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Analyze Risk the Right Way As a company grows, so does the need for risk analysis. The stakes of every business decision mount as revenues and head count increase. Savvy leaders develop tools and strategies to weigh risk. They realize that by calculating their next move with care, they can reduce the kind of dangerous variables that can sabotage their best intentions. Craig Warhurst, a chiropractor in Broomfield, Colorado, has launched four successful practices by engaging in careful planning. He began by equipping one room at a time rather than filling his entire office space with expensive new machinery. "I see new chiropractors committing to big new offices with such high overhead," he says. "It's very difficult to make that work. I've found it's better to grow incrementally as your patient volume grows." Risk analysis rarely exists in a vacuum. Most executives begin by gathering facts and feedback from a range of sources. Then they digest all the input and factor it into their thinking. In considering a high-stakes risk, it's common to explore the issue with your management team and perhaps a few trusted people outside of work such as your spouse, mentor or executive coach. When evaluating certain kinds of risks, you may also solicit input from your most influential customers, vendors or independent contractors who work with your firm. A Framework to Weight Risk If you decide to proceed, it's often necessary to involve professional experts such as attorneys or accountants. Their "Here's what you need to worry about" bias won't make things easier, but at least you will know what potential roadblocks lay ahead. Eliminating the element of surprise can facilitate your analysis. Nevertheless, weighing risk is a pressure-filled exercise. Most issues arise quickly and require somewhat hurried analysis. Evershifting market forces, deadlines or other time-sensitive considerations can prevent you from sitting back and mulling over a risk in a calm, dispassionate manner. This three-step approach to risk analysis provides a broad framework for orchestrating the process: Identify the issue. In defining the threats that accompany the risk, check for both internal and external influences. If your company's current controls are flawed or outdated, addressing internal vulnerabilities becomes a priority. If customers make repeated errors or omissions in transacting business with your firm—or competitors wield a strategic advantage—your risk analysis may involve reviewing your service delivery or business plan. Quantify the risk. To calibrate the potential impact of a threat, apply worst-case thinking. Imagine the aftermath of a high-magnitude blow to your business and the extent to which your existing controls would mitigate the damage. A scientifically minded executive might classify the probability of a certain threat occurring in the next year as high, medium or low—and then use that scale to describe the impact of such a threat. Mitigate or eliminate the risk. Armed with a clear understanding of what risks exist and their probability and impact, the final step is to devise a plan to protect yourself or make smart decisions given the business realities you face. This usually means enacting safeguards to contain the risk or make it acceptable. These three steps require extensive commitment and team involvement. In a fast-moving workplace where you're putting out fires every day, it may seem impractical to apply such a deliberate process. In practice, even those business owners who embrace this three-prong strategy tend to race through it or skip steps entirely. "This process takes a lot of time and can make people feel that they're not adding much value," says Jim Nightingale, a Chicago-based consultant and author of Think Smart, Act Smart. "It's important that everyone feel that they're not just going through some long, disciplined process but they're also making smart decisions along the way." At some companies, the CEO assembles a risk review board comprised of a group of employees with diverse perspectives. This ensures that "the right people on your team go through the right gates" in analyzing risk, Nightingale says. Sift through the Right Data Even if you streamline the process, the biggest impediment to risk analysis is synthesizing mounds of data. In today's information- rich business culture, the challenge in assessing risk is concentrating on the correct data streams. Many entrepreneurs have a high tolerance for risk, but they may fret when forced to make a critical strategic decision without sufficient data. Some executives always crave more information regardless of how much data they've already amassed. Others fear that no matter what data they've collected, the facts and figures may prove faulty or misleading. Another vexing aspect of data review is discovering contradictory information among different studies or sets of statistics. This can frustrate individuals who wonder what to believe. At the same time, the prudent risk-taker must balance the "good" data (which confirms an existing bias) against the "bad" (which throws a wrench into a preferred course of action). In your excitement to pursue a certain risk, you may inflate the importance of information that supports your hunch and disregard or downplay everything else. "If I'm looking to buy a company, the upside is usually easy," says Randy Poole, president and chief executive of GlobalSCAPE, a San Antonio-based software firm. "I can reel off the benefits— I'm buying a revenue stream, I can cross-sell their customers, I can combine technologies and make us both better. Because the downsides aren't as easy to list, it's important not to get seduced by all that can go right." To ensure that he engages in thorough, balanced risk analysis, Poole devotes an equal amount of time to the pros and cons of any major decision. That protects him from the perils of overenthusiasm. In some cases, risk analysis and customer input work together. When a major customer shared a problem with Stewart Cramer, president of Phoenix-based LAI International, he thought that he could develop an innovative technology to solve it. But that would require a significant, multi-year investment. "At the time [2001], we were a small company and addressing this problem for our customer would require a huge commitment," Cramer recalls. But he listened to his gut—and considered the potential size of the market for this technology—and plunged in. Within a year, Cramer had marshaled 80 percent of his engineering resources on a project that was largely speculative. The customer signed a contract for a small sum, but LAI's development costs vastly exceeded that amount. "It wasn't obvious in the first few years that this would pay off," he says. "I bet the farm on it. And I met with some internal resistance from my CFO and others who couldn't understand why I was locked in on this." By mid-2005, LAI achieved a robust production capability for its developing technology and the initial customer was pleased with the results. Along with strengthening its relationship with that influential customer, LAI now seeks a broader application of this inventive new tool. Looking back, Cramer says a key factor that shaped his risk analysis was a realization that LAI couldn't overextend itself. He knew that "we couldn't bet big everywhere but we could pick one thing where we could be the best and play large with that one thing." The Power of Preventive Risk At its best, effective risk analysis can preempt problems down the line. Creating processes that insulate a company from mistakes can provide a kind of protective shield. "Because we're process-oriented, we can avoid risk in the first place," says Paul Sussman, district manager for Waddell & Reed, a financial advisory firm. "We have specific procedures in place that enable us to limit our risk exposure." Sussman, who's based in Boulder, Colorado, participates in monthly meetings in which approximately 35 financial advisors practice their presentations to clients. Each advisor uses preapproved materials that meet regulatory requirements. By ensuring that every financial advisor uses pre-approved presentation materials and follows all regulatory procedures, Sussman avoids the risk of improper or incomplete disclosure to clients. By ensuring that every financial advisor uses pre-approved presentation materials and follows all regulatory procedures, Sussman avoids the risk of improper or incomplete disclosure to clients. Warren Williams, an independent real estate broker in Boulder, Colorado, created an even better process to manage risk: a spreadsheet that helps determine whether to buy and develop a property. He designed the spreadsheet by identifying about 12 variables that affect the potential attractiveness of a property, from its age to its construction type to the cost of taxes and insurance. Then he assigns a grade to each factor using a 1-to-10 or 1-to-5 scale. "After I plug in all the factors on the spreadsheet, it usually spits out a yes or a no," says Williams. In the three years since he adopted this strategy, he has purchased less property. But the transactions he did make have all proven profitable. "I decided to do this because I wanted a more advanced, reliable formula to evaluate risk," says Williams. "And it has served that purpose well." Opinions expressed are those of the author(s) and do not necessarily represent the opinions of Compass Bank. April 2008 |
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