What's the Right Risk?

What’s the Right Risk?

I despise books that characterize entrepreneurs as “risk takers.”  It’s total bunk and dangerous to boot.

Sure, being an entrepreneur is about taking risk.  But, the characterization makes business owners seem like gamblers.  Strategic risk taking and gambling are completely different.

In reality successful entrepreneurs take appropriate risks.

An appropriate risk is where:

The Best Outcome,

Multiplied by the likelihood the best outcome will occur, is

much greater than

The Worst Case Outcome

Multiplied by the likelihood of the worst case outcome will occur.

This analysis is exemplified by the risk–reward ratio.  Where the likelihood of a bad outcome – the loss of investment principal for example - increases, the benefit –the return on investment - must increase to offset that risk.

Take, for example, a lottery ticket.

According to the Florida Lottery website, the chances of winning Florida Lotto are one in 22,957,480.  In other words, you’re not going to win; the likelihood of a negative outcome is almost a certainty.

And the downside risk ($1.00 for the ticket) is extremely low and known.

The best case scenario is that you win millions or tens of million of dollars.  So, although the likelihood of winning is extremely low, the beneficial outcome is high. 

As a result, many believe playing the lottery is a reasonable risk to take.  (I’m also certain that most who play don’t actually consider any of this.)

It also seems to me that the Florida Lottery knows that most people consider the price of the ticket lost.  This is why they add a “good cause” to the benefit side of the equation by highlighting the money contributed by the lottery to Florida education. 

The purchaser gets the added benefit of doing good by buying the ticket.  Even if there’s no win, there’s still a benefit to the community.

What if, on the other hand, each lottery ticket cost $100.  At this point the downside risk would become material and the risk would not be palatable for a much larger group, even with the additional “good cause” benefit.

In fact, because the negative outcome is a virtual certainty, its only when the best case outcome becomes in the high tens or hundreds of millions of dollars that most people are willing to play.

How does this apply to your business?

First, as long as you accurately assess the likelihood of each outcome, the formula can help you arrive at a go / no-go decision.  You can’t be overly optimistic or overly pessimistic.

Jim’s software development business entered a license agreement where the other party refused to pay.  This licensee owed Jim’s business $20,000 in unpaid licensee fees.  After he consulted with litigation counsel, Jim determined it would cost about $10,000 in attorney’s fees and costs to get a judgment against the licensee.

Jim shouldn’t file suit unless:

• the license agreement permits him to recover his attorneys fees from the licensee;
• the licensee’s liability is almost certain; and
• Jim knows the licensee has more than enough assets to satisfy the judgment, interest and the costs of levying on assets.

If the licensee only has $30,000 in assets, Jim should not take the risk of suing the customer because:

• the best outcome is $30,000;
• there is a low likelihood that Jim could actually net $30,000 by levying on the licensee’s assets;
• the downside is paying an additional $10,000; and
• the likelihood of not being able to collect at all is very high.

Second, in the business realm the likelihood of either a positive or negative outcome can be manipulated by reducing and shifting the risk.

You can decrease the likelihood of a negative outcome through:

• investigating how the other party operated in the past;
• investigating the other party’s assets;
• having specific written rights and obligations of the parties; and
• getting a security interest in assets.

There’s no way to eliminate all risk. 

Unfortunately, this is what many lawyers try to do.  They try to push all the risk on to the other party and, in the process, kill the deal. 

Or, even if the other side signs a lopsided agreement because they “have to,” the deal doesn’t survive long because the other side won’t abide by the unreasonable deal terms.

It’s also important to remember that, without any risk, there’s usually no gain – no upside.  Consider an investment in government securities.  While there’s very low risk of a negative outcome – you’re virtually guaranteed to get the return of your principal – the benefit is also very low – a low return on investment.

Taking appropriate business risks won’t guarantee success.  But, it will avoid bad outcomes that did not have corresponding potential benefits.

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Clients in the News:

Here’s a link to Assessing the Damage, a Gulf Coast Business Review article about GeoCove, Inc., a developer of geographic information system software for disaster assessment (and Entrepreneurship Law Firm client).

Thanks for reading,

Ed

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