A Bias Against Risk
You can understand why so many SMEs are growing at a
low rate because they believe their business is “good enough”.
Their revenues are fulfilling the owner’s lifestyle and they are a
manageable size. Growth in revenues of a private company
depends on the owner and their appetite for risk.
In public and larger corporations, overconfidence is a natural
bias in managers. In stark comparison, private companies’ lack
of risk is more prevalent because the money is coming directly
from the owners’ own pocket. The profit foregone by passing
on the new product is not seen to be drastic, in the example
above, it was under $10M. Yet, these decisions to push back
from business expansion risk are being played out across many
owner-managed firms in Canada and collectively this has a
larger impact on the economy.
Owners make hundreds of these decisions about their risk
appetite, often alone. The penalty to the business owner and their
company with this low risk vs. reward bias is that the company
ends up with underinvestment and fails to achieve financial
performance. The impact will become evident at the time of sale
with a weaker retirement fund for the business owner. In the end
their poor risk appetite will reduce their potential lifetime earnings.
Build a Company Approach to Risk
A business owner interested in improving the quality of risk
may want to borrow a few best practices from private equity.
First, the business owner can ask how much risk they
are prepared to carry on their own. Family business owners in
particular, can be vague on this key point, and it freezes their
team and discourages them from seeking new opportunities. Key
personnel may even leave the company.
The business owner can draw on the expertise of an Exempt
Market Dealer (EMD) who is an expert in risk and can work with
the owner and the CFO (if there is one) to manage and reduce
their risk bias.
Retooling how to assess risk can help a company’s revenues
increase and take pressure off the owner.
Size of Investment
The first place to begin to improve risk assessment is by
size of project. Owners and their CEOs who look at the projects
requiring larger investments will naturally have a bias against risk.
Their job, and the company’s performance, will be impacted if the
project goes awry. In contrast, the middle level of the business
will be taking smaller risk decisions, which on their own do not
risk the financial health of the company. In fact, managers at this
mid-level tend to err on the side of risk aversion too. All across the
company, the growth is being held back.
Portfolio of Risk
The company CFO and senior management can work with
an EMD to assemble an overview of the portfolio of risk decisions
being proposed and made across the business. The individual
small investment decisions can then be pooled and the discount
rates applied will be far more realistic. For investments under 5%
of capital, a lower discount rate can be used and management
can be confidently encouraged to work with a higher level of risk.
Sensible Appetite for Risk
The EMD can assess what causes bias and will look at how
the company weeds out good projects from too risky ones. They
will assess if the incentive program rewards the people within
the business for the right decisions. The right EMD is a valuable
resource in risk management for the ambitious owner, and of
course can be a valuable partner in raising the capital needed to
support taking those wise risks.
Set a Process for Risk
Have a time and place to invite senior management to put
up a project idea and ask them to describe the project and
potential returns. Then get them to do a Scenario B but increase
the risk of the project. If possible, try for three or four scenarios
with different risks.
Scenarios should not be an easy percentage increase, but
should include additional costs such as production along with
sales force considerations, expected market penetration rates
and brand impact. Have the manager give an analysis of the
best outcome and worst flop for each scenario. By pushing for
the highest potential upside, risk can be made more tangible
The process will develop the skills of the team to make better
investments in projects with higher returns. Scenario planning for
projects can be run on a regular timetable and the skill of risk
analysis will be more developed at the management level.