56% of small businesses fail after 4 years. Why? Well lots of reasons, but poor risk management is one of them. Let’s look at risks for small businesses, and how you as an entrepreneur can manage them.
Step 1: Classify Risks by Probability and Consequences
All risk is defined by two factors – how likely it is to happen (probability), and what happens when it does happen (consequences). Risk management is figuring out what goes where, and how you deal with it. Dealing with risk is a function of expense, i.e. you need to ask yourself, “Is trying to fix this risk worth what it will cost me?”
A: Ignorable Risks
Ignorable risks have a low probability of happening, and don’t matter much if they do happen. In other words you can ignore them. These risks aren’t cost effective to try to solve.
For example, there is always the risk of getting a flat tire. Now to prevent that risk you could invest in high end, armor plated, bullet proof tires that will never go flat… or you could remember that there’s a spare in the trunk. The chances of a flat tire are minimal, and at most you lose 10-15 minutes changing a flat, so it just isn’t worth the cost and effort to mitigate the risk.
B: Nuisance Risks
Nuisance risks don’t affect your business much, but they happen frequently, or are really likely to happen. In real life these risks can usually be dealt with quite easily if you’re mindful of the situation.
Printer ink running out is a nuisance risk. Very likely to happen with little to no warning, but it doesn’t impact you that much because of all the alternatives. If this is a big issue for you, being mindful of the due date, and starting the printing early can mitigate the risk.
C: Catastrophic Risks
These are the kinds of risks you spend money on. They rarely happen, but when they do, they can absolutely break your business. These are the kinds of catastrophes you insure against. A fire at the factory is a serious hazard, but not very likely to happen if you’ve taken proper precautions.
D: Deal Breakers
Deal Breakers are what prevent businesses from succeeding, and investors from investing. They are very likely to happen, and can sink your company when they do. Your survival depends on how well you can manage these risks.
If you’re operating a diamond store in a bad neighborhood, you will absolutely get robbed. And when you do, your business will fall through the floor. Deal breakers can only be dealt with by changing the entire business model, also known as don’t open a diamond store in a bad neighborhood.
Deal breakers can also be a combination of many smaller risks. They might seem manageable individually, such as a number of unrelated nuisance risks, but taken together can break the company.
There’s a 90% chance that you can attract the right target market. There’s a 90% chance that your marketing budget is enough. There’s a 90% chance that your target market niche is big enough to support your business. There’s a 90% chance that your competitors can’t replicate process. There’s a 90% chance that your competitors won’t replicate your patented product despite the threat of litigation (Apple vs. Microsoft, Apple vs. Samsung). There’s a 90% chance that your production lines won’t break down. There’s a 90% chance that your main engineer won’t take the day off at a critical moment. There’s a 90% chance that your supply chain will run smoothly. There’s a 90% chance that your customers will pay on time. There’s a 90% chance that your bank will cover you for working capital with short term loans. There’s a 90% chance that weather won’t affect your business this year. There’s a 90% chance that your insurance will pay out on losses due to weather.
The chances of getting hit by any of those are 10%. Get hit by all at the same time though and your chances of survival are suddenly 28.2429536481%. The point being all risks are ultimately important, and being reasonably good at handling them isn’t good enough. You’re the entrepreneur, risk management is your life.
Step 2: Classify Risks by Category
Next you should classify the risks by what category they fall into.
- Market Risks revolve around people not buying your products. Is there enough demand for your product at the price you have set? Accurately predicting market risks require good market research. The most successful companies spend millions every year on figuring this out. This is why we always tell our clients to avoid falling into the perfection trap. Your product will never really be finished. Ship the product as soon as it’s good enough, and start collecting feedback.
- Competitive Risks are those created by your competition and your competitive advantages. Your competitors will play full contact. They’ll copy your business model, try to improve on your innovations, out-spend you on marketing, start price wars, try to circumvent your patents, steal your trade secrets, and poach your best people. You need to develop appropriate defenses for each, then do it again as competitors figure ways around your defenses. Know your SWOTs, and focus on maintaining your competitive edges.
- Technology & Operational Risks are everything to do with execution. It includes your suppliers and vendors, your team, your product, your distributors, your supply chain and supporting infrastructure, and your backup plans. With execution there is no substitute for proper planning and experience.
- Financial Risks involve you running out of money. Many startups and small businesses fail because they are unable to secure the external funding they were banking on. They did not have backup plans for actions to take when the investor says no, or doesn’t say yes soon enough. We suggest two sets of business plans – one for when you have a hefty investment and can do it right, and the other for when you have no money and have to bootstrap. The other financial risk is changing financial scenarios – your customers might default, raw material prices might go up, exchange rates and interest rates can move, taxes and levies can go up, and the general economic structure can change.
- Team Risks are caused by people, if that wasn’t perfectly clear. People are simultaneously the most critical and least predictable of all business elements. The right team, the right experience, contacts, and synergy will guarantee success, while failing to recruit, motivate, and retain the right people will guarantee bankruptcy.
- Legal & Regulatory Risks are one of the most difficult for entrepreneurs to handle, and the nature, direction, and source of these risks are endless. It’s worse in heavily regulated industries like pharmaceuticals, or finance. That’s why it always pays to have at least two lawyers on the team – one for corporate disputes and one for intellectual property issues.
- Systemic Risks are system/economy wide risks that affect everyone in the industry. They are almost always out of your control. The housing bubble was one such systemic risk. These risks needn’t even always be so big and notorious. A simple rumor about mad cow disease diagnosis can cut down beef consumption by a large margin.
Step 3: Make the Risk Management Table
Step 3 is to fill out this table.
|Risk factor||Risk Category||Probability||Consequences||Control||Cost of Control|
|What is the risk||Market Risks, Competitive Risks, Technology & Operational Risks, Financial Risks, People Risks, Legal & Regulatory Risks, Systemic Risks||High, Medium, Low||What would happen if this event took place||How can you control or minimize the risk and consequences||What would these control tactics cost|
Be sure to get feedback from the entire team, they can offer multiple perspectives on the problems. Review the risk management plan on a regular basis, but don’t get caught up in it. Obsessing over the things that can go wrong is a great way to ensure something goes wrong. Being flexible and adaptable is far more important.
Also consider that most VC backed incubators have only a 30% success rate on average. That is to say promising businesses, with tried and true business models, in a growing market, run by gifted entrepreneurs, chosen through a highly competitive process by experienced VCs, monitored and advised by consultants and advisors with decades of experience fail more often than they succeed.
You’re an entrepreneur. You take risks for a living. Risk management is your life. Don’t be caught unprepared, but don’t let it paralyze you.