Value and Risk: Understanding Value Creation in the Context of Risk

Risk is a nebulous thing.  It’s hard to define, hard to understand, and very often misunderstood.  Complicating matters further, the term ‘risk’ is thrown around a lot in business.

We are certainly not experts on risk. To suggest that we were, well that would be downright egomaniacal. But we do acknowledge it, and we work hard to understand it, and most importantly, we work our understanding of it into our process for our clients.

Understanding risk, even in its most basic form, can provide an extraordinary amount of clarity in business, and it can help operators make better decisions. As importantly, it can help operators avoid bad decisions.

To those of us that acknowledge risk, learn to navigate it, or have - at a minimum - grown to appreciate it, we find it infuriating that so much of the business world seems content to ignore its very existence. Or worse, they hide its existence, because it’s convenient to do so.

And these days we’re growing more and more impatient and frustrated with this media-driven feedback loop of ignorance. News articles, press releases, and social media rarely - if ever - cover it. Think about it, have you ever come across a press release that read:

 

“[company] grew to $12m in revenue, with a majority of their revenue from a single contract! How amazing!”

 

Or a podcaster say:

 

“[Firm] has seen some extraordinary growth over the past few years, all via acquisition using high-interest debt, which now absorbs a majority of their monthly cash flow! What a win!”

 

Celebrating wins, celebrating successes, I’m all for it! Hell, some would even say I’m a celebratory guy, but cheering wins while ignoring the context of risk. I think it’s downright reckless because it incents the wrong behavior from others. 

 To better understand risk, let’s start with what risk most certainly is not.


What Risk Is Not.

Risk is not the same thing as investment, be it in fixed assets or people. This misunderstanding happens often. A lot of people automatically equate investment with risk. Investments can certainly produce risk, but investments are not inherently the same thing as risk. We’ve seen investments made within businesses that REDUCE risk.

If we confuse investment for risk, we may make the mistake of avoiding spending or investment, which might, in fact, reduce the risk profile of a business. Similarly, we might make the mistake of thinking we’ve avoided risk simply by not spending.

Risk is not the same thing as volatility. If you’ve never heard this academic argument, I promise you it’s more pervasive than you think. It might have started in academic circles, but it quickly permeated into Wall Street. The theory goes that financial assets with higher volatility in price imply a higher risk. Fine, you Wall Street bros can do with that what you like, but what really grinds our gears is when people misapply this concept to cash flow.  Volatile cash flow may imply risk…or it may just imply inconsistent cash flow. If I forecast an inconsistent stream of cash flow from a business, and the business produces this cash flow as I expected, does it make any sense that this necessarily implies risk?

Howard Marks (with Oaktree) writes a lot on this subject, and we highly recommend reading some of his works. Marks dives deep into this topic, and his conclusion is clear - fluctuations in price do not necessarily equate to risk of loss.

The problem with the misapplication of the concept is that too many people inadvertently use this framework to and subsequently think they can solve for risk simply by solving for volatility. If volatility equals risk, then all I have to do is solve for volatility and voila, I’ve solved for risk. There’s truth to the idea that volatility has an impact on risk, but to conflate these two things as the same thing is wrong.

Risk is not about quality.  Low quality products, assets, or services are not necessarily higher risk, and high-quality products, assets, or services are not necessarily lower risk. To think that low quality equals high risk and vice versa ignores the price paid for the product or asset or service. I can buy the ugliest damn house on the block (and we may actually have) with less risk than my neighbor who bought the prettiest, because we paid twenty percent below market. Quality ≠ risk.

The problem with this misunderstanding is it implies that one can solve for risk by buying high quality. How many times have we heard this logic applied to ‘hiring up’ and subsequently paying for a very expensive new resource or teammate?

Risk is not obvious, all the time. In fact, risk is usually quite hidden when things are going well. I think most businesspeople like to think that risk is obvious and subsequently easy to navigate and avoid, but my experiences tell me that we are all actually quite bad at seeing the risks inherent within our own businesses. And we tend to not see risk when things are going our way.

Risk is not the same thing as unexpected upside. This is a weird one because it feels so obvious, but upside can’t be risk. I see this perspective when people consider all unknown outcomes as ‘risk,’ regardless if it is downside or upside. Or they think any possible outcome that can’t be predicted somehow represents risk. To be risk, truly risk, it needs to be downside, it needs to hurt – which we’ll get to shortly.


