Managing Business Risk
“Life can only be understood backwards; but it must lived forwards.” — Søren Kierkegaard
I don’t know what is going to happen in the next minute, hour, day, week, or year.
Neither do you.
The future is uncertain and unknowable. That image above captures much of the challenge — the future is neither linear nor possible to see.
Guiding principles on leadership from some of the best in our lifetime including Colin Powell and Jeff Bezos, recommend seeking out leaders who “can see around corners”, “anticipate” and “think differently.”
Most of the focus is on “seeing around corners” and “anticipating.” I do not believe either are possible.
I will say more about “thinking differently”, because I see that piece of advice as both undervalued and poorly implemented.
Jason Zweig reposted a transcript (well worth reading) of his 2004 interview with investment manager and economic historian Peter L. Bernstein. Bernstein talks about two important lessons in investing (applicable to both personal and corporate finance.) My thoughts below are heavily influenced by the content of this interview.
The Role of Finance Leaders — Predicting the Future
Finance leaders are repeatedly asked to forecast the future, to provide a point estimate, in the normal course of business. Every year we prepare and defend an annual budget to the Board, we defend a 5-year business plan to get to a 409(a) valuation (for private companies issuing options). And, in growth companies burning cash, we are asked by investors “how long will the cash last?”
Predictions about the future are a normal part of our lives — turn on CNBC and you will hear stock price and interest rate predictions or listen to sports radio for Super Bowl score predictions. We make judgments and risk personal capital (whether in the financial markets or the betting markets) based on the input of “experts” who make predictions.
Why the obsession with predicting the future? Psychological research has found that uncertainty (not knowing what will happen) contributes greatly to fear and general bad feelings. Point predictions suggest an ability to control the future. Having control over our lives and future outcomes is a deep, primal desire.
Precision Masquerading as Accuracy
Financial models (whether related to future outcomes in personal or corporate finance) suggest a degree of precision that is unwarranted. Companies approve business plans and associated incentive compensation plans based on precise point forecasts for revenue, EBITDA, and free cash flow. Public companies will provide guidance within a tight range to investors and analysts.
If we were to look back just 1 year to early February 2019, very few people would have forecast the next 12 months with any accuracy (whether for jobs data, the stock markets, e-commerce growth or change in travel patterns.)
We are hard-wired to accept forecasts and predictions. We mistakenly assume that a combination of specificity, a detailed story with lots of factual data from the past, and a confident presentation by someone with an appropriate pedigree means their forecast will be correct.
We do not spend enough time thinking about the implications of our precise forecasts turning out to be inaccurate.
Creating Multiple Plans — A False Sense of Security
The most common (and possibly dangerous) words uttered in a business meeting when a somewhat complex capital allocation decision must be taken are, “Let’s build a model.”
Financial modelling has become the go-to data point to inform decision-making under uncertainty. A modelling exercise is assumed to be a core part of risk assessment and management.
A common approach to annual planning is to create “multiple” models to show the Board. This approach might include a “base Plan” for approval, a “stretch Plan” (that may become the internal plan against which employee targets are set), and a “downside” or “conservative” Plan to show awareness of the existence of risk.
I have yet to see a “downside or conservative” plan presented to a Board or investors showing the business “self-destructing” or getting into a difficult financial predicament.
Just because the Finance team has created multiple models does not mean they have captured a reasonable range of possible outcomes.
Bernstein refers to Leibniz’s warning as a core part of his approach to thinking about the future. Leibniz’s warning is based on the following story. In the early 1700s, two now famous scientists and mathematicians, Jacob Bernoulli and Gottfried von Leibniz were exchanging letters discussing probability and predicting outcomes where chance was involved. Bernoulli’s asked about the merits of prediction (about diseases) based on extrapolating from past experiences (from examining corpses.) Leibniz replied that not everything could be forecast accurately (or modelled based on the past) saying, “Nature acts in recurring patterns...but only for the most part.”
Given our experiences that the future is, in most instances fairly similar to the present and the past, we have become overly reliant on models. We do not think enough at Leibniz’s caution “only for the most part.”
The Path Forward
Realizing that risks exist and no one can actually see around corners, what is a thoughtful Finance leader to do?
