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Online Guide To Starting A Small Business

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Thinking Like An Entrepreneur

Thinking Like An Entrepreneur
Table of Contents

Chapter 3
Men Are Cheaper Than Guns

Chapter 4
Intellectual Capital And Bootstrapping

Thinking Like An Entrepreneur


Risk Management In Small Business

Part 1: Insurance

Many small business owners want to know what "risk management" means. All business owners want to know how to limit their "risk."

But, what exactly do we mean by "small business risk"? Some business writers, such as Azriela Jaffe, author of Starting from "No:" 10 Strategies to Overcome Your Fear of Rejection and Succeed in Business, address facing psychological risks, such as the risk of being rejected on a sales call. Such psychological fears are real barriers to success and might be more significant than pure measures of financial loss to the average, small business owner.

If your fear of being rejected by a potential customer is so great that you fail to make needed sales calls, demanded by your business, you will probably fail financially, even as you protect your ego from the risk of personal rejection.

While all psychological risks, such as fear of rejection, are barriers to success, they are also illusionary risks. They feel real, but they aren't. It is like the grown elephant, who when young was restrained by only a light rope around his foot. He learned he can't break it. Now, the elephant stays in place, despite the rope no longer being strong enough to hold him.

Even if you are rejected a dozen times while making sales calls, or approaching venture capitalists for financing, you are no worse off. Some entrepreneurs incorrectly feel that they are "out" a potential customer or source of financing. They feel the person on the list was a potential resource that is now exhausted. But, what good is a potential customer or resource you never contact? We are assuming, of course, that you are prepared to make the sales call or the presentation to the venture capitalist. Blowing opportunity through lack of preparation is never acceptable.

I define "risk" as the possibility of experiencing a financial loss. From the entrepreneur's standpoint, this risk can be divided into two parts. First, the entrepreneur, as an individual, runs the risk of losing money. Second, the business started by the entrepreneur runs the risk of losing money.

In most cases, someone starting a small business puts his or her own money at risk and the two above divisions are somewhat artificial. Some entrepreneurs, however, shift the financial risk of starting their business onto investors.

Consider an entrepreneur who starts a company which raises $100 million and goes public. The entrepreneur receives a nice $200,000 annual salary. Three years into the business, the entrepreneur sells many of his shares, netting him several more million in cash. Six years later, the business goes bankrupt. The investors who bought-and-hold the company lose their entire investment. In this case, it should be clear that the entrepreneur has taken no real risk. The entrepreneur has done well, despite the business failing. This is an extreme case of "risk-shifting." New angel investors need to be alert to the possibility of unreasonable risk-shifting. You don't want the entrepreneur to succeed financially if the business fails!

One of the most common ways entrepreneurs can protect their personal financial assets from losses incurred by their business is through incorporation. All entrepreneurs should choose a business structure which limits their personal losses in the event of company failure. You will then only risk losing the money that you directly invested in your company.

You can now devote your full attention to reducing your potential financial losses within your company. This is usually what is meant by "risk management."

We can divide our possible losses into two categories. First, are the extraordinary events which could sink a company. Such events do not occur regularly in the normal operation of business and, hopefully, will not happen. But, there is a small probability that they might occur and the potential losses would be large. For example, your manufacturing plant burns down.

Losses of this type can be mitigated by insurance, which is deducted as a business operating expense. The expectation value of insurance is negative. You expect to lose a little bit of money when you buy insurance. You will pay premiums, and your manufacturing plant probably won't burn down. Yet, buying insurance is a smart business decision in this situation.

The chance of a fire is small, but real. And, the consequences, if uninsured, are huge. Because the chance of a fire is small, your premiums will not be that much and should not detract much from your overall business profitability. Part of the insurance premium paid is compensation for the risk the insurance company is taking to insure your manufacturing plant. A smaller part is a reasonable profit for the insurance company underwriting the policy.

You should consult a trusted and knowledgeable small-business insurance agent to discuss your company's insurance needs. Your banker is one good source of possible insurance agents.

Some possibilities are very expensive to insure against. You might find that you can't afford some particular insurance which you feel your company really needs. Some business owners try to set aside money to cover such a contingency. This is called "self-insurance."

However, in practice, "self-insurance" is often a euphemism for "I really hope that doesn't happen." If the cost of the insurance is too high for your business, it is unlikely you will be able to set aside enough money to cover an occurrence of that contingency, either.

For example, imagine saving and setting aside enough money to cover the rebuilding of your manufacturing plant. Recall, this is something easily and cost-effectively insured. Large, possible liabilities you might want to "self-insure" will probably demand more money or have a much higher chance of occurring. It would take many years to save enough from your earnings to have reserves to rebuild your manufacturing plant. If your plant burned down in the meantime, you are out of business. Your "self-insurance" offered no real protection.

Another disadvantage to self-insurance is that cash set aside to cover contingencies is not usually tax-deductible as a business expense. The money will probably be considered earnings and will be taxed.

One way to lower your insurance premiums is to increase your deductible. This means you will pay more of your own money before the insurance begins covering your losses. You only need to insure against things which are financially significant. You don't want to insure against small losses you can easily cover. The loss of your entire manufacturing plant, you canít cover. A broken window, you can pay for yourself.

Ask your insurance agent how your premium varies with deductible. You probably want to choose a high-enough deductible so that you feel the loss, if it occurs, but can easily survive it. You want a low-enough deductible so that you can cover the deductible, if need be, and still remain in business.

In fact, here is one area where a form of self-insurance makes sense. Invest the money you save by having a higher deductible in a special account, and use the savings to cover the higher deductible.

Also ask your insurance agent what you can do to decrease the risks against which you are insuring. Are there steps you can take to reduce the likelihood of a manufacturing plant fire, for example? People who insure against extraordinary risk usually know how to minimize the likelihood of the risk occurring.

Regular, reoccurring losses can't be insured cost-effectively. These are normal operating expenses of your business. Suppose, for example, you wish to buy insurance protecting your accounts receivable from being defaulted upon. The loss of unpaid accounts receivable is a constant, ongoing, business expense.

If you wished to insure against unpaid accounts receivable, the insurance company would need to calculate your company's overall, anticipated, yearly loss on such accounts receivable. Then, the insurance company would charge you slightly more than the anticipated loss for the policy. The difference represents the insurance mark-up, which is expected to become profit to the insurance company. The overall effect is that you would be paying more than if you just absorbed the loss directly. And, the loss would occur with near certainty. It is not an extraordinary loss. It is a business expense.

Similarly, there's no business insurance which will guarantee business success. You won't find a cost-effective policy which reads, "In the event that your small business fails to make you a multimillionaire within five years, Insurance Company agrees to pay insured $1 million dollars."

You are responsible for making your business operationally profitable. Insurance covers those rare, financially significant, extraordinary events. Much can be done to reduce the risks of losing money in the normal day-to-day operations of your business. We will discuss this in next month's column.

Small Business Insurance from our online guide to starting a small business.