Category: Strategy

The real risk is the unknowable, not the unknown

Image Source: BBC Wildlife

I was discussing the SVB blowup situation yesterday with one of my friends who manages the public markets portfolio for a large family office. He and I both have deep financial services backgrounds, having worked across diverse services & asset classes (VC, PE, public markets, Investment Banking, debt etc.). Both of us came to the same conclusion regarding what has unfolded:

Given the complexity of financial markets, with many direct & indirect stakeholders, influencers, interconnections, interdependencies, manual & robo decision engines at play, it’s almost impossible for even the smartest operating teams & regulators to stay on top of systemic risks building up across thousands of organizations in our financial system.

Of course, this risk management challenge gets further exacerbated in pure capitalist markets such as the US, that consciously allow free market cycles, driven by excessive greed followed by excessive fear, to play out without much intervention.

Going beyond the macro discourse around SVB, of which there is enough now in the media & on Twitter, I want to highlight one learning that all of us need to pay attention to from this episode – the real risk in most things in life is in the “unknowable”, not the “unknown”.

What does this mean? In most planning exercises we do around risk management both professionally (eg. what’s the sensitivity around my company’s 2023 revenue?) & personally (if I plan to do a startup, how much personal runway do I need to be able to operate without a salary?), we focus mainly on outlining the “unknowns” – variations in outcomes of visible & obvious elements. Things like revenue from existing customers, attrition of top performers, house rent, holiday budgets etc.

Planning for unknowns is largely driven by first-order thinking. This includes the classic sensitivity analysis playbook of (1) listing out all obvious elements of the game, (2) thinking of a range of values for them (best case/ likely case/ worse case) & (3) using these values as inputs to model out various output scenarios that consequently drive the overall decision-making process.

But if most organizations & individuals follow this kind of solid decision-making framework, why is the real-world full of surprising blow-ups – bank runs, hedge fund unravels, fast-growing companies unexpectedly going bankrupt etc.?

It’s because the real world is a complex adaptive system with emotion-driven humans as actors. Michael Mauboussin, legendary analyst, academic & public markets investor, beautifully outlined the qualities of this type of system in his recent conversation with Tim Ferris:

So, “complex” means lots of agents. Those could be neurons in your brain, ants in an ant colony, people in a city, whatever it is. “Adaptive” means that those agents operate with decision rules. They think about how the world works, and so they go out in there and try to do their thing. And as the environment changes, they change their decision rules. So that’s the adaptive part, their decision rules that are attempting to be appropriate for the environment. And then, “system” is the whole is greater than the sum of the parts. It’s very difficult to understand how a system works, an emergent system works, by looking at the underlying components.

Michael Mauboussin

In such a system, while some risks fall under “unknowns”, a majority of them are “unknowable” given the system is self-evolving & therefore, impossible to predict at a granular level. Many words are used to describe these unknowables – edge cases, tail events, black swans etc.

Even if we do get some additional visibility into a few of these probabilistic unknowables & can foresee their 1st-order impact to an extent, their 2nd & 3rd order effects are really hard to model out.

Given this context, classic risk management approaches work well most of the time, until they don’t. And when they don’t, participants are caught unaware, unprepared, & often facing the Risk of Ruin.

So, how can organizations & individuals prepare better to deal with the unknowables? The following steps can help:

  1. Start by recognizing the presence of “unknowables” – a major first step is to acknowledge one’s ignorance, & consciously keep overconfidence bias at bay by reminding oneself that even after all this data & analysis, there is a lot that is just not possible to predict. Approaching risk management with humility & in defense mode creates a conducive mindset for this.

2. Add a significant “Margin of Safety” on top of your analysis – while a rigorous Sensitivity Analysis will cover the unknowns well, adding a Margin of Safety goes a long way in providing a buffer for the unknowables. How much of it you want to add depends on context but given we live in a highly risky world, it should be significant enough. As an example, legendary value investors like Buffet & Munger insist on a 50% Margin of Safety while buying public securities (buying at half of the intrinsic value of a company).

Btw, this isn’t anything new. Engineers who design everything from trains & storage tanks to nuclear reactors & space shuttles, recognize error rates in their assumptions & therefore, always include an “allowance” in their computations. Millions of lives depend on this method!

3. Routinely stress-test & update your assumptions – with software continuing to eat the world at an exponential pace, cycles are becoming shorter & feedback loops quicker. The Fed raised rates from under 0.5% in Mar’22 to ~5% in less than a year! With information transmitted in real-time, especially via networks like Twitter, & decisions manifested at the push of a button, we saw how SVB unraveled in literally a day. Given this speed of change, it’s important to frequently stress-test your state-of-state, accounting for changes in external & internal environments & updating your assumptions (esp. Margin of Safety) accordingly.

