The most successful business owners have an innate understanding of risk and how to manage it. This article evaluates four different businesses in the context of risk to draw lessons about effective risk management.
Risk concerns the overall impact and probability of a specific outcome. For instance, a 20% probability of a $100,000 loss has an expected value of ($20,000) while a 10% probability of a $1,000,000 gain has an expected value of $100,000. The smart business owner constantly assesses risk in his or her business dealings in order to minimize potential downside and maximize potential upside.
Put another way: It is wise to invest in businesses and business deals that have a high probability of upside and minimal downside. While this seems obvious when stated explicitly, many businesses operate on quite the opposite principle. That is why so many entrepreneurs invest their life savings into a business only to see their dreams dashed.
Following are four different businesses and their risk profiles:
One: Online publisher. This business develops online distance education programs for fitness professionals. To manage risk and avoid large investments in product development, it begins with a simple ebook written by an investment. It tests the ebook with a low-cost website. If the ebook sells well, the company invests in an expanded program with a hard-copy book, DVDs, and seminars. It also tests different marketing strategies on a small scale, and rolls out the strategies that perform well. In short, this business is able to generate excellent profits through a strategy of low-cost testing and roll out. At the same time, it focuses its products in a niche market (fitness) in order to offer new products to its loyal customers, at a much lower marketing cost.
Two: Mortgage brokerage. While almost everyone and their brother were starting mortgage companies in the first decade of the new millennium, only a few were really generating profits. In the case of this business, the owner had over twenty years of experience originating loans for one of the top financing companies in the world. He had outstanding contacts with lending firms, relationships with the top salepeople in the industry, a proven approach to closing business, and a keen understanding of his customer. He recruited four of the top salespeople he knew – on a commission-only basis — and set up show with nominal costs in the basement of his house. Within a month he was generating over $100,000 per month in fees with almost no overhead. Here you see a business that generates excellent returns with nominal risk.
Three: Event promoter. The promoter put on professional fighting events in a rapidly growing market. It cost over $85,000 to put on an event, and most of this money needed to be paid up front – before any receipts. It was virtually impossible to project ticket sales on a given night because most people purchased tickets two weeks before the event. A competing event, bad weather, or cancellation by an event participant could be costly and stressful. The returns on an event ranged from revenue of $150,000 to only $60,000. In short, this business provided very unpredictable returns with a high upfront investment (e.g. risk). The promoter depended on the glamour factor of the business, and hoped to brand his business and sell it down the road to someone interested in an exciting lifestyle business in a rapidly growing industry. However, does it make sense to rely on this exit strategy without a predictable cash flow?
Four: Fitness facility. A fitness facility usually requires a large up front investment, in order to purchase equipment. This business owner began with a moderate space and equipment, and financed it at an excellent rate. He then marketed heavily to customers in order to generate ongoing monthly fees to cover his finance expense and rental costs. After six months, and thanks to effective and aggressive marketing, he was able to break even on his outgoing cash flow. After a year, he was profitable and preparing to open a second location. He had groomed a manager to run his first location, so that he could repeat the cycle on a second one. In this case, the owner generated excellent returns despite the requirements of a large investment up front.
From the above examples, one can conclude the following rules of successful risk management:
- Test products and marketing strategies before investing huge sums. Expand only when the strategy has been proven. If a business requires a huge upfront investment on an unproven investment, don’t invest.
- Seek out and hire top talent who understands the business and can generate exceptional results – while providing leverage to the business owner.
- As Warren Buffet advises, only get into businesses that you understand and know. If you don’t know the business and still want to get into it, spend plenty of time on research.
- Look for businesses where cash comes in before it goes out – not the other away around. Where possible, minimize cash out with leverage.
- Seek out businesses with annuity streams of cash from repeat charges, membership fees, and high customer loyalty.
- Don’t invest in businesses that require high risk and offer only moderate returns (like the promotion business). Rather, seek businesses with low risk and high returns – or manage them with this principle in mind.
- It should be easy to flex up and down with business cycles; keep fixed costs low.
- Avoid business based on glamour instead of on steady streams of cash.
- Develop systems that enable business growth and expansion.
- Buy at a profit, don’t sell at a profit. That way, a market downturn will have only minimal effects on an investment.