So, What is Risk Then?

Ever the nerd, my favorite source for definitions and etymology is the Oxford English Dictionary (if you know, you know). The OED defines risk as “the possibility of loss, injury, or other adverse or unwelcome circumstance.” The OED goes on to stress that the definition involves potential events, and it focuses on negative outcomes, not simply unknown outcomes. It writes that risk is not a certainty, it is a possibility or chance that something bad might happen. Well done ol’ chap! In an age of bullshit content, the OED remains wonderfully dry and on-point.

At Ballast, our preferred definition of risk is from Howard Marks. He either wrote this word-for-word or his writings on the subject inspired the following mangled version. Either way, he deserves full credit (along with a lot of the content of this letter frankly). His definition of risk goes something like this:

“Risk is the probability of an unintended circumstance, which negatively impacts returns.”

Risk then is not about a definitively bad result, it’s about the probability of an unintended, undesirable, bad result.


Who Cares? Understanding Value Creation in the Context of Risk

Why should you care about the definition of risk? We would argue that any legitimate financial decision in business should be made in the context of risk. Specifically, our definition of value creation requires the incorporation of risk as an input. Again, we surely stole this from someone smarter (I actually think we might have adopted this from the Goal by Goldratt, then jumbled it together with Marks’ writings. Either way, we don’t deserve any form of credit here). We believe that the definition of valuation creation is:

 There have certainly been times when we’ve called this definition into question (especially during go-go bull market years), but throughout the last few cycles, it’s held up well.

Value creation according to this definition requires

  • an improvement in return (which we can define as eventual after-tax free cash flow) while keeping all else constant,

  • a reduction in investment (the capital invested into an enterprise, concept, or project) while keeping all else constant, or

  • a reduction of risk, keeping all else constant

This idea of risk being the underlying denominator to value creation has had significant and material implications for both the way we run our own business, and also for the ways in which we consult for our clients. That isn’t to say we’ve figured it out, but it is to say we’re using this formula to figure it out. 

Simply increasing return by turning up the risk dial is not value creation, at least not to us.  In our view, driving down your investment in a project does not inherently create value if it subsequently increases the risk by a similar factor. I think one of the reasons we became so attached to this definition of value was because we felt like it gave us x-ray goggles to see through bullshit.

We often see examples of people driving returns (either by design or through pure blindness) by driving up the risk profile of the firm or their investments. Then, they run around claiming victory. Generating return by increasing risk can produce a wildly successful result, or it can result in extraordinary losses. These wins are feats of risk tolerance, not feats of value creation. They’re fun, they’re interesting, we find them wildly entertaining, but let’s not call it value creation.

And so, we’ve incorporated this concept into our frameworks here at Ballast. Every financial decision our clients make -- be it investing in a piece of equipment, expanding a product line, launching a new service line, or hiring a new person -- all needs to be run through the above framework. That is not to say that all decisions absolutely must create value according to this formula, but it is to say that smart decisions are made in the context of this formula. And the inverse is also true, we believe that to ignore this formula, even if it results in accidentally successful decisions, is unwise.

If we might jump on our soapbox for a moment…

Maybe one reason we seem to take this so personally is because so many of our competitors either don’t address this or simply can’t grasp the concept. Not all business owners have the same risk tolerance. Hell, the same business owner might not have the same risk tolerance throughout their life. So, you can’t go around peddling the same advice to all business owners. That’s a recipe for failure.

To be very frank and put a final point on this - our approach requires that we damn well better understand the client’s tolerance for risk, and we damn well better do our job of highlighting risk. Meet the client where they are, understand their goals and desires. Our charge is to help them towards their goals, work with them to drive improvements in their businesses. But it’s a business sin to just slam on the gas with some wild west attitude towards risk, claim credit when things go swimmingly and then blame the client when things crumble. We’ll leave that to our competitors.

…and we’re stepping off the soapbox. 

Let’s talk about how to incorporate some of this into decisioning at your business.


How to Incorporate Risk and Value Equation into Business Operations

One thing we’ve learned is that we can improve value creation from financial decisions simply by acknowledging the existence of risk and implementing some minor tweaks and changes to decisioning. The goal is not to run from risk. The goal is to learn to navigate it.