While the Treasury, the Fed & FDIC have joined forces to save everyone impacted by this specific SVB case, most of us can’t count on such White Knights bailing out our families or our startups each time. A pragmatic & defensive risk management approach that accounts for unknowables, incorporates a healthy Margin of Safety, & includes periodic stress testing, can help us cope with outlier events & keep us in the game.

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David (Microsoft) vs Goliath (Google)

Image Source: Channel Futures

By coming out & saying “I want people to know we made them dance” in this clip, Satya Nadella has officially announced the beginning of an AI war with Google, who in turn, has also accepted the challenge by launching its own version of ChatGPT called Bard (unfortunately, the launch was botched, wiping out ~$100Bn from its market cap in a day).

Btw, how awesome was this clip? Just the look in Satya’s eyes & the intent behind the statement fired me up, & I don’t even work at Microsoft.

The first battleground of this war is Search. And it’s expected to see classic “David vs Goliath” type asymmetric warfare (Google has 90%+ market share in Search, as opposed to single digit % for Bing). Goliath has everything to lose while David has relatively fewer resources (existing Search distribution in this case).

So, how would each of them be thinking about war strategy? There are clues in asymmetric military wars that have unfolded historically eg. the US in Vietnam.

David’s view (Microsoft):

David can’t beat Goliath in conventional warfare due to the sheer gap in resources. So, it doesn’t make sense for him to engage Goliath by following standard rules in the open. David’s best bet is to engage with Goliath unconventionally, perhaps playing by a new set of rules ‘cos that’s when existing resources will mean less.

Real-world examples of this include (many of these ideas are covered in Sun Tzu’s Art of War, & can be seen in historical military confrontations):

  • Attack Goliath when he least expects it.
  • Target areas where Goliath has more to lose than David (eg. a classic nuclear threat).
  • Avoid a battleground that Goliath is familiar with. Take the battle to unfamiliar territories.
  • Prefer guerrilla warfare over all-out confrontation.
  • Use new modes of warfare wherein there is more parity with Goliath eg. economic warfare, communications warfare, strategic diplomacy etc.
  • Engage in indirect conflict by leveraging third parties that have some edge over Goliath.

If one closely observes how Microsoft is approaching the AI war in Search, it’s using many of the above elements.

First, under Satya’s leadership, Microsoft made itself stronger as a software conglomerate (Teams winning over Slack, LinkedIn’s massive moat, Azure taking a significant lead over GCP etc.). This has brought it more parity with Google at a group level.

Second, while Microsoft has increasingly become an agile & aggressive war machine, Google’s unthreatened monopoly in Search has eroded both the rate of innovation & sense of urgency from its operating culture. In a way, Microsoft is attacking Google when it is at its weakest culturally, while itself being at its strongest in a decade.

Third, the rise of AI is fast changing the rules of the game and as OpenAI’s ChatGPT has shown, Search is likely to look very different in the future. This change is being organically driven by a technology inflection, making Google’s existing dominant position in Search potentially less meaningful going forward.

Fourth, Search is a battleground where Google has much more to lose than Microsoft – the classic Innovator’s Dilemma. Microsoft can afford to take bolder bets, while Google has to fend it off while also protecting its existing business.

Fifth & final, Microsoft is leveraging a third party (OpenAI) as a main actor in this war. Unencumbered, unpredictable, agile & brave – third parties like OpenAI are hard to figure out & gameplan against by large incumbents, similar to how large military machines often struggle against guerrilla warfare.

So, how can Goliath counter these tactics?

Goliath’s view (Google):

While David’s main aim is to use his “brain” & make the battle as unconventional as possible, it makes sense for Goliath to use his “brawn” & exploit David’s vulnerabilities, in particular the disparity of resources.

Some ways he can do this include:

  • Attempt to drag the war back to familiar territory.
  • Open multiple fronts against David so he is forced to spread his resources thin.
  • Drag the war out for as long as possible, to drain David’s resources.
  • Cut off any access points that David can use to replenish.
  • David’s key strength is his morale so think of ways to destroy it.
  • Focus on de-throning the general & the army will automatically collapse.

So, while Microsoft’s challenge appears stiff, Google can use many strategies to counter it.

First, Google shouldn’t be deterred by the first punch. It can strategically prepare itself for a long drawn-out war & leverage its Search distribution might to outlast the competitor.

Second, it can open up multiple fronts against Microsoft to distract it. Potential areas include Cloud, enterprise workflow (GSuite) etc.

