Life is uncertain. Any entrepreneur knows that to start a business, you have to take a chance. You can calculate the risks, manage what factors you can, work as hard as you want, plan as extensively as possible, but there is always uncertainty and risk. Frank H. Knight defined risk as events that have a probability and a severity and are calculatable. Uncertainty is defined as those events without a probability and a severity. We face both uncertain outcomes and risk in our lives.
As a professional CFO, I’ve worked to limit uncertainty and manage risk. Eliminating risk and uncertainty however is impossible and will kill a business. The very nature of profit comes from taking a chance and offering a solution for a customer. A risk-free (and low uncertainty) business doesn’t exist. The closest we have to a risk-free return is a 10 year bond, which is trading today at about 2.2%. If you want to make more than 2.2% you are going to have to take on risk.
- Running a business is about balancing all the factors: risk and uncertainty, the operations and the market so at the end there is a profit and a return on capital.
Profit comes from risk taking. The risk taking must be commensurate with the return, or it is foolish. Steven Crist wrote a chapter (see here) on value in the book: Bet with the Best: Strategies from America’s Leading Handicappers. Crist points out that even bets that are likely to lose (betting on a 4:1 horse, when the payoff is 12:1) can be a good investment.
Managing risk (and opportunity) sometimes means thinking about what c
ould change. What assumptions are foundational to the business model which if changed would result in a serious impact to the firm? Although you think that there are relatively few of these, there are many, but thankfully they are relatively rare.
Many retailers were well aware of the impact of e-commerce, but few generated a capable response. Most dumped their catalogs and full product line on the internet and waited for customers. Worse yet, few planned for the inevitable loss of market share or the increase in new competitive business models (Stichfix, Frank + Oak, Thred-up) that might arise on-line.
Nassim Taleb talks about the four largest potential losses in Las Vegas, one of which became real: Siegfried and Roy’s magic and wild animal act was ended when a tiger attacked Roy. Roy later went on to say that he had high blood pressure and believed he had a stroke during the show and the tiger sensed that and was dragging him to safety. If Roy had died from the stroke and not the tiger attack, the result would have been the same, cancellation of the show. When a great deal of income depends on the health of one man, then there is a big assumption of risk.
- Business decisions can increase or decrease risk and uncertainty.
Every decision we make creates new risks and uncertainty. Selecting a new ERP system? Hiring a new executive? Changing a key purchase policy? All will create both a primary effect and secondary effects that are unknown. Not making a decision, often called strategic dithering, creates additional uncertainties. Mark Fields was recently replaced as CEO of Ford, apparently because he wasn’t moving fast enough on self-driving cars (see here). I am not certain that a faster approach to self driving cars creates a lot more value than being second with a better product. But either way is uncertain.
Too often executive teams ignore risk and uncertainty factors in making their decisions. Anecdotes are easy to understand and are compelling although they are often sample sizes of 1. In the hedge fund business we used to say “beware the narrative” as we were afraid of being seduced by the simplicity of a good story. Balancing the trade-off between customers and operations without assessing the change in risk will likely lead to increased risky behavior and calamity.
- Invert the decision making model – think about increasing risk.
Risk is necessary for profit, but risk as I’ve noted is calculable. Can you decrease risk for a customer and create greater sales and profits? Grouping uncertainty and risk can decrease overall risk. That is what insurance companies do. Offering a money back guarantee on products for a retailer is simple. If you realize you can return the product, you are more likely to buy, even if you are extremely unlikely to return the product. The highest margin item I’ve ever sold was warranties on electronics. Most are never used.
If you are a SaaS business, how can you lower the customer uncertainty and increase your payout? Most firms find buying a new system a major endeavor. They’d like to be married, without the process of getting married (which is a hassle). The risks are centered in the conversion, implementation, training and the first 90 days of the new system. Firms will pay to have implementation risk decreased.
Playing safe isn’t always a good option (see here). My local community has half a dozen businesses that are clever, deliver great value and could have a national presence. They don’t because the owners are happy enough with a small local business. Every couple of years change comes to the community or one of the owners and one of these businesses dies. I am not arguing all small businesses should become Staples, but as John Shedd wrote “A ship in harbor is safe — but that is not what ships are built for.”
Conclusion
I think a lot about balancing risk and returns. If you bet the long shot that is undervalued, you may win big, but you will most likely lose. Losing isn’t bad in this case, it is just one iteration of a process that brings a profit. Avoiding risk isn’t possible, but whatever approach you take, keep an eye on the tiger.
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Dr. John Zott is the Principal consultant at Bates Creek Consulting. John is the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and comments regularly on issues that affect consumer businesses. If you are looking for a CFO for your e-commerce/retail/consumer company, or are a former student, colleague or would just like to connect – reach out.