Risk – Smart Entrepreneurs Avoid and Manage Them

A Google alert steered me to an article called “Beating the Odds When You Launch a New Venture” in the Harvard Business Review, authored by Clark G. Gilbert and Matthew J. Eyring. It was one of the best pieces Iʼve ever read about entrepreneurs, their attitudes, and management of risk. They said that entrepreneurs arenʼt cowboys—theyʼre methodical managers of risk.

I thought their concepts applied equally to small and big business. I contacted one of the authors, Clark Gilbert, to discuss his ideas and decided I wanted to share his thoughts with my small business friends. The result is my interview (below) with Clark.

My comments follow his answers and are primarily addressed to small business owners. To read the full original article, click here.

Clark Gilbert is the President of Brigham Young University Idaho and was formerly a professor at Harvard Business School.

1. BR: Do you think Small Businesses spend enough time identifying their risks and planning on how to deal with them?

CG: Because capital is scarce, start-ups are not likely to get very far without having to adjust to data from the market. In this sense risk identification is almost “imposed” on a start-up. The scarcity of capital forces discipline. That said, entrepreneurs who think more carefully about the risks they face, systematically target the most critical risks, and remove them will be more successful that those who do not. When you start a new venture, you donʼt have all the data to make the right decisions. You just have to wade into the venture process and learn from the data that comes out. For example, you might have a hypothesis about the pricing structure and you can do things to test it, but until you actually close a sale, you donʼt have the data as to the price people are really willing to pay.

BR: I have found that in start-ups and small businesses, so much time and energy is spent on putting out fires and surviving, that risk management gets short changed. Periodic time outs for reflection are needed.

2. BR: Does this differ between start-ups and established companies?

CG: Believe it or not, one advantage start-ups often have vs. established companies is the lack of available capital. This forces start-ups to be more disciplined with their at-risk capital either because it is scarce or it will cost them equity. Too often, big companies had an overabundance of capital, which makes them less responsive to changes they need to make while the venture is being formatively developed.

BR: To bolster this point and no. 1, I would like to tell you about an interview I had with Stephen Gordon, the founder of Restoration Hardware. In response to my asking, “What were the factors that most contributed to your success?” He answered, “If sufficient capital had been available to me in the companyʼs early stages, I might not have been as successful as I was.” I myself learned that Bootstrapping out of necessity helps you form good habits that stand you in good stead even when you are in a healthy cash position.

3. BR: Do you think Entrepreneurs go into their own business with the idea that they must take risks to be successful and therefore accept more risk than they are comfortable with or capable of overcoming?

CG: Good entrepreneurs donʼt take risks, they manage them. Of course you can manage them completely away, but what I find differentiates good entrepreneurs from others is the ability to not to take risks, but to manage them.

BR: I believe the media has promoted the idea that to be successful, entrepreneurs must see and take on risk. (Think of reality shows like the Apprentice and Shark Tank.) Those that buy into this and donʼt identify risks, no less manage them, will find themselves a statistic in the long list of failed companies. It is surely a myth that good entrepreneurs love risk.

4. BR: In your recent article for Harvard Business Review titled “Beating the Odds When You Launch a New Venture,” you refer to the R&R case to illustrate some of your premises. As I have an intimate knowledge of this case, I was wondering if you thought its lessons apply to service companies as well as to product ones, which R&R is? Also if they apply to large companies, which R&R was not?

CG: I have used the R&R case with non-profit leaders, Fortune 500 companies, and more traditional entrepreneurs. Its lesson applies universally and grows from the idea that entrepreneurship is a way of managing, not a type of company. I remember teaching the case to the new venture group of a major U.S. media company when the lights went on for everyone. They had initially looked at the case as something for a small business owner. But as they got in and looked at how you used risk reduction not just to save money, but to fundamentally increase the prospects of the venture, their perspective began to change. Ironically, the scarcity of capital imposed on the start-up entrepreneur gives him an advantage over big corporations with all of their resources. One executive finally realized: “We need to manage like we donʼt have capital, not to save money, but to raise the probability that we find a winning strategy.”