Third, given AI is so early, there isn’t likely to be any first-mover advantage. As we speak, many high-quality teams are already working on OpenAI competitors, providing Google with a valuable opportunity to partner with them & make up for lost ground.

Fourth, one of Microsoft’s major strengths is its leader. Google should be open to making moves in the market that distracts Satya or puts him under pressure.

Fifth & final, Google should use this rare competitive pressure to revitalize its execution culture. Perhaps one of the founders returning to the helm is a possibility? If taken in the right spirit, this is a valuable opportunity for the company to reset itself for the next 2 decades.

These are just game-theory conjectures at this point. Given the resources at the disposal of both companies, this AI war in Search is likely to unfold over several years. We will see many of the above tactics get played out in each scene, which will be tremendous learning for lifelong students of strategy like myself.

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Using the Focus Canvas to Cut Burn

As the fundraising environment continues to get harder in 2023, founders & investors are deep into rationalizing business plans & finding ways to cut burn. The first temptation is to follow what I call an “excel sheet” approach – starting with the largest expense items without enough strategic thinking around the revised set of goals, business constraints in this new environment, what is working well right now, & how capital should be most efficiently allocated going-forward.

As opposed to big companies, startups operate with a finite runway, trying to address significant customer problems that remain unaddressed by large incumbents. This requires constant innovation – essentially doing hard, non-consensus things across the stack, everything from technology & design to customer experience & business model, that incumbents aren’t doing.

While big companies can afford to be relatively unscientific in cutting costs & still tide through tough macros with the help of their existing PMF, startups unfortunately, have no option but to play offense at all times in order to continue innovating & thereby, give themselves a chance to survive & succeed. In financial terms, this implies investing incremental $$ into innovation that drives more revenue (& profit), which is what will ultimately save a startup, not investor cash sitting in the bank.

So how should founders think about playing offense while being capital-constrained? I would like to propose a thinking tool called the “Focus Canvas“:

  • As a first step, rather than focusing on P&L line items, break down your business into specific buckets. These could include customer segments (eg. Individual, SMB, Enterprise etc.), product lines (eg. shrink-wrapped, custom deployment, pure services etc.), platforms (eg. desktop app, iOS, Android, browser extensions etc.), distribution channels (eg. self-serve, inside sales, direct sales, channel partners etc.), geographies (eg. US, EU, India etc.), teams by function/ type (eg. engg., product, design, sales, marketing, offshore contractors, agencies etc.) & other buckets that are relevant for your business.
  • Arrange all the relevant buckets & their constituent elements on a single page. This is your “Focus Canvas“.
  • On the top-left corner, list the most updated business goals for this year that all stakeholders in the company have aligned on. These could be things like “hit $1Mn ARR”, “show x% retention”, “start fundraising in Q4” etc.
  • On the top-right corner, list all the business constraints you expect to face this year. These could be things like “12 months runway left”, “only 2 backend engineers”, “sales cycle taking 6+ months to close” etc.
  • Now, as you are looking at this Focus Canvas, try and answer the question “what is working well right now?”*. You need to define “working well” for each bucket as per your specific context, also taking into account the above goals & constraints. It could be driven by one or more of revenue growth, most profitable, highest ROI, generating the most valuable feedback, creating the most differentiation, highest team productivity etc. *Note: this step is well-suited for a team workshop/ brainstorming session.
  • The most important step – for each bucket, put a ✅ in front of the element(s) you believe is your best bet to achieve this year’s business goals while navigating expected constraints. Then, ❌ out all other elements in the bucket. This is where ruthless focus is extremely important for the Canvas to do its job well – ideally, force yourself to ✅ only your #1 focus element. In the case of most startups, that’s probably all you can afford to execute anyway.
  • Finally, take the ✅ element from each bucket & weave them into a simple, 1-2 paragraph Focus Narrative. An example to illustrate this – “In 2023, we will focus on the Enterprise customer segment & offer them the standard product suite with a billable custom deployment services wrapper. The product roadmap will focus on the desktop app. We will double down on the internal sales model for distribution, with founders pitching in for strategic logos. To increase our team’s efficiency, we will significantly reduce contractor headcount & re-allocate them to full-time hires in engineering & internal sales.”

This Focus Canvas now provides a clear & strategic view of opportunities to both cut burn & re-allocate resources, while staying on track to achieve business goals & making progress toward PMF. The Focus Narrative can be used to socialize the going-forward strategy across teams in an easy-to-remember way. If used well (read: with ruthless focus), this approach can help startups in playing offense even in a tough economic environment.

PS: sharing a Focus Canvas template that you can use as a starting point. Feel free to download a copy & modify it as per your requirements.

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