Protect your Downside - The Khuram Dhanani Blog
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Khuram Dhanani

Protect your Downside

Rule One and Rule Two

This famous quote by business tycoon Warren Buffett is often quoted, “Rule number one: never lose money. Rule number two: never forget rule number one.” 

When you’re starting a business, it takes time and repetition before everything clicks together. One of the problems many entrepreneurs encounter is that they have not put themselves in a position where they can afford to wait for everything to click. They may exhaust their funding or, worse yet, go into debt; they may also run out of time or lose enthusiasm for the venture. 

The way to protect your downside is by making only asymmetric bets. An asymmetric bet gives odds that are in your favor, so even if you’re wrong multiple times, you only need to be right once to come out on top.

Here’s an example of asymmetric betting. If you only make bets that give you $10 for every $1 you risk, you can be 100% wrong nine times in a row, lose all of your money, and still break even if you get it right only once. If you’re wrong eight times in a row, lose all of your money, and get it right twice, you come out ahead. As you can see, the bet is in your favor.

This same dynamic was that play in the 2015 movie The Big Short.  In the film, a small group of financial traders saw the 2008 mortgage crisis gathering on the horizon. Initially, they were mocked by traditional-minded traders for their warnings. However, by the end of the movie, they had made billions of dollars by correctly betting on the outcome, leveraging their small investments asymmetrically. The story is an excellent allegory for how asymmetric betting can make people extremely wealthy. 

The Power of Asymmetry

Symmetry is when two parts of an object have equal form and size … for example, a circle with a line drawn straight through its middle. Generally, symmetry is considered attractive. The more symmetrical someone’s face is, the more beautiful that person is perceived to be. The same typically applies to art, architecture, and landscaping.

However, when it comes to finances, symmetry should be avoided as much as possible. Investors often look for asymmetrical circumstances where the potential upside is much greater than the potential downside. Should you choose to risk $10 for a chance at making another $10, you’ve made a symmetrical bet. On the other hand, if you bet $10 for a chance at making $100, you’ve made an asymmetrical bet.

If you were looking for asymmetry in stock investment, you’d want to look for stocks that have more than a 100% upside potential. When you buy a stock with a 500% upside potential, and you’re prepared to cut your losses at 50% of your investment, that’s an asymmetric bet. Your upside potential is 500% and your downside potential is 50%. The odds are 10 to 1 in your favor.

How Entrepreneurs Can Protect Their Downside with Asymmetrical Bets

To make an asymmetrical bet as a business entrepreneur, you have to conduct an in-depth study of the market you’re entering and decide how much money, time, and energy you’re willing to invest in your idea and opportunity, and what the potential upside could be. 

For example, suppose you’re opening an e-commerce store. There might be potential to grow the business to $5 million/year in sales with a $500K initial investment. The initial investment would include such expenditures as setting up the online store, purchasing inventory, marketing, and labor.

In this example, once you invest $500K unless you can reassess your situation and see evidence that the business will grow as you intended, you should cut your losses and move on to the next idea.

It’s important to regularly analyze your business situation and assess your risk. You’ll need to understand the common causes of business failure in your industry and identify if there are signs of these that are likely to affect your venture. Monitoring the business situation gives you forewarning about whether you should make organizational changes and press on, or shut down the business and protect your downside. It’s better to get out with some losses than to hold on and lose everything.

Let’s take a look at the common causes of business failures.

The Five Most Common Reasons Businesses Fail, and How to Avoid Them

Seven out of ten startup businesses will fail. The best way to protect your downside is to reduce the risk of failure from these five most common reasons. 

1. Mismatch Between the Product and Market

Entrepreneurs often fall into the trap of developing a product that fails to solve a big enough problem. On the other hand, if the problem is too minor, people won’t be willing to pay for the product. 

The development of Google Glass is a perfect example of this mismatch. Google spent millions of dollars in development and launched its “smart glasses” with a price tag of $1,500. Sales floundered and Google temporarily discontinued production soon after. Google had utterly failed to estimate the degree that people wanted wearable tech. 

If you have a product that is not delivering unquestionable value to your market, you should shift to a different market or adjust the product to fit the demand that does exist. The reality is that most startup businesses have to pivot multiple times before they find their best route to success.

2. Running Out of Money

Poor financial planning or forecasting is another common source of business failures. This is especially common in capital-intensive businesses that involve significant upfront investment such as restaurants and retail stores. In the digital world, streaming services are examples of businesses that can quickly run out of money due to costly royalty payments. Since there is little a company can do once they are hemorrhaging cash, it’s best to avoid the situation as much as possible by building informed, well-researched forecasts from the start. This allows you to make informed, wise decisions.

3. Not the Right Team

From grade school to college, housemates to national governments, PTAs to corporate board rooms, you’ll find examples of people who don’t work well together. This is as common in business as anywhere else. If you build a team that can’t work in harmony, it will be extremely difficult to grow your company. 

Finding people with ample experience and perfect skill sets does not mean your team-building is complete. Before you hire someone, be sure they know how to work collaboratively, will listen to instructions, and possess conflict-resolution skills. Furthermore, as you add team members, think of how the potential new hires will interact with your existing staff who already have a strong functioning behavior pattern. 

4. Outcompeted

Some markets have room only for a few large companies, with very little space for smaller players. Think of Coke and Pepsi, Uber and Lyft, Apple Music and Spotify, Walmart and Amazon, or Lowes and Home Depot. As a startup, going head-to-head with any of these behemoths would be like climbing Everest without supplemental oxygen! 

Suppose you’re in a market that’s already dominated by a few big players, or you’re in a fast-growing market that has the potential of being monopolized by a few companies. In these situations, you will need to constantly be on the lookout for companies that can outcompete you. 

Look for holes in your business they can exploit, and plug them as soon as possible. For example, marketing aggressively in your town, region or niche could help you protect the customer base you’ve already built.

You don’t want to be taken by surprise. Be proactive and thorough. In almost every potential market, competition is very likely to be fierce. You can win by being fiercer. 

5. Pricing and Cost Issues

Many businesses fail as a result of poor pricing decisions. They may have priced their product or service at a cost their customers are unwilling to pay, or so low that they don’t have enough margin to stay in business. 

In retail, you usually need margins of over 50% to cover costs and have a profit. Retailers who enter a market trying to undercut the competition may find themselves out of business quickly if they haven’t figured out how to maintain a margin in this range. 

It’s better to charge too much initially and lower your price if you need to later. If you start too low, customers will balk when you raise your price. If you start high, you validate the product at the higher price and have room to reduce the price should you need to. 

Khuram Dhanani
Khuram Dhanani
Khuram Dhanani
kd@softstonecapital.com