Always Ask Yourself ‘What if We’re Wrong?’. First things first, when making a financial decision spend as much time talking with your team about what could go wrong as you do talking about what could go right. Don’t overcomplicate this with some academic exercise. Literally just ask, ‘what if we’re wrong?,’ and then list the things that could go wrong. Once you have this list, you can implement elements to mitigate against the losses stemming from each possibility.


For example, let’s say you’re dead set on expanding into a new geography. The plan is to hire a new team of four, sign a new lease, spend on marketing, and drive sales in a region.  Cool. 

Question: what if you’re wrong about the chosen geography, and it’s a dog? 

Response: well, then we let go of the new hires and stop spending on marketing. 

Question: right, what about that lease? 

Response: ah…it’s a 5-year lease with a 2-year notice on the termination, and if we walk prior we’re still on the hook for the lease payments.

Question: welp, how might we mitigate this? 

Response: maybe we take a more expensive lease somewhere else, but it’s month-the-month and if we are wrong, and we shut down this geography, we’re not on the hook for the rest of the lease.

Note this approach trades return for risk. This example traded higher rent on a month-to-month basis for the optionality of walking without a large outstanding liability, which leads us to the next lesson.

Learn to trade return for risk reduction. Maximizing profit is not always a good idea when considering value as we’ve defined it. Sometimes the right call is to spend more if it allows for risk reduction. We see this situation present itself often with the age-old material purchase decision. If I generally use 10 units / month, have a contract to cover the next two months, and have the option to purchase 50 units worth of a raw material to get a 5% discount should I proceed? Well, it all comes down to risk. Your options are to:

  • buy more materials up front (higher investment), but pay less per unit (increase return), and hope for more work to absorb the remainder of the inventory (increasing risk), or

  • pay more per unit and not load up on inventory. 

There’s no right answer, but there is a right process, and the right process is to consider the probability of unintended circumstances, which leave you holding unusable inventory.

That is not to say you should always trade return for risk, in fact, learning to take risk for return is a very important skill, which leads us to the next lesson.

Learn what level of risk you ARE comfortable with. It isn’t always about risk reduction.  Sometimes, knowing this framework allows you to utilize all of your risk tolerance. Taking too little, or not utilizing all of your risk tolerance often means leaving returns on the table. To avoid this, with every decision, ask yourself what level of loss you are comfortable with if everything goes wrong. And ask yourself if you’re comfortable with that risk. We have seen and participated alongside clients who won because they took risks when their competitors did not. The goal isn’t to avoid risk, it’s simply to ensure that the outcomes if things go well pay for probability of loss when things go poorly.

Understand Time as it Relates to Risk. There are situations where time increases risk, and situations where time decreases risk. Investment bankers live in a world where ‘time kills all deals’ because they live in a world where time increases risk. A lot of our clients live in a world where more time decreases risk, because time allows for more information, and more information allows for better decisioning.

Know which situation you’re in, and ask yourself  ‘does more time decrease or increase the probability of unintended circumstances?’  If time increases the probability, learn to move quickly on those decisions, build processes that work towards efficiency, and remove unnecessary steps and functions.

If time decreases the probability, well you’re probably negotiating with someone who lives where the inverse is true, and they’re probably trying to get you to sign on the dotted line by a certain date. Build processes to slow things down, and learn what information to gather and document as you go. If information improves decisions, learn how to make time your friend.


Conclusion

Someone once taught me that the difference between bravery and courage is the knowledge of the impending danger. Bravery is about to showing fortitude in the face of the unknown, but courage, based on the French word ‘le coeur,’ is about having the heart to proceed knowing full well the danger and peril.

I think a lot of new clients expect us to highlight risk and then try to convince them to run away as quickly as possible, that somehow our goal to work to avoid risk at all costs. Let me put this to bed and clarify our position.  We feel it’s hard to run a business, even harder to start and build a business, and hell impossible to function as an entrepreneur if that’s your general attitude towards risk.

Our job isn’t to guide clients away from risk at all costs. On the contrary, our job is to help clients identify it, price it, and often navigate right through it. Entrepreneurship isn’t about avoiding risk or ignoring risk. Entrepreneurship is about knowing the risk and having the courage, the heart, the fortitude to proceed anyways. And good financial management for entrepreneurs is about making sure that the wins compensate for the level of risk.

I hope that our view on risk and this letter specifically help more entrepreneurs on this journey.  We are always learning, and we’ve come to love this journey.

 

Godspeed to all you courageous maniacs out there.

 

 

Kyle Benusa, Jack Allen

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