dominated by a single executive also tend to underestimate risks. Although I’ve worked with some great CEO’s, no one executive can reasonably see or know all the questions. If the CEO calls all the shots, over time, management teams will let the CEO handle all the thinking too.
- Firms with long term winning track records can begin to ignore risks as success begets complacency in the company culture. Company culture can be a great strength, but when the culture becomes too dominate, it blinds management to problems. Andy Grove suggested that only the paranoid survive, which is good advice. However, when you win a lot, it is tough to remain paranoid.
- An executive team that is highly incentivized by the stock price (usually with options) tends to stay focused only on the positive news, and to only invest in strategies that appear to have a direct correlation with option value (usually growth initiatives). Stock options skew management priorities because the risk is one-sided. If the stock price fails to increase or the company goes bankrupt the options are worthless. So for the option holder, ignoring the risk of a blow-up makes sense, they only get paid if the stock goes up. In these firms, it can be hard to get management focus on the known issues, much less invest in searching for unknown potential problems.
CFO’s have to assess risk. To do this, we must examine the business, the environment and the management team.