I propose that Finance leaders adopt the following processes and approaches.
1. Think Differently — “Diversity” of Thought and Experience are a Huge Help
When hiring senior leaders, most CEOs and Boards tell the recruiter to find someone who has been through this experience or stage before. Most candidates, especially “great” candidates want growth, learning and challenges, which requires doing things they have not done before.
I have argued (with limited success in interviews) that the “been there, done that” approach to hiring is sub-optimal. The real skills that matter are two-fold.
First, hire Finance and People Operations leaders who understand how to make capital allocation decisions and to hire, engage and retain people. Industry knowledge matters much less and can be learned quite rapidly by the right candidate. Spend time asking them to articulate set of principles they use to solve problems.
Second, seek out diversity of thought and experience. People who think differently and have a varied set of experiences are more likely to creatively solve problems and manage future risk better.
Peter Bernstein says that financial markets have “memory banks”. He goes on to say, “Experience shapes memory; memory shapes our view of the future.” This resonates deeply with me and helps me get even more convinced of the importance of diversity.
In the risk management and assessment conversation, I recommend involving people with different backgrounds and experiences — cultural, geographic (overseas experience), socio-economic, industries, different business challenges (turnarounds etc.), age etc. The challenge is to give them a real voice (listened to, respected, and taken seriously) even when their “rank” or “pedigree” may not be as “high” as others around the table.
2. Identify Business Risks
When Donald Rumsfeld gave a press conference in February 2002 about the situation in Iraq regarding WMDs, he brought the phrases “known unknowns” and “unknown unknowns” into popular speech.
All companies forecast the outcomes they want (e.g., revenue, expenses etc.) as well as the build-up to those outcomes (i.e., # of goods sold * average price or # of customers acquired * average contract value). Often the forecasting process ends there. This limited effort is the equivalent of focusing on the “known knowns.”
The next two steps I suggest include:
(i) Identify all the activities and stages (or events) that lead to an outcome (such as a customer being acquired or renewed); and,
(ii) Identify the risks and friction points to these activities happening smoothly and with successful outcomes. These two steps will force deeper thinking on “known unknowns” and “unknown knowns.”
3. A Pre-Mortem Exercise
Spend more time thinking in advance about what could go wrong.
For important decisions or future milestones, engage in a “pre-mortem” exercise. The graphic below show the steps.
This exercise, when done well, creates a sense of psychological “safety” allowing employees to raise issues they are concerned about. And it opens to lens to more creative thinking about what could happen, beyond what we hope does happen.
4. Know When to Apply Expected Value Math — The Answer is Not Always
We are generally taught to make decisions on the basis on expected value. Expected value is calculated as follows.
(i) Assign probabilities to all outcomes.
(ii) Figure out the likely value (positive or negative) of each outcome,
(iii) Multiply these together and summing the results to get a weighted average (or expected) value.
(iv) Choose the option forward with the highest expected value relative to its cost or investment.
This simple advice does not apply in many circumstances. Only rely upon expected value math to make decisions when the following is true:
(i) Downside consequences are not material. An example would be if you were taking a small allocation of the marketing budget (say 5% or 10%) and choosing to experiment in new channels. Even if you lost all that money (i.e., got no new leads or business), the opportunity to learn and potentially get the upside would be worthwhile. Or,
(ii) The decision is reversible. Jeff Bezos called these types of decisions “two way doors”, where after seeing the impact, and if it is negative one can get back to the original point without much pain. Or,
(iii) There are multiple, independent chances to take a similarly sized positive expected value risk. An example would be a financial advisor who gets paid on upside creation recommending high risk, high return bets to multiple clients. A poor outcome for any individual client will not substantially offset the overall good outcome for the average client and thus the financial advisor.
5. Avoid Risks Which Can Have Bad Outcomes, Even When the Probabilities are Low
Bernstein’s second piece of advice from history is what he calls his version of Pascal’s Wager.
“Consequences are more important than probabilities.”
Put another way, if the downside of an outcome is really bad, even when there is a large upside and even when the weighted average outcome is positive, one should never take that risk.
Morgan Housel’s recounting of a skiing experience he had when on a competitive ski team, called the Three Sides of Risk, brings this concept vividly to life.
