It is a fundamental tenet of military strategy that one should only take on major risk if there is a prospect of a major victory. The Normandy Landings were a major risk, but the potential rewards were huge, as proven by subsequent events. The same principle applies in investing, where the idea of a congruency between risk and reward is well established (though not always applied).
This logic must also be applied to running a business. Companies should know their return on risk. They need to identify their risks (quantifying them if possible), find cost effective ways to prevent or mitigate them, and identify a clear gain or reward potential for those risks that can't be eliminated. Risks and potential rewards should be matched up to get a reasonable return on risk in all areas of a business. Major risks should only be taken on if they have a potential for a major positive outcome.
Here are two relatively typical instances. Company A has enjoyed a long run of stellar results in its main business line. Customers are happy, investors are happy, its thousands of employees are happy. The only issue is a new technology that has been introduced by an small competitor and that is making inroads in a minor segment that has always proven elusive to company A. The VP R&D sees this technology as disruptive, but the VP Marketing & Sales has talked to all the company's major customers about it, and they have no interest whatsoever in this technology.
In the second situation, company B is a small business that was founded by three former employees of company C, company A's main competitor. Company B has been operating for 3 years and has mostly struggled, though it is the company that has introduced that new disruptive technology. It is selling well, but finances are still month-to-month. They have about a hundred employees, but almost no other overhead, with all manufacturing and logistics being outsourced to reliable suppliers. They concentrate on new product development and aggressive marketing to traditional and non-traditional clientele in their sector.
The question is this? Which of these two companies has the better return on risk? Is it company A, with stellar results and with excellent relationships with its major customers? Or is it company B, the shaky start up with a great new product, but with little capital and only one major product line?
Company A, being the established competitor, is locked in to its existing customer base. This provides great revenues and profit, but everyone in the company is focused on pleasing existing customers. The company also has major overhead, thousands of employees to keep productive, and investors to please.
Company A's results have been extraordinary, but what is the potential for future growth in its main business? There are threats out there, but what exactly are they? There is company B, but it is only selling to a marginal segment of the market. The truth is, company A is carrying risk, but doesn't know its full extent. Nor is there a full understanding of the rewards for carrying that risk. Company A faces many vague risks and its future profit and growth picture is hazy. As a result, its return on risk is uncertain.
Company B is the shaky upstart. It has little in the way of resources to fend off a counterattack by established companies, but it also has much less to lose as compared to the incumbents. Moreover, if successful, the rewards could be tremendous. Company B's return on risk is high, and that is how it should be. That is why investors and venture capitalists seek out these types of companies. The risks are high, but so are the potential rewards.
The company A situation is much more common, and also much harder to manage. All companies face risks. The trick is to gauge their relative probability and impact, and then to match them up with potential rewards, so as to have a reasonable return on risk. What is your return on risk? Could you identify all of those major risks and match them with potential rewards?Back to newsletters