Striking the Right Balance Between Risk and Reward

Striking the right balance between risk and reward.

I am old enough to remember watching SaturdayNight Live when, during a segment of Weekend Update, they trotted out a special commentator, Father Guido Sarducci, “gossip columnist and rock critic for theVatican newspaper.” Anyway, that night, Father Guido announced his five-minute business school, which, after a decently long poetic pause, he revealed as a single rule: “Buy low. Sell high.” Which, despite its momentary comedic value, is accurate. The reason I mention that is because the topic I wanted to talk about today may be as obvious and as basic­—but is more often overlooked.

In the end, it’s only innovation if it’s good business.

The relationship between risk and reward is fairly established—it’s unlikely you get the latter without taking on the former. And if you read this blog often, you’ll know we adhere to the Clayton Christensen school of thought that if you don’t take risks on innovative ideas, some competitor will, and, in the process, eat your proverbial lunch. 

But that really only addresses the risk of inaction. If you’re convinced some risk is required to create or protect future opportunities, other than “gut,” how can an established business assess when the risk of commercializing innovation ideas is more than balanced out by the potential reward?

First, think like an evangelist.

In our business, we often see heads of innovation or product managers crafting an appealing pitch deck or pro forma for a new product or venture laying out a case illustrating only the best possible outcome. And that certainly has a purpose and value. There is no question, selling in any truly innovative idea to the C-suite or the Board may require painting as rosy a picture as possible (the evangelizing referred to earlier). But your analysis shouldn’t stop there.

Then, think like a hedge fund manager.

We’ve covered evaluating the scale of new opportunities in our Math for Marketers post last year, so we won’t go over those formulas again here. But any honest strategic assessment of an opportunity should also include an assessment of the potential risks. Here is a classic framework for modeling downside potential: VaR (Value at risk).

For all of you who are worried you’ve reached the math portion of this article, you may exhale now. While there is a tiny bit of underlying math, how to calculate VaR can easily be explained in plainEnglish. What could I expect to lose, as a percentage or monetary value within a specific period of time?

In other words, try to determine what are the chances that you build it and no one comes. Obviously this, like your pro forma, will be filled with assumptions. And the level and accuracy of business intelligence supporting those assumptions directly influence the value of your result.

Let’s use a mythical startup as an example, say a go-kart sharing service (hey, nobody thought scooters would be a thing).You would want to list out all the inputs and assumptions you have in your pro forma, like cash on day one, the monthly burn rate of running a go-kart sharing service, e.g.: data service fees, cloud servers, office space, salaries and benefits, capital expenditures for go-karts, customer acquisition rates, subscription income, etc. and begin to start adjusting for negative scenarios.

What if the adoption rate is slower than expected? What if you need an excess of karts, day one, just to make the service viable or appealing to your initial customer base. Ultimately, you want to add up all the potential bad, then multiply that result by what you believe are the chances it will happen. Overly simplified, in this scenario:

VaR=(potential losses x odds of incurring those losses)

Of course, it’s rudimentary on a Father-Guido-esque level to say that you want the net value of your pro forma to exceed the net VaR—meaning you believe the odds of being profitable to exceed the odds of loss. But there’s also another complicating factor—time.

Map the upside and downside over time.

A common issue with innovative businesses is that it’s tough to predict adoption rates. New ideas take time to be understood, let alone adopted by customers. Hence, risks may be immediate and rewards may take years. The point here is to be aware of scenarios where both the best- and worst-case scenarios are crossing the zero into the negative and anticipate bottlenecks/low cash flows. In other words, you want to anticipate moments of exceptional risk on the way to greater rewards (and be properly capitalized to weather them).

It’s funny, because it’s true.

Coming full circle, we laughed at Father Guido because ultimately we recognize that for all the complications of business, it all boils down to “Buy low. Sell high.” As basic, is the relationship of risk and reward. The trick is not being so entertained by the potential rewards that we don’t weigh and balance the risk side of the equation.