Risk control

Controlling risk for startups – Part 2

In part 1 of risk control, I started a discussion on ways to reduce the impact of ‘luck’ in the very early stages of a company. We said that risk control is nothing but an act of managing skill and luck at various times in the lifetime of a company. I introduced 3 ways to reduce the impact of negative luck – First one was to rapidly increase our skills. Second is to reduce exposure to misfortune and third one is to be cognizant of biases and eliminate them. In this article, I discuss the second method in detail. Lets jump right into the topic.

We said that when skill levels are low, we need to control the exposure to misfortune. I’ve been using the term ‘exposure’ since the last episode without actually explaining what it really means. Let’s start by understanding this term.

Risk Exposure

Let’s plot the impact of risk on y-axis as shown below- so, lower down the axis, we have low impact and as we go higher we have a higher risk impact. Now red line is an ideal curve that goes downwards – anything that follows this line is a path we should consider as it actively reduces the impact of risk.

There are 3 actions we can perform that put us on this path –

  • Avoid risk – avoiding is to reduce the likelihood of coming face to face with negative luck
  • Blunt the risk, blunting is to soften the destructive power of a ‘negative luck’ event
  • Eliminate the risk, eliminating is to identify and remove the source of risk.

‘Avoiding’ doesn’t reduce risk, but reduces the probability of us being in harms way. Blunting is stage 2, the risk that cant’ be avoided is blunted to a degree that helps us to survive the event. Stage 3 is Elimination , a powerful form of risk reduction – it attacks the source and hence the impact on risk reduction is the highest with this method.

Avoidance & Blunting are passive forms of risk control. Elimination is an active form of risk control.

Lets look at an example to intuitively understand these 3 methods. I lived on the upper west side of Manhattan and the risk of ‘mugging’ was always a real risk late into the night. To put in place a ‘risk control’ strategy, I can do one of 3 things

This brings us to the question – how to decide which method of risk control to choose at which time? How do we know what the optimal strategy is?

Circle of Influence

Answer to the above question is in a concept called the ‘Circle of Influence’. There are lots of random events happening in the universe on which we have absolutely no control. Why did Prince and Meghan Markle separate from royal family, who got elected as the president of foreign country, which cricket team wins the world cup etc – things that are totally out of our control. Irony is the amount of time & energy such events suck out from our life (more on this in the ‘productivity arc’ I plan in future)

And then there is a small circle somewhere inside this universe called our ‘circle of influence’ (a term I borrowed from Stephen Covey, author of ‘7 habits of highly effective people’). Each of us has this circle, the size of which depends on what we’ve accomplished in life so far. Inside this circle, we control and influence the outcome of events to various extent. For eg, we have (almost) complete control on deciding which school our kids study at but we have limited control on who they pick as friends. As we grow in life and accumulate resources, our circle of influence grows but it still will be a small subset of the universe. 

Luck is what happens when events we don’t influence or control impact the outcomes – Luck originates in the grey region. Skill originates within the red circle.

Which form of risk control you adopt is dependent on how big your circle of influence is. Early on, when our influence is low, avoidance is the best strategy. As you build more influence, a combination of avoidance and blunting would be the optimal risk control strategy. Once influence becomes high, you can adopt a risk elimination strategy.

When influence is low, avoid and blunt risk. When your influence grows, attack and eliminate risk from its source

For eg, if I own a small e-commerce portal that is attracting a lot of customers, I ‘avoid risk’ of Amazon by building a ‘niche set of products’ with a strong value proposition that I can defend, On the other end, Amazon can choose to eliminate my risk by either giving me a buyout offer or by poaching my key employees or suppliers. While I can only avoid risk, Amazon with its massive resources, can eliminate risks.

Risk control methods

Reducing exposure to risk effectively means adopting an ‘avoid and blunt’ strategy. There are 2 components to this strategy – reduce likelihood of coming face to face with a negative luck event., and second is to reduce the intensity of that event, whenever it happens.
Here are the top 3 ways to cut down the exposure to risks:

  • Minimize spend
  • Have a deep hibernation plan
  • Keep the business simple.

1. Minimize spend

We go back to the old grandma formula to cut needless spending – this is a risk avoidance strategy. Cutting spending doesn’t reduce risk in the venture but leaves us better prepared to face adverse situations. Greater the spend, greater is the dependence on external resources – Greater this dependence, greater is the exposure – and as exposure increases, fragility of business increases. One hard blow of bad luck, and the foundation of business can collapse.

For an early stage startup, effectiveness v/s cost curve follows the power law. The least cost item that is also the most effective weapon for an early startup is the team of founders; founders keep their compensation to a minimum and are highly motivated to deliver. Next come the early core team that needs to be hired to build the product/service. Next is the most important acquisition channel that works for the company  – As Peter Thiel in his book Zero to One says, most startups have 70% of their business coming from one key acquisition channel. 

As we go down the curve, cost increases but the effectiveness continues to drop – this is where the ‘minimize spending’ mantra comes into play. Realizing what the absolute core is and restricting spending only on that core is the best way to avoid risk exposure in the early years.

2. Deep Hibernation Plan

Nature has a lot of lessons for us – one such lesson is deep hibernation. A deep hibernation plan is to use absolute minimum resources to keep the core business alive. Deep hibernation plan is the best blunting strategy because it helps us identify our absolute core, the thing that defines what we do and just focus on sustaining that core. An ounce of extra energy or a dollar of extra capital above the minimum threshold is a ‘wasted’ resource while you are in deep hibernation mode.

Deep hibernation mode is the best strategy to tackle unknown unknowns, risks we don’t know exist (Nassim Taleb calls such risks as Black Swans) – as you grow bigger, hibernation plan can allocate more and more resources for the rainy day.

3. Keep it simple

Keep the business simple and focus on the core. This master formula kills two birds in one shot – it is both an avoiding and blunting strategy. Chasing simplicity helps us in improving skills while cutting down exposure simultaneously. It helps us channelize our focus and objectively measure our progress. A simple business with lesser number of moving parts can also implement a better hibernation plan faster.

When you’re starting to build a business, start with a skateboard instead of a car. Keeping things simple means that there are lesser things that can fail – lesser things to fail automatically reduces the wrath of misfortune.

To summarize our key learnings of this episode,

  1. Reduce exposure levels when skill is low early on in the company
  2. Risk can be avoided, blunted or eliminated. When influence is low, avoid. When influence is high, eliminate risk at its source
  3. Spending brings dependency & dependency creates risk. Cutting expense is a best risk avoidance strategy for early stage companies
  4. Nature teaches us hibernation for tough times. Have a deep hibernation plan. Its a best risk blunting strategy to face unknown risks that can happen into the future
  5. Keep business super simple – simplicity is the ultimate ‘risk control’ strategy because it improves focus and reduces number of things that can fail