By Daniel Archibald | CFA
Running a business is generally not for the faint-hearted with risks to prosperity apparent in many facets of operation. Academic studies put the failure of small business at around 20% in the first year and 30% in the second, with about only 30% making it beyond 10 years. The causes for the high failure rate vary, but some key reasons include (in order of likely frequency):
1. Lack of capital/cash
2. Lack of demand
3. Lack of skills/management
4. High competition
Looking at a business from the top-down, there are 3 levels at which to consider risks:
- Organisational-level risk - These are the risks that arise due to the way the business is established and structured. These risks are inherent in the vision, mission, values and corporate structure of the business.
- Strategic-level risk - These are the risks that arise as a result of the strategies chosen to achieve the business' mission. This involves the business' strategic objectives and business plan.
- Operational-level risk - These are the risks that arise as a result of trying to execute the business' strategy and plans.
These levels of risk indicate which level of the business might have 'ownership' for the risks (i.e. directors, senior managers, operational managers, respectively). There are also types of risks that exist within some or all of these business levels and include:
External/environmental risk - These are unexpected outside events that affect the business in some way.
Financial/capital risk - These are risks that arise due to events affecting the financial assets or liabilities of the business. All other risks are likely to have an indirect affect on a company's finances, but direct financial risks include market risk, credit risk and liquidity risk. Some of this risk might be mitigated using financial derivatives such as options or futures contracts.
Reputational risk - These are the risks that affect a business' brand. Legal risk - These risks might arise due to some unexpected legal liabilities or lawsuit.
Staff risk - This is the risk that arises due to harm or danger that might befall staff members as a result of carrying on the business. Think OH&S.
Property risk - This is the risk of loss due to unforeseen events affecting physical assets such as property and equipment. This risk is generally the easiest to manage due to the large and mature property insurance industry.
So which of these risks should small business owners focus on the most? Looking at the causes of failure given above it is evident that there are some key risks to which business owners and managers should be most alert. Financial/capital risk is of great importance especially as it relates to the ability of a business to hold sufficient liquid assets (e.g. cash) and raise adequate levels of capital (debt or equity). Other than this, the key risks would likely be both strategic and operational in nature.
Having the right business strategy seems fundamental, so it is interesting to see lack of demand and high competition as major reasons for business failure (as these risks should have been well understood in planning the business strategy). It would seem as though small business owners are willing to take on more strategic risk, possibly as they are seeking rewards beyond the financial (fulfillment, passion, etc). The operational risk of businesses struggling to find the right people to execute strategy is less of a surprise, given the particular skill sets that might be required for any given business model. And while the other business risks mentioned (external, legal, reputational, staff, etc) should be part of a business' risk management processes, getting the finances, strategy and people right is likely to be a major factor in overall success.