Pinnacle Business Solutions
Financial Review Issue #52

  
 

 

Managing Business Risk

Business owners, just by their very nature, are greater risk takers than the average person on the street. In many cases, the process of starting a business requires that the entrepreneur put a significant portion of everything they have worked for on the line, based on a belief that their efforts will lead to success. Furthermore, once the risk of starting up is over, other risks, with the potential of even greater opportunity, continue to entice business owners.

 

Large contracts, new products, acquisitions, and expansions into new markets are just a few of the risks. These opportunities along with increased competition are just some of the reasons entrepreneurs need to take a serious look at placing the business at risk again and again. Much of the research about appropriate risk taking, warns against overconfidence, that biases in human behavior against risk might lead business owners to overstate the likelihood of a project's success and minimize its downside. Such biases were certainly much debated during the financial crisis.

 

 

 

Often overlooked are the behavioral forces, company structures and reward systems that lead businesses to become risk averse or unwilling to tolerate uncertainty even when a project's potential earnings are far larger than its potential losses. The profit forgone by choosing a safer alternative, putting less money at risk with a shorter time to payoff could result in underinvestment that would ultimately hurt company performance, share-holder returns, and the economy as a whole.

 

Mitigating risk aversion requires that companies rethink activities associated with investment projects that cause the bias, from the processes used to identify and evaluate projects to the structural incentives and rewards used to compensate employees. Much of the typical risk aversion related to smaller investments can be attributed to a combination of two behavioral biases. The first is loss aversion, a phenomenon in which people fear losses more than they value equivalent gains. The second is narrow framing, in which people weigh potential risks as if there were only a single potential outcome instead of viewing them as part of a larger portfolio of outcomes.

 

Diversifying risks across multiple projects could help reduce risk aversion. If the same employee faced not one decision but five, the story would change. The employee's range of outcomes would no longer be an all-or-nothing matter of success or failure, but instead a matter of various combinations of outcomes, some more successful, some less. In other words, combining risks can lead to a striking reduction in risk aversion.

 

Evaluating employee performance based on a portfolio of outcomes, not single projects could help to reduce risk aversion. Wherever possible, employees should be evaluated based on the performance of a portfolio of outcomes, not punished for pursuing more risky individual project. Reward skill, not luck. Companies need to better understand whether the causes of particular successes and failures were controllable or uncontrollable and eliminate the role of luck, good or bad, in structuring rewards for project owners. They should be willing to reward those who execute projects well, even if they fail due to anticipated factors outside their control, and also to discipline those who manage projects poorly, even if they succeed due to luck.

 

Promoting an organization-wide attitude toward risk that guides individual decisions, can help reduce the effects of risk aversion.  Encourage employees to explore innovative ideas beyond their comfort levels, ask for project ideas that are risky but have high potential returns. Encourage further work on these ideas before formally reviewing them. Require employees to submit each investment recommendation with a riskier version of the same project with more upside or an alternative one.

 

Consider both the upside and downside. Business owners should require that project plans include a range of scenarios or outcomes that include both failure and success. Doing so will enable project evaluators to better understand their potential value and their sources of risk. In many cases,downside risks are seldom fixed. If you look at the opportunity creatively and objectively, there are often ways to decrease the downside and reduce the risks. The range of scenarios evaluated should not simply be the baseline scenario plus or minus an arbitrary percentage. Instead, they should be linked to real business drivers such as penetration rates, prices, and production costs. By forcing this analysis, business owners can ensure that the likelihood of a home run is factored into the analysis when the project is evaluated and they are better able to thoughtfully reshape projects to capture the upside and avoid the downside.  One rule every business owner needs to follow, if you do not have the time to determine what the downside is, pass on the opportunity.

 

Have a contingency plan, even though the majority of time and effort spent evaluating an opportunity will not, and should not, be directed towards the downside, it is important to have a back-up plan. The contingency plan needs address how the company would recover in a worst case scenario. From there, a step-by-step plan can be designed. The major value of having a contingency plan is that if the ship starts sinking, benchmarks and plans to take action have already been devised. A contingency plan can also help keep the business focused on going forward with the knowledge that a back-up plan is in place.

 

Utilize your trusted advisors, at times like this, you need to rely on the opinions of your advisors. Talking to the company's accountant, banker, attorney, or other business people can provide a wealth of information based on their professional or life experiences. The purpose of listening to these individuals is not necessarily to do what they say, but to build a foundation of information upon which to base the decision.

 

Monitor your results, compare your actual results to your projected results on a regular basis. If the project is not going according to plan, understand what is causing the diversion and take action to correct it as soon as possible. Also, understand at what point you begin execution of your contingency plans. Monitoring project results on a regular basis can allow you to identify when a project is not on track and gives you the time to make the necessary course corrections to get it back on track.

 

Business owners, just by their very nature, are greater risk takers than the average person on the street. However, often overlooked are the behavioral forces, company structures and reward systems, that lead businesses to become risk averse or unwilling to tolerate uncertainty even when a project's potential earnings are far larger than its potential losses. The profit forgone by choosing a safer alternative, putting less money at risk with a shorter time to payoff could result in underinvestment that would ultimately hurt company performance, share-holder returns, and the economy as a whole. Utilizing techniques to encourage employee risk taking, evaluating performance on a portfolio of outcomes, considering a project's upside and downside, having a contingency plan, utilizing your advisors and monitoring performance, can have a significant impact on a business owner's ability to effectively manage risk.

 

Please contact us if you have questions concerning managing business risk or any other financial or business planning issues.

Sincerely,

 

Paul J. Beckert MBA, CPA
President,
Pinnacle Business Solutions  

 

Quick Links
 

Key Points of Interest 

  

 

Diversifying risks across multiple projects could help reduce risk aversion

 

 

  Contingency plans allow you to take action quickly if the project is failing

 

 

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