In the business world, these situations apply to what some call “bet the company” moments. Ideally avoid taking “bet the company” risks, and if you chose to go down that road, think very carefully about the alternatives. A common example is engaging in significant, steady burn rate increases (usually related to hiring) when the Leadership Team believes the company has product-market fit, is across the chasm, and sizable revenue growth is just around the corner.
If these three beliefs are not all true, then a variety of negative outcomes will result. Running out of money, a large, forced downsizing, a deeply dilutive investment round or a fire sale are all bad outcomes for almost everyone involved with the business.
6. Do not confuse Time Probability (the actions of one entity making multiple decisions) with Ensemble Probability (multiple entities making one decision)
This is a principle I have recently been learning more about. It is at the core of ergodicity economics, a concept first discussed by Ole Peters in 2011 and more recently popularized by Nassim Taleb in his books Antifragile and Skin in the Game. The best explanation I have seen for how humans naturally follow ergodic behavior is in this piece by Mark Buchanan who says, “individuals optimise for what happens to them over time, not what happens to them on average in a collection of parallel worlds.”
A more visceral version of the same concept was this Naval tweet in 2018: “Six people playing Russian Roulette once each is not the same as one person playing it six times.”
Ergodicity economics helps explain that it is perfectly rational for humans to have an asymmetric risk appetite towards gains (less enjoyable) and losses (more painful). This concept, known as Prospect Theory, was popularized by Kahneman and Tversky.
This distinction between Ensemble and Time-based probabilities is at the crux of the difference in risk appetite between most venture investors and most operators. The former has the chance to place tens if not hundreds of “return the fund” investment bets in unrelated companies with similar odds of success. Operators (especially non-wealthy founders, CEOs, and Finance Leaders) have a single opportunity (one company) where they have to make multiple, risky decisions over time, and where the financial outcome of the company really matters to their net worth.
One party, the operator, must survive to succeed. The other party, the venture investor, must accept and embrace failure to earn the returns demanded by limited partners.
7. Be prepared for the “status quo” to change
Right now, raising capital in the public and especially private markets seems easy, even compared to a few years ago and certainly compared to a decade or two ago.
If you are the finance leader at a free cash flow negative business which will likely need to raise equity in the future, don’t assume it will be as easy as it is today. Your business plan should not rely too heavily on “luck.” By luck, I mean permanent, cheap capital willing to take high risks being available in the future.
So, what does that mean in practice:
(i) Focus — Take fewer “risks” and ensure by focus you increase the probability of a good outcome.
(ii) Defer some investments — Reduce your burn rate (e.g., hire fewer resources) to stretch cash flow out a bit further, knowing you are reducing the chances of a home-run outcome in the near term.
8. Reduce dependence on a few things going right and staying right
Some examples of where a high dependence on certain variables is risky includes:
(i) Customer Concentration. Revenue quality is much poorer when a few customers account for a disproportionate percentage of revenue.
(ii) Employee Reliance. One example I often see are companies where a single technical person must be part of most product demos and technical sales conversations. That is a non-scalable business.
(iii) Asset Liability Mismatches. Some examples include borrowing short term funds and investing in longer-term illiquid assets (a major component of the collapse of Lehman Brothers) or earning in one currency and borrowing funds in another (a lot of Eastern European home buyers borrowed funds in Swiss Francs and Japanese Yen during the housing bubble of the last decade).
(iv) High leverage. When asset values are increasing, leverage is your friend. Today, with interest rates really low, leverage is more appealing than ever. However, in many normally stable businesses (e.g., real estate) high leverage can destroy you during a downturn (as many retail, office and hospitality real estate owners are finding out during COVID.
We live in an age when the prevailing advice is to strive for greatness, even if risky. Don’t just settle for good enough. I admire and even relate to that philosophy as it applies to many aspects of life. Yet I would suggest a different approach to Finance leaders. The CEO/founder may be readying to launch a rocket destined for Mars. The investors may be urging you to get there tomorrow and with less fuel wasted. The responsibility of the Finance leader is to ensure the rocket does not explode in trying to achieve escape velocity or run out of fuel before reaching its destination.
You can’t reach your destination if you don’t survive the journey.