Reinventing Business Models Through Risk Management
Managing risks can be far more profound than just improving financial performance-some risks can disrupt not only a single company, but entire industries, forcing those that want to remain successful to reinvent their business models. This requires managing two risks in particular: informational risk and alignment risk. By addressing these threats and carefully considering risk-return tradeoffs, any organization can elevate risk management to the boardroom level and use it as a tool to innovate, rather than simply manage.
Consider Netafim, an Israeli company that manufactures drip irrigation equipment used in some of the least-developed regions of the world. The company had developed a new, high-tech irrigation solution that it believed would drastically improve crop yields. Initial attempts at selling this equipment, however, did not gain traction. Farmers were skeptical about potential benefits because of informational risks (the company claimed the equipment worked well, but the farmers had no independent third-party information about the performance of the technology) and alignment risks (the company had an incentive to sell the equipment regardless of its performance, but the value of the equipment to the farmers depended highly on performance). Add these to the many other risks that farmers already face, from the weather to the economy, and Netafim was facing an uphill battle.
Paying for performance rather than for equipment shifted the risk to Netafim. By virtue of its knowledge of the risk, and now with the right incentives to design, install and tune its equipment for peak performance, the company assumed the greatest burden, reducing the risk for farmers. Netafim could diversify the performance risk across many farms with different weather and could, in fact, further decrease risk through design and installation choices. Most importantly, by changing the risk-return equation, the company was able to increase adoption and drastically raise its market share. In essence, by selling the product as a service, Netafim provided a sort of insurance against the risks of using new equipment.
The company’s struggle is typical of many high-tech companies. More often than not, the equipment they sell is costly and has unproven benefits. While most companies prioritize product and equipment innovation to overcome these issues, this effort is often misdirected since a relatively small change in the business model can lead to greater investments to improve the technology.
The solution to this deadlock came again in the form of a business model innovation. Energy efficiency services companies offer the service of electricity bill reduction rather than selling energy-efficient bulbs. They offer an organization a contract that involves sharing the reduction in the electricity bill at the end of the year, while taking over the job of changing the lights, installing motion detectors to switch off lights and even insulating the windows. Given the uncertainties in electricity costs, consumption patterns and outside temperatures, these companies, like Netafim, essentially offer insurance against various risks that the organization faces when switching