Risk Analysis

When you’re writing a business plan, one of the things your investors would like to know is how much risk you’re taking. It’s possible that you might also want to know.

A brief diversion into game theory

As I type this, I’m sitting at a tournament of Magic: The Gathering, semi-eavesdropping on a conversation between two of the lowest-ranking players in the tournament.

“That takes you to 10 life. Then next turn I can draw a Chalice and you won’t be able to play your cards, and I’ll win.”

It’s a good strategy as far as it goes. Chalice of the Void is a good card, and it does cause a lot of problems for his opponent’s deck. But he’s relying on an awful lot of luck. What if next turn he doesn’t draw a Chalice? What if his opponent has a way to get around the Chalice and still play cards? What if his opponent wins this turn, and he never gets a chance to draw a card? If any one of those things goes wrong, he’s in trouble.

A Pithy Mantra for Strategy

In The Vor Game (a wonderful series if you’re into philosophical sci-fi), Miles Vorkosigan is given advice on planning a military campaign:
“The key of strategy, little Vor, is not to choose a path to victory, but to choose so that all paths lead to a victory. Ideally.”

That is, it’s good to have a plan based on what you think is most likely to happen. But it’s better to have a plan for anything that might happen… and best to have a such a plan that leads to success in all cases.

OK, so I should…?

Make a plan

While you put together your plans, write down the things you know for sure. This is mostly confined to things that you’re going to do (you can be pretty confident that you’re going to run an ad in the newspaper or that you’re going to pay your workers $7/hour), but may include information you have from others on what they’re going to do.

Take a guess…

Then, for each thing you have to guess, make your best guess based on the data you have. This could include the number of customers you’ll get (based on the number of people who will see your ad or the number of people who drive by this location), the weather where your products are made (based on NOAA’s forecasts), or whatever. Calculate how you’d do if those numbers were correct. Will you be making money? Will you be making enough money?

…and cut it in half…

Now take all of those numbers, and cut them in half. Assume you’ll get half as many customers, or that they’ll pay only half as much as you thought, or that you’ll only get half as much product as you expected. How would you do if those numbers were correct? Will you still be making money? If not, how much do you lose? What can you change in your plan to accommodate and mitigate those problems?

…and double it

Now take your original best-guess numbers and double them. Assume you’ll get twice as many customers as you thought, or that you’ll get twice as much product as you expected. How would you do if those numbers were correct? Would you be able to meet demand? Would you have enough employees? Would you have space to hold the extra inventory? If not, what can you change in your plan to accommodate and mitigate those problems?

And synthesize it all together

You don’t want to act as if your half-as-much or your twice-as-much numbers are accurate when your best guess puts it right in-between. It’s silly to cut expenses for a customer drop you haven’t seen: all you do is guarantee that your customers will in fact drop. And it’s silly to buy storage space for inventory you don’t have; it may never come.

But if you know what you would have to do, you can keep yourself more flexible. You can buy your advertising in 3-month chunks instead of paying for the full year upfront (in case you need to cut expenses). You can keep an extra $1000 on hand to pay for a storage unit if necessary. And the things that remain the same in all three plans you can implement with confidence.

Risk Analysis, not Risk Elimination

Depending on your business, your industry, and your situation, your half-as-many numbers may look pretty bad. Your twice-as-many numbers may also. This method doesn’t guarantee that you’ll have no risk. It only tells you how much risk you’re taking on, letting you know upfront what you might be getting yourself into. You have to decide for yourself if you’re ok with those consequences.

Resources for Further Reading
My Business Plan Isn’t Feasible
Tactics vs Strategy