BR: When the Harvard Business School case was written, R&R was my one person company in a small office in New York City. The case was about my venture to ride the coattails of the rapidly rising Trivial Pursuit game. To give R&R credibility, we obtained a license form TV Guide to use their name and create the 6,000 questions that were needed. It was a time sensitive project as we knew the large toy companies were developing their own Trivia games. Briefly, we outsourced the manufacturing, selling, shipping, and financing of the game. Our major RISK was that we wouldnʼt get the purchase orders we wanted because the large toy companies, who promote their games on TV and Trivial Pursuit reorders would come ahead of us in the order chain. To combat this risk, we asked for and received 5 free ads in TV Guide in exchange for increased royalties. We then promised major retailers their names in these expensive ads at no cost to them. This translated into immediate purchase orders of $3,000,000 prior to our first shipments and eliminated our risk. (This case and all the Bootstrapping tactics employed are spelled out in my book, Bootstrapping 101.)

5. BR: Can you explain your thesis that “Risk and Value are inversely proportional?”

CG: Think of a chart where every time you take a unit of risk off the table, you increase a unit of value. Thatʼs how risk works in a new venture. A venture that has multiple rounds of investment demonstrates this effectively. Every key risk the entrepreneur takes out of the venture increases the value of the venture in the next round of funding. The challenge for entrepreneurs in corporations or non-profits is that they do not have this interim scorecard. But it is there in principle and managers who embrace this will be more successful with their ventures.

BR: Everything you say is also true for small businesses. For them, every risk taken off the table increases their chance for survival and profits. Small companies do not have the cushion to absorb a risk gone wrong that larger corporations have. Risk reduction or avoidance should have a larger priority.

6. BR: Can you briefly explain the three types of risk you refer to that have to be dealt with?

CG: Let me focus on the first two. Deal killer risk is the type of risk that if left unresolved will kill the venture. Some entrepreneurs make the mistake of waiting until pretty far into the life of a venture before removing this type of risk. In the article we talk about the example of a satellite radio company pouring millions into a satellite system only to discover the receiver was prohibitively expensive. Path Dependent risk is risk that once resolved might change the subsequent direction of a venture. For example, working on product pricing might fundamentally change your manufacturing strategy. Resolving the one will shape the other.

The problem is, many managers proceed as if all risk is equal. Hereʼs the problem with that approach. Suppose you donʼt look at a deal killer risk until youʼve spent millions on a new venture. Or you spend millions on one risk that becomes irrelevant upon future information. That is why we talk so much about sequencing risk in a way that recognizes that all risk is not equal.

BR: The third type of risk, according to Mr. Gilbert, are ones that can be resolved without spending a lot of time and money. They are not as crucial as the Deal Killer and Path Dependent Risks, but if not addressed could lead to a serious problem. Not every risk in this category can be addressed prior to your venture formation or youʼll never get started. . .nor can every one be discovered until you are in business. However, your success chances are improved if you deal with them. You should try to prioritize them.

7. BR: How does an Entrepreneur with limited cash go about the process of identifying the different risks his venture will face?

CG: The fact that you have limited cash should make you more focused on identifying risks. You can start by asking questions like, which risks, if unresolved, could threaten the entire venture itself? Which risks will impact others? Which risks are the easiest and cheapest to resolve?

BR: I would also challenge all assumptions in planning the business, like your projected sales and how fast they will occur, expenses that you may not have anticipated, particularly those in acquiring customers, and your basic reasons why customers will buy your product or service. If any of your assumptions are seriously flawed, an unforeseen risk is awaiting that you may not have the resources to resolve. I would look for free outside help in addressing these issues.

8. BR: In your experience, how much change of direction does an average start-up company employ in their first year of operation and in subsequent years?

CG: There are a number of academic studies in this area. Most will show you that most new ventures have to change multiple times before getting on the right path. At Deseret Digital Media we have a huge poster that says: “We adapt”.

BR: My experience and studies show that almost all business plans dramatically change as the business progresses. Many of the opportunities you envisioned do not materialize and many new unexpected ones appear. Write your business plan in pencil.

9. BR: Expand on your thesis of investing in stages to maximize success.

CG: The key is finding points along the way to pull back and readjust. Staging capital often forces readjustment (so does running out of money). Imposing milestones, where key uncertainties will be resolved or managed, forces learning early in a venture. When resources are scarce this is forced. When resources are not scarce, the entrepreneur must impose discipline. A staged approach can help this.

BR: In my experiences, testing was always paramount in introducing a new product or starting a company. . .no doubt motivated by lack of cash. Never start out nationally or globally. Test your product in a small geographic area for customer acceptance and to tweak your offer and/or product. If itʼs a product, make a prototype and show to prospective buyers. If all say no, rethink whether to proceed or re-engineer the product or offer. Test on the Internet, direct mailings, ads, etc., in small inexpensive doses. Staging allows you to set measurable goals that need to be met before proceeding to the next step and its resource commitment.

10.BR: What advice can you give a resource challenged new Entrepreneur on where to get advice or the process of going about resolving the ventureʼs risks that he has correctly identified?

CG: Learn from others. Get a group of people around you who are willing to tell you where you are wrong. Do not reinvest until you have learned and adjusted to the market.

BR: You can learn from others by utilizing mentors, a board of advisors, or the free advice of organizations like SCORE, SBDC, and incubators whose missions are to help small businesses start and grow.

11.BR: Why arenʼt experiments good for confirming that your initial ideas are correct as well as to redirect a venture?

CG: Too many people run a test to “prove” they are right, rather than to adjust and learn. The power of experiments is to learn. Thatʼs why I keep coming back to the theme of scarce capital. It forces you to adjust and prevents you from perpetuating a pattern that is not working.

BR: We ran our tests to determine whether we were right or wrong, and the result dictated our next moves regardless of prior beliefs.

12.BR: Do you find managers reluctant to shut down their venture when the evidence shows it wonʼt succeed?

CG: Hope springs eternal for good entrepreneurs. That is a good thing, but it needs to be tempered with forcing mechanisms that help you adapt. You might hold on for pride/ego, because of financial commitments you have made, or from sheer cognitive blindness. Thatʼs why structured experiments and staged capital can be such powerful forcing mechanisms. They enable you to step-back and adjust.

BR: Many managers get a false sense of their products worthiness because they fall in love with their idea instead of in like. They rely too heavily on opinions of family, friends, or employees, who usually are overly supportive and reluctant to express negativity, even if itʼs called for. Often their ego interferes with their objectivity. Better to change course and admit you were wrong, than fail.

13.BR: Could you compare a New Ventures Development between a large company and a bootstrapping entrepreneur, based on their financial resources?

CG: Two things probably stand out. First many large company settings donʼt really treat resources as scarce, and the venture managers receive more resources on average. Second, the resources are not the venture managers, but the corporations so some individuals in large companies donʼt treat the resources with the same sensitivity.

BR: There truly is a difference when itʼs your money or someone elseʼs. The bootstrappers with their money at stake are more dedicated to taking less risks and managing those that they do to reduce or eliminate them.

14.BR: Is it safe to say that from reading your article that you believe that risks do not produce the intended rewards?

CG: Risks in themselves do not produce rewards, risk reduction does. Those who are better at this skill are better at generating returns.

BR: This should put to rest, the publicʼs perception that good entrepreneurs love and seek risk.

BR: Some additional thoughts on risk:

Risk is not absolute. Two people in identical circumstances can have dramatically opposing risks. The one with the experience in running a company with industry knowledge, with a good and experienced team, and a strong rolodex is facing minor risks compared to the person with little industry knowledge, experience, and relationships whose risk may be too much. The former is an insider and the latter an outsider. Risk is a little like beauty—it varies in the eyes of the beholder. The insider sees more beauty than the outsider. No matter which camp you fall into, your assessments and managing of risk must be analyzed and prioritized in light of your assets. Sometimes the best decision one can make is deciding to abort the venture because the deal killer risk canʼt be successfully managed.

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