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Food For Thought: Business Model Risks

    • 88 posts
    May 23, 2010 7:29 AM EDT

    A good model is one that is scalable, requires little manpower (minimal payroll) and minimal rental.

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    • 394 posts
    June 14, 2007 9:20 PM EDT

    Food For Thought: Business Model Risk

    This article is a quick discussion on business models and risk. This article is by no means a definitive guide for entrepreneurs - or for anyone - but hopefully it will stimulate some discussion and lead to a few book recommendations. This article doesn`t deal with things in really classical terms as I try to use analogies in an attempt to avoid enormous piles of jargon. Nor does this article attempt to select a superior model - there are of course risks and benefits to each.

    Business Models

    1. Shallow Skew. Typically a volume sales model. Lots of customers contributing a similar amount to your annual revenue and profits. Target stores. Grocery stores.

    2. Deep or Steep Skew. A few customers who contribute large amounts to your annual revenue and profits. Car dealerships. Furniture stores. Generally fewer transactions.

    Risks

    There are pluses and minuses to each model, especially when it comes to risk management and the interaction between risk management and cash flow and costs. Generally speaking, you have less cash flow risk with a higher transaction count, because statistically speaking, the odds of suddenly losing a big chunk of your customer base are smaller. The statistical decrease is proportional to the number of customers.

    If you have a large network of customers, negative or positive changes to one section of the network are less likely to affect the other portions. Think of it like the phone company. Since they have millions of customers, it doesn`t matter if they lose thousands of customers. But they only make a little money from each, so they have higher risk with respect to cost increases that spread across their customer base.

    So in that sense, margin risk is often much much higher with shallow skew. Most markets are subject to natural price fluctuation, from direct or indirect market forces. When your margins are smaller [ dollar wise, not percent wise ] you are much more at risk of "seemingly-small" cost fluctuations affecting a lot of your revenue.

    If you make $1-$5 on thousands of items, a 50 cent increase in cost per item reduces your profit margins between 10%-50% while your revenue does not change. These are huge numbers that will spread across your entire range of transactions. So with risk better distributed, you also have to take into account that the risk can affect more of your transactions. [ This has its own almost never-ending series of pluses and minuses. And here I write a few sentences against the thousands of pages devoted to this subject in books! ]

    On the other hand, if you sell cars, you have another risk: transaction risk. Since you have fewer customers, it is statistically more likely that you will lose customers and each customer`s contribution to your annual profit is much higher. But if you are making several hundred or several thousand dollars per sale, you have much more insulation against nominal cost fluctuations. Think of this like a super expensive and exclusive phone company with only a few thousand users. In this case, if 300 of 3000 customers go elsewhere, it is indeed a very big deal for cash flow, and if it occurs at an inconvenient moment, it can be quite disastrous. On the other hand, nominal cost increases don`t matter as much.

    With this business model, it is also easier to induce high value customers to spend more money on additional products and services. This model makes it much easier to have extremely - and I mean extremely - profitable customers. In fact it might be entirely reasonable to assume that the strategy of selling additional products and services to high value customers is what leads to a deep skew.

    At the beginning of this article, I said that each model has benefits and risks. I`m sure most of us can think of companies that are either prosperous or in trouble, regardless of the depth of their skew.

    Entrepreneurs

    Entrepreneurs are very cost sensitive. They know that liquidity is a great way to hedge against the broad risks of the business environment. In fact, from the time I`ve spent at SUN, it`s clear that many entrepreneurs believe [neither rightly nor wrongly] that maintaining liquidity is the only practical hedge against cashflow risk, margin risk, time risk, capital risk, cost risk, labor risk, project risk, non-payment risk, etc.

    That said, a desire to conserve cash in an effort to guard against risk has many of its own risks and they are often significant. I`ve seen people on SUN who clearly went through a lot of work to develop their business, only to sabotage what appears to be a $25,000 or even $100,000 investment by doing their web site themselves, resulting in no sales.

    The same goes with homespun marketing/copywriting, which is usually a complete disaster. A rigorous analysis of the risks involved [ spend $4000 for a web site -vs- venture failure ] would of course show the total and utter common sense in paying for web design. But hardly anyone - myself included - is really good at quantifying risk. I can`t even begin to tell you all the mistakes I`ve made in this area. It would be an awfully long list.

    A great example of poor risk assessment is drunk driving. Put aside the moral issues for a moment while we examine the costs. Even if the cost of a taxi ride home is $100, driving drunk puts at risk between $2000-$10000 dollars in both the short and long term. This means that the certain risk of losing $100 seems less palatable to many people than the possible risk of losing 20x to 100x as much in the event that you are arrested for driving under the influence. Even if you imbibe responsibly, it is difficult to precisely ascertain your blood alcohol level before you get in your car. In fact you could argue that many thousands of dollars are unthinkingly put at risk any time you leave a bar unsure of your blood alcohol level, regardless of how much you`ve had to drink. Certainly this is not meant as a moral argument; it`s just an example.

    One of the rarely-ever-mentioned keys to success as an entrepreneur is learning how to measure risk and design a business and business processes, that take risk into account and make it survivable. Redundancy is one way. Hedging is another. For example, you can hedge the risk involved in paying for web design by agreeing to subdivide the total cost into four separate payments. This better manages your risk of capital against your risk of non-completion. It also reduces your cashflow risk because cash in your bank account is the only hedge against the checks you`ve written against the account. If you pay a web designer with installments, the money stays in your account for longer.

    Generalized fear or business anxiety is often rooted in poor risk assessment and unimplemented risk management. Paradoxically the very things designed to alleviate these vague worries often make things worse. The desire to maintain some kind of cash flow leads a business to take on unprofitable clients. This wastes time and energy; while the client may contribute to temporarily positive cash flow, you`ll be no better off at year`s end financially speaking and certainly more stressed. Poor pricing decisions and ad hoc price cuts are another frequent reaction to unmeasured risk, when perhaps price increases would be appropriate.

    Of course there is one hedge against risk that is perhaps the most powerful of all and probably the only real solution if someone`s budget is tightly constrained. What is that? Information of course. If you have project risk or venture risk because you know very little about marketing, you can always pick up a book or two. You can hire a brilliant accountant or a fantastic lawyer. Risk management requires creativity and an ability to think about the big picture for a few hours a week.

    Choices

    To conclude: entrepreneurs must choose a business model but their choice of model should align with their tolerance for risk and their ability to measure and manage it.

    As I said at the start, this article does not - cannot - address the intricacies of business models and risk. But hopefully it starts a conversation! How do you guys think about risk? How do you manage it?

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