EVALUATING RISK AND WHEN TO ACT

Risks need to be evaluated based on two important criteria:  probability of occurrence and financial impact if it occurs.  Based on this analysis, we categorize risk into three buckets:

• 1) completely ignore
• 2) monitor and be prepared to address
• 3) need to take immediate action.  Let's explore several examples to distinguish the different kinds.

Most car renters choose to skip paying extra for this optional protection because they believe the probability is low that they will ever need it. Although cost is relatively low, the chance of ever needing this liability coverage is slight. Some like to add this to their rental coverage yet most do not. It is a choice with minimal risk because the probability of occurrence is so low.

Compare this with a more urgent threat. In this situation, the potential for loss is immediate, and the consequence of not addressing this risk could have a catastrophic impact; financially, emotionally, and professionally. Most car renters choose to skip paying extra for this optional protection because they believe the probability is low that they will ever need it. Although cost is relatively low, the chance of ever needing this liability coverage is slight. Some like to add this to their rental coverage yet most do not. It is a choice with minimal risk because the probability of occurrence is so low.

I will use a real life example as I am a parent with young children in school. Let's assume my 10 year old daughter is researching a book report. She is very capable of cruising around the web, and daddy surely doesn't want her to accidentally hit a p when she is searching to discover the origin of corn flakes. So naturally, this is a very real risk and parental software controls are implemented.

Contrast this with my ongoing battles with my mechanic. He is always suggesting various services and giving me estimates of what mileage things need to be replaced.  He wanted to change the timing belt at 60k miles even though the factory recommendation was at 70k.  I told him I wanted to wait.  This type of deferred risk can be described as a potential threat that DOES need to be dealt with, but pushing it off to a later date is acceptable. I know this situation has to be addressed sooner than later, but I can put it on my To Do list.  If I wait too long however, the probability of occurrence will become so high that the overall risk profile will become unacceptable.

In contrast to the examples above, some risks are much more subtle and may be completely unrecognized.  Failure to realize significant risk creates the potential for catastrophic consequences.   An example of this type of exposure is loss of key personnel.  Many in the Venture Capital community believe that the risk of losing a key executive is not worth mitigating (I happen to adamantly disagree with this viewpoint, but I don't run a VC fund!). If I was investing $20 Million into the next Dropbox or Pinterest, I would want to protect my money. The point is, there is often hidden risk that could negatively impact a company's financial health, maybe even cripple it. This is the case with business ownership risk, more specifically, cash flow risk.

So now that we have looked at examples, what does this have to do with you and your company? EVERYTHING! Let me say that again, ABSOLUTELY EVERYTHING! Absent a protection mechanism, cash flow risk is very real, and threatens a company's ability to sustain itself and grow. Let me illustrate:

Business Ownership Risk = Cash Flow Risk = Operational Risk = Sustainability Risk

Consider two co-founders. If equity shares must be purchased from the beneficiary of a departed owner, where is the money going to come from? It must be paid from somewhere or the company's financial health is jeopardized. If these partners have not taken safeguards to assure there is available cash to pay this liability, THERE WILL BE PAIN! Not "stub your toe pain", more like the "crash on your mountain bike going 40 mph pain" (trust me, I did this recently). What event could threaten a company in this way? Death, disability, bankruptcy, departure to another company, even divorce.  It would be a huge mistake to assess the risk of losing a key employee as similar to the rental car insurance example above.  Your partner or key employee doesn’t have to die or become disabled for this to affect you.  The MUCH more common situation is divorce or voluntary departure to another company.

If your business partner's partner is partnering with another "partner" without your partner realizing it, and divorce assets (including business interests) must be liquidated and divided, the remaining partner's business is threatened. Got it partner?

So how do we mitigate this risk? Simple: Create a Buy-Sell Agreement, fund it correctly, tie it to the valuation of your company, and update it annually. If you are a fast growing company or are obtaining multiple rounds of funding, it may be prudent to review this financial protection more often.

Why am I telling you this, other than the fact that writing is cathartic? Because at Fifth Street Financial Group, we help clients mitigate this risk. We are specialists on the structure and funding of Buy-Sell Agreements. We are all about the protection of your cash flow. We want you to succeed, grow, and be prosperous.