Damage Control Feel like your business is an accident waiting to happen? Try breaking big, scary risks into smaller chunks.

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 BIZ Experiences 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 BIZ Experiences for nine years.

Probable Cause

The scientific study of risk management probably began in the13th century, when mathematicians studying gambling odds built thefoundations of modern probability theory, according to Bryan.However, risk management has only flowered during the 20th century,as financial institutions have employed increasingly complexstrategies in order to enhance investment returns without addingtoo much risk. "That," says Bryan, "is whereit's become quite a sophisticated art."

Many of the risk management techniques used by large financialinstitutions, such as options pricing and portfolio managementtheory, are built around complex mathematical formulas. These maybe used to do such tasks as manage pension fund investments, setprices for government bonds and so on. However, you don't haveto be a mathematician to manage the risk and reward of such commonbusiness activities as starting a company, entering a market,developing a new product, signing up a strategic partner orembarking on a marketing campaign.

One basic risk management strategy is to disaggregate risk. Thatmay sound complicated, but, in essence, it simply means breakingdown a large, unwieldy risk into smaller, more manageable pieces.Typically, a company might, as X.com did, break a risky initiativedown into areas defined by corporate departments: marketing,finance, operations, human resources, legal and so forth. With theproblem thus separated, BIZ Experiencess are better equipped torecognize, analyze and manage the separate risks.

At X.com, for instance, Musk dealt with the financial risk byraising more money than the firm was likely to need. "Ifthings don't work out exactly as planned," he says,"we've got plenty of capital." In fact, raising moneywas relatively simple; the public is well aware of the enormousgains early investors have made in numerous Internet start-ups,including Musk's earlier firm, Zip2 Corp., which he sold toAltaVista for more than $300 million earlier this year.

Another way to manage risk is through the leveraging of whatBryan calls familiarity advantages. This is similar to conceptssuch as relying on core competencies, focusing on niches and simplydoing what you know best. In a sense, leveraging familiarityadvantages 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'retrying something for the first time.

Musk did this, first by leveraging his own expertise at startingInternet businesses. "It's important to have expertise inwhat you're going to do," he says.

However, there's more to X.com than simple e-commerce. Muskhad only minimal knowledge of the financial services industry; hedealt with this issue by bringing in people who could provide thefamiliarity advantage that he lacked. That meant Musk had to hirepeople with experience at starting banks and mutual funds fromscratch. "They know what steps need to be taken," hesays. "They don't have to figure it out along theway." It also meant retaining the most experienced legaladvice 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 themost of familiarity advantages. As Bryan puts it, "Leveragewhat you're already good at, and figure out how to do more ofit."

Choose The Best

Improving your management of risk doesn't have to beexpensive. You don't need costly technology, time-intensivetraining or disruptive reorganization, says Bryan. The mainrequirement is a change in your mindset which forces you to thinkabout opportunities in terms of breaking down big risks andapplying familiarity advantages whenever possible. This can be donealmost unconsciously, and many good risk managers do just that."The best are instinctual," Bryan says. "Theyhaven't thought about what they're doing. Good businessmanagers just [naturally break down risks and use familiarityadvantages]."

Clearly, it can be costly to hire top talent to provide you withany familiarity advantages you lack. However, just as clearly, thisis well worth it, Musk says. And BIZ Experiencess are often uniquelywell-positioned to give talented and ambitious people what theymost want from their jobs: a chance for ownership, in the form ofstocks or share options, in a fast-growing enterprise.

"BIZ Experiencess shouldn't try to hold on to too much ofthe company," says Musk. "It's better to give away apiece of it to get somebody stronger and maximize the overall valueof the pie than to try to hold on to too much."

Risky Business

BIZ Experiencess who try to remove all risk will take no chancesand, as a consequence, generate no rewards for themselves. On theother hand, BIZ Experiencess 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 orincredible success, Bryan notes. Somewhere in between these twoextremes is the playing field for most BIZ Experiencess, but exactlywhere your spot on that field is depends on your own familiarityadvantages and risk management skills.

In the next 20 years, Bryan believes, these risk managementtechniques will become universal among successful businesses. Whilesmall businesses may do it less formally, they will still do it, hesays. "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 smallbusinesses."

Next Step

Peter L. Bernstein's Against the Gods: The RemarkableStory of Risk (Wiley) is a highly readable and informativestudy of the development of risk management, from the gamblingstrategies of Roman legionnaires at the ancient game ofknuckle-bone to the arcane financial strategies of 20th centuryspeculators.

Contact Source

X.com Corp., http://www.x.com