Risk at the heart of any successful business strategy

The single greatest driver of business success is not a unique idea, innovation, marketing, networking, leading or managing. It is the willingness and ability to take calculated risks.

There are many different definitions for risk, but a useful one is that risk is the presence of an unknown negative outcome. Another point to make clear is that the key success factors are taking and managing risk, as opposed to simply the existence of risk. An example of this crucial point is the decision to introduce a new product. That is taking risk, whereas a competitor entering the market is just the introduction of risk.

The next step is to understand that there is a link between risk- taking and business success. Again, there are many different models but a simple one that makes the point even if it is not complete is the arbitrage model. Basically, if a business can make a profit without taking any risk then other businesses will be encouraged to provide the same product or service until the price is pushed down to cost, so that there is no profit. This same argument can then be extended for higher levels of risk-taking, in that price is compressed to cost plus perceived risk levels.

The final part of this success formula is the taking of calculated risk as opposed to just taking risks. Calculated risks are risks that are well understood and prior analysis indicates that the expected returns compensate for the risk taken. In essence this means that it can make sense to take higher risks if the return more than compensates for them. This often happens when investors over-invest in low-risk opportunities, thus driving down the returns to below those acceptable for the low risk, while at the same time avoiding medium and higher- risk opportunities, thus allowing the returns to rise well above what is required to compensate for the greater risks. The tools to perform this analysis vary depending on the business but are well understood.

This model of prudent risk taking as a source of returns often fails because of the principal-agent problem. The problem is that an agent responsible for decision-making on behalf of a beneficiary, the principal, can be conflicted to take decisions that benefit himself but harm the principal. This dilemma is central in the business context of management as agents to the shareholders as principals.

The basic dilemma can be stated as management may be incentivised to take on a risk level that is not optimal for the shareholders. In the western capitalist context this has played out as management taking on far too much risk, betting the firm in the hope of getting paid massive bonuses. If the bet goes wrong then the shareholders lose everything, but the management only lose their jobs – not their money. The Middle East has been the scene of such behaviour with cult personalities taking imprudent risks, which has led to multiple business failures and the need for multiple bailouts.

Just as destructive is the other end of the spectrum, with whole businesses refusing to take any commercial risk whatsoever simply because boards and senior management wish to avoid negative outcomes. There seems to be the belief that avoiding taking a decision will protect the decision-makers, even if it means the ultimate failure of the business in the long term.

If we consider the latter group as “risk minimalists”, it is clear that they are the ultimate form of bureaucracy, holding back firms to protect themselves. The only way to break their selfish hold on the business is for shareholders to learn to measure the performance of the board as distinct from the performance of the company. This is not easy but it is the only way to avoid having a board slowly destroy a company for its own benefit, even if it is not malicious.

The former group, the “risk maximalists”, use the stagnation of the risk minimalists to frighten shareholders into giving them entirely too much authority to take risk. These are usually management as opposed to board members, thus inverting the corporate governance structure.

Finding the right balance pays off. It starts off with shareholders insisting that the board lead the risk-taking process. This is not an audit issue and shareholders will need to ensure that audit committees do not hijack the process. A risk committee of the board, tasked with directing company-wide risk-taking, needs to be formed to lead this process.

One might ask how one knows if they are risk minimalists or risk maximalists. Minimalists take no risk, so feel no worry. Maximalists do not care about risk, so feel no worry. In the end, for a business to be sustainable management needs to be able to take risks and feel that it will be judged on the quality of its decision and not the randomness of the outcome.

Sabah Al Binali is an active investor and entrepreneurial leader, with a track record of financing, building and growing companies in the Mena region

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