How big are your risks? What is the outcome? What can I do about it?
Simply treating all risks that you may be exposed to in your business “as equal” in your business plan doesn’t really help you manage them effectively, nor will it help an investor understand them. Further, whilst you probably know intuitively that some are more likely than others to occur, an investor who doesn’t really know you, will be left thinking you haven’t really thought them through.
I had a lot of exposure to risk in my investment banking career, and have subsequently carried this discipline to business. Of course, the risk metrics used in the investment banking world has been proven to be flawed post GFC, but the framework of assessing risk is a good one.
That is – for any given risk, a bank assesses what is the probability of it happening and what is the likely impact, and what are the mitigating actions to minimize the risk and or address the outcomes if it does happen. I don’t think Lehmans were very good at assessing risk to put it lightly but the framework was there I am sure.
It is pretty straightforward when all we are talking about is numbers – and when you have huge statistical ddatabases at your fingertips:
eg $100,000 invested in a company is a $100,000 at risk.
A) What’s the worst case scenario? $100,000 loss.
B) What is the probability of this happening? Using statistics, the bank would consider that, on average, it should be expected that a loss will occur x% of the time [averages proved to be a very expensive metric to rely upon in the run up to the GFC – as it was not an average event].
C) What can we do to reduce the impact of risk?
a. not take one [and not get a return] or
b.hedge.
Hedging is generally the preferred option.
I am not suggesting that it is necessary to develop the level of sophistication that a bank might have in their assessment of risk, but we can apply similar principals that will add enormous clarity on what the risks are in your business. It is not necessary to get too hung up on the exact score you give something your gut will tell you.
In business and ideally in your business plan, your assessment of risk can follow a similar framework as follows:
- State the risk – in wordss is fine
- Apply a score between 1-10 to show the probability of occurrence
- Apply a score between 1-10 to show the impact of such an occurrence
- Take the product of the probability and impact scores
- Rank them
- Add in a mitigating action to minimise the impact
- Are there any actions that can be taken to minimse the actual risk of it occurring?
Here are some examples of how risk in your business might be presented – you wouldn’t have all these entries in your assessment only one for the risk of death of the owner for example – the ones listed are only for illustration purposes:
Assessment of risk is A LOT more subjective in business in general than lending money. But attempting some sort of objective assessment like the above will go along way to demonstrate you have a handle on the overall risk of being in business.
Is your business ready to grow?
Some ideas just don’t scale. Some businesses, though profitable are just not suited to expanding.
This could be for several reasons, including:
- being dependent on a founder with a highly technical skill
- being dependent on a founder with personal connections
- having a small overall target market
- lacking a unique position in the market
Under these conditions you may have a business which is able to survive even thrive. But even though it may provide a good income for the owners of the business it may not excite an investor. You may see these conditions in a small business which has been started by its founder with or without a core team and has grown because of their skill, persistence, and tenacity. But with the addition of a few employees, it has stagnated. To clarify, this kind of business can be profitable but still not right for an outside investor.
Take as an example a builder who buys properties to renovate then sell. His business may be excellent, but unless he has the ability to systemise and leverage his skills, the profits are limited to what he is capable of doing himself. Thus, not scalable. So while this builder may make a good profit, an investor is unlikely to back this as a business.
An investor wants to see growth opportunities – by several multiples, not steady improvements. They want their money (and potentially their skill) to be the catalyst that propels the business, exponentially.
If your business is not one that fits the ideal profile for an investor, the options are to raising capital may be:
- seek it from friends and family, who have different criteria as an investor
- raise money through debt through a bank (usually secured against personal assets)
- grow organically
Another option is to isolate the constraint you have and design a strategy to minimise the effect on growth. For example if you, as the business owner, are the biggest asset and the biggest liability then the following may work:
- recognise that you are the bottleneck in the business, and due to which factors (sales ability, technical knowledge for example)
- hire/organise to duplicate these skills (not replace them) thus spreading the risk
- hire/organise to remove your non-core duties. If you are the best sales person for your product, and also do the accounts, cease to perform accounting duties yourself. It is unlikely you are the best at everything.
Every business has constraints. If the constraint is YOU, then it is unlikely that your business will attract an investor. If you rearrange your business in the right way you may still become an attractive investor target.
Make Your Business More Attractive to Venture Capital Investors By Derisking
Derisking is the process of removing risk factors from your business in order to make it more attractive to an outside investor or to an outside buyer. It is one of the most important factors in the grooming process in order to be an attractive company to invest in i.e. “Investor Ready”.
There are dozens of areas and hundreds of ways in which a business may be exposed without knowing it. In the normal course of business an owner may not worry about these factors, as they are within the “comfort zone” of operation. For an external party to get involved however, they need a much more transparent organisation so they are not confronted at a later date with skeletons in the closet.
It is important because businesses already face uncertainty. And while a venture capital investor may have a reasonable tolerance for risk, they will not welcome unnecessary risk. The goal is to control as many areas of risk as possible, so at least the risks are known. Most companies who have had an internal focus (i.e. have focused on sales, marketing and operations in order to grow) have not thought about all the areas in which they are vulnerable.
The process of derisking limits the areas of exposure, and therefore decreases exposure to uncertainty. It also increases the chance of success through improvements in clarity in almost all areas of the business.
Derisking falls into two areas – one is simply clarification (i.e. creating a contract where an informal arrangement was in place) and the other a change of substance i.e. changing a supplier because it lowers risks.
Some examples include:
- Formalising employee agreements. This may mean creating contracts for employees that have previously operated without one, or strengthening existing contracts. Particular issues would be with protection of IP, ownership of IP, confidentiality and restraint of trade after employees leave.
- Creating / clarifying written agreements with suppliers
- Creating/ clarifying agreements with customers
- Moving “ad hoc” sales to contracted revenue where possible
- Formalising and documenting internal processes
- Protection of IP – patents, designs, copyright and so on.
- Protection of data by limiting and monitoring access to key systems (CRM, accounts etc)
- Key employee insurance (including of the owners) in the event of death.
- Creating or clarifying credit terms and policies. Getting credit offered back within trading terms, and ensuring that all credit offered is documented with the correct application forms and personal guarantees.
- Removing reliance on key personnel, in particular vulnerability to information or relationships which may be lost on their departure. This may mean adding additional points of contact to key client accounts so individual relationships are less critical.
- Documenting key processes – getting the knowledge out of people’s heads
- Ensuring insurances of assets are up to date, and sufficient.
- Lowering legal exposure (liability). Ensuring insurances are held that cover product liabilities and so on.
- Ensuring compliance with all ATO and ASIC regulations. Creating systems for their ongoing compliance.
As you can see, this is a lengthy, but not even remotely exhaustive list. The due diligence process will highlight those areas which need further work. This might cost several thousand dollars, and lead on to significantly more expense than that. In some cases the process may take a year, and cost hundreds of thousands of dollars.
One of the important things to remember in raising capital is to build in the cost of raising the capital.
This falls into two main areas:
- Actual costs – such as hiring consultants – legal, accounting, corporate advisors, strategists etc
- Opportunity cost and change in focus. The process of raising capital for business can take anywhere from three months to a year (or more) of attention from key owners and managers of the business. During this time, it can be difficult to maintain a normal focus on things which are essential for survival – sales, marketing and operations for example. This cost can be significant, while at the same time be difficult to measure. In fact, this defocusing may have a major impact for any growing company that is pursuing two goals – new business, and business funding (or preparing for a sale of the business).
The need to derisk is apparent if you place yourself in the shoes of a buyer contemplating a purchase of (or investment in) your company. Without going through the derisking process, your company could contain any one of a dozen hidden time bombs (key staff who could leave and set up in competition, unsettled legal issues, poor data security etc). By transparently documenting how you have examined, reduced or been able to totally eliminate risks in your business then you are showing a buyer that you understand their concerns.
The flip side of the coin is that your company is now a far more attractive proposition to purchase or invest in. You will have invested a significant amount of money and time in the derisking process, but the result will be a company that is now sellable (all other things being equal) compared to a mystery. This means first of all that you may achieve a sale when previously none would have taken place, and secondly that you are likely to achieve a far higher sale price than before.
