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Elon Musk faced a big risk. In fact, in trying to create an all-in-one financial services supermarket on the Internet, he faced risks that, taken as a whole, were too big to understand, much less deal with.
So Musk, a 28-year-old entrepreneur who'd graduated from the Wharton School of Business at the University of Pennsylvania in Philadelphia and already had one successful Internet start-up behind him, split the risk into pieces when he started his Palo Alto, California, Internet company, X.com, this past March. To reduce the chances of running afoul of government regulators with his innovative venture, for example, he and his investors chose to buy an existing bank rather than face the hurdles of licensing a new institution. He similarly separated risks associated with marketing, financing and other aspects of X.com. Then, separate strategies were devised for dealing with each area of risk.
Musk's technique of disaggregating large, unwieldy risks into smaller, manageable chunks is part of the practice of risk management. Along with tools such as real-options pricing, portfolio theory and leveraging familiarity advantages, risk management is used by a number of large companies and almost all major financial institutions, according to Lowell Bryan, a director at management consulting firm McKinsey & Co. in New York City.
In Race for the World (Harvard Business School Press), a book on global business strategies Bryan co-wrote with three other McKinsey consultants, Bryan identified risk management as one of the most important abilities for surviving in a 21st century business climate abounding in complexity, globalization and competitiveness. "Changes going on in the economy," he says, "are making this essential."
Mark Henricks is an Austin, Texas, writer who specializes in business topics and has written for Entrepreneur for nine years.
The scientific study of risk management probably began in the 13th century, when mathematicians studying gambling odds built the foundations of modern probability theory, according to Bryan. However, risk management has only flowered during the 20th century, as financial institutions have employed increasingly complex strategies in order to enhance investment returns without adding too much risk. "That," says Bryan, "is where it's become quite a sophisticated art."
Many of the risk management techniques used by large financial institutions, such as options pricing and portfolio management theory, are built around complex mathematical formulas. These may be used to do such tasks as manage pension fund investments, set prices for government bonds and so on. However, you don't have to be a mathematician to manage the risk and reward of such common business activities as starting a company, entering a market, developing a new product, signing up a strategic partner or embarking on a marketing campaign.
One basic risk management strategy is to disaggregate risk. That may sound complicated, but, in essence, it simply means breaking down a large, unwieldy risk into smaller, more manageable pieces. Typically, a company might, as X.com did, break a risky initiative down into areas defined by corporate departments: marketing, finance, operations, human resources, legal and so forth. With the problem thus separated, entrepreneurs are better equipped to recognize, analyze and manage the separate risks.
At X.com, for instance, Musk dealt with the financial risk by raising more money than the firm was likely to need. "If things don't work out exactly as planned," he says, "we've got plenty of capital." In fact, raising money was relatively simple; the public is well aware of the enormous gains early investors have made in numerous Internet start-ups, including Musk's earlier firm, Zip2 Corp., which he sold to AltaVista for more than $300 million earlier this year.
Another way to manage risk is through the leveraging of what Bryan calls familiarity advantages. This is similar to concepts such as relying on core competencies, focusing on niches and simply doing what you know best. In a sense, leveraging familiarity advantages means avoiding or minimizing the risk of the unknown. It's common sense: When you know what you're doing, you're less likely to make a mistake than when you're trying something for the first time.
Musk did this, first by leveraging his own expertise at starting Internet businesses. "It's important to have expertise in what you're going to do," he says.
However, there's more to X.com than simple e-commerce. Musk had only minimal knowledge of the financial services industry; he dealt with this issue by bringing in people who could provide the familiarity advantage that he lacked. That meant Musk had to hire people with experience at starting banks and mutual funds from scratch. "They know what steps need to be taken," he says. "They don't have to figure it out along the way." It also meant retaining the most experienced legal advice he could find, sometimes from several different law firms, to mitigate the possibility of legal and regulatory problems.
In essence, there's nothing complicated about making the most of familiarity advantages. As Bryan puts it, "Leverage what you're already good at, and figure out how to do more of it."
Choose The Best
Improving your management of risk doesn't have to be expensive. You don't need costly technology, time-intensive training or disruptive reorganization, says Bryan. The main requirement is a change in your mindset which forces you to think about opportunities in terms of breaking down big risks and applying familiarity advantages whenever possible. This can be done almost unconsciously, and many good risk managers do just that. "The best are instinctual," Bryan says. "They haven't thought about what they're doing. Good business managers just [naturally break down risks and use familiarity advantages]."
Clearly, it can be costly to hire top talent to provide you with any familiarity advantages you lack. However, just as clearly, this is well worth it, Musk says. And entrepreneurs are often uniquely well-positioned to give talented and ambitious people what they most want from their jobs: a chance for ownership, in the form of stocks or share options, in a fast-growing enterprise.
"Entrepreneurs shouldn't try to hold on to too much of the company," says Musk. "It's better to give away a piece of it to get somebody stronger and maximize the overall value of the pie than to try to hold on to too much."
Entrepreneurs who try to remove all risk will take no chances and, as a consequence, generate no rewards for themselves. On the other hand, entrepreneurs who risk everything by, for instance, trying to create new industries where they can play central roles, are setting themselves up for either disastrous failure or incredible success, Bryan notes. Somewhere in between these two extremes is the playing field for most entrepreneurs, but exactly where your spot on that field is depends on your own familiarity advantages and risk management skills.
In the next 20 years, Bryan believes, these risk management techniques will become universal among successful businesses. While small businesses may do it less formally, they will still do it, he says. "Is this practical for most people?" Bryan asks, rhetorically. "It's going to be practical for the winners, because this is really what differentiates successful small businesses."
Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk (Wiley) is a highly readable and informative study of the development of risk management, from the gambling strategies of Roman legionnaires at the ancient game of knuckle-bone to the arcane financial strategies of 20th century speculators.
X.com Corp., http://www.x.com