Risk management in corporate ventures
Stephen A. Allen
Visualizing, gauging, and managing venture risk are critical functions of entrepreneurship. Successful risk management reduces downside prospects, while preserving or not proportionately reducing upside possibilities.
Corporate ventures are defined here as material investments – of money and scarce talent – which have prospects for changing a firm’s (or business unit’s) competitive position, opportunity set, or financial footprint. They generally involve new business development, but may extend to new ways of doing business with cur rent customers or other members of a company’s value chain (Schumpeter, 1934). While risk 218 risk management in corporate ventures management is treated in the context of large, established companies, underlying concepts are applicable to smaller firms and start ups.
Visualizing Risk
Venture champions know that substantial risks come with the territory, yet their mental models of risk are often under specified and subject to denial (Kahneman and Lovallo, 1993; March and Shapira, 1987). Bernstein (1996) observes that increasing acceptance that risks could be measured and actively managed dates only from early in the last century.
Mental models which recognize multiple dimensions of risks can provide a powerful foundation for deciding how and when they can be most effectively managed. First, contrary to common usage, the notion of risk should not be limited to prospects for downside outcomes. It also resides in failure to fully capture upside prospects of a venture. For example, a biotechnology firm recently launched a superior treatment for rheumatoid arthritis, but with pro duction capacity which turned out to be substantially lower than market demand. While company executives had viewed this lower capacity investment as prudent risk management, it carried costs of forgone revenues of as much as $450 million and provision of a two year window for competitors to enter the market. Aggressive investment to maximize potential first mover returns is not always merited (Cottrell and Sick, 2001); however, managers need to estimate costs of decisions which place a ceiling on the upside of venture.
Further insight into venture risk can be gained by decomposing it into three interacting components, as suggested by the classic treat ment of Knight (1921):
risk (exposure)(uncertainty of benefits)(time)
Exposure results from decisions about size and timing of outlays to launch and sustain a venture. Uncertainty can relate to exposure along with onset, ramp, stability, and duration of cash inflows. The impacts of exposure and uncertainty of benefits on overall venture risk are time dependent: risk is not time invariant. Venture development involves learning (McGrath and MacMillan, 1995) and management of cash burn rates in order to attain key milestones and resolve uncertainties (e.g., technical feasibility, market acceptance, timing and vigor of competitor reactions). The staged investment common to venture capitalists recognizes the value and cost of uncertainty reduction, with start ups being revalued (or abandoned) across multiple funding rounds (Sahlman, 1988). While similar approaches have been advocated for large company ventures (Hodder and Riggs, 1985), they remain uncommon in practice. Many large firms have adopted stage gate systems, which link support levels to attainment of operational mile stones (Cooper, 1990).
Linking Risk Analysis to Venture Decisions
Most large US and European companies require discounted cash flow analyses at stages in a venture’s development which involve significant in vestment. While these formal justification procedures are designed to avoid investments with unattractive return prospects, they are generally applied late in the venture development process, after a project team has made most of the decisions which will influence their venture’s risk return profile (Allen, 2002). Viewed from the perspectives of venture champions in the middle of organizations, corporate investment justification practices provide signals on risk return profiles unlikely to receive approval, but provide little help in developing and actively managing winners.
Allen (2002) advocates arming venture teams with capabilities for developing simple cash flow scenarios, which permit gauging risk return trade offs underlying key decisions about how their ventures should be configured. These ana lyses can inform decisions at two important stages in venture development. The first stage – lying between opportunity identification and a detailed go to market plan – is the time frame within which several decisions will determine a venture’s initial risk return profile. These decisions include which capabilities to develop internally versus which to outsource, which early customer segments to target, channel selection, and initial scale of production and service capacities for going to market. Subsequent reversal of these decisions is generally expensive and time consuming. The second stage is after a first win risk management in corporate ventures 219 (or lack thereof) in the market. This involves the next round of decisions regarding venture scale and scope.
Decisions at these two critical stages are often made in a piecemeal and iterative fashion, as market and technical knowledge accumulates. Parallel gauging of risk return effects of alternatives for these decisions can yield several bene fits: a more tightly integrated overall strategy; avoidance of lazy (underutilized) investments and inflexible cost structures; clarity regarding overall level of risk being incrementally built into the venture; and a stronger basis for developing formal appropriation requests. Case evidence reported by McKinsey and Company suggests that active use of simple risk return analyses can have substantial effects on venture economics. In five consulting assignments in volving capital intensive projects in chemical, mining, building materials, and mobile tele phone businesses, use of these approaches helped venture teams increase expected net pre sent value of their projects by 35–45 percent over initial plans. These improvements were based on capital savings of 15–45 percent and revenue improvements/cost reductions equal to 20–35 percent of the capital expenditure base (Carter, van Dijk, and Gibson 1996).
Risk Management Strategies
Within broad technological and market constraints of their particular industries, venture champions have many possibilities for how to scope and actively manage their projects. The same venture can be structured to target quite different combinations of risk and return potential. Decisions on size, scope, timing, and course corrections for a venture reflect a combination of several generic strategies for bearing, sharing, and managing risk:
- Bear substantial risk. These are typically big bet situations in which the venture and its parent firm are unwilling to share returns or may be unable to find suitable partners. Examples include development of new commercial aircraft bodies, blockbuster pharmaceutical candidates, and contests for establishing technology standards. There is often a presumption of substantial and durable first mover advantages.
- Risk sharing can take many forms: outsourcing parts of the value chain; joint ventures; contractual arrangements with customers and suppliers with lock ins or options regarding price, volume, and duration (Billington, Johnson, and Triantis, 2003). Insurance and government investment incentives are also risk sharing mechanisms. Sharing risks involves sharing prospective returns; however, the sharing formula need not be proportional. Different parties have different capacities to bear and manage different risks, which can reduce total costs for bearing venture risk (Brealey, Cooper, and Habib 1996; Stulz, 1996).
- Spread risks over time. Sequential expansion of production capacity and sales and service infrastructure can limit exposure as uncertainties are progressively resolved. Merits of this strategy should be weighted against the countervailing risk of successfully developing a market and not being able to fully satisfy demand.
- Input/output flexibility. Flexible production technologies can be used to mitigate revenue or cost risks. The value of these approaches in adapting to changes in markets for end products or supplies should be weighed against potentially higher investment requirements and penalties to economies of scale.
- Truncate losses or marginal performance. Moves can range from downsizing parts of a venture to abandonment. These decisions tend to be more effective if abandonment criteria have been set before the fact, though venture champions often find such discipline difficult to apply when their immediate concern is growth.
Corporate entrepreneurs who tailor combinations of these risk management approaches to the particular challenges posed by their ventures can reduce downside prospects without un necessarily sacrificing upside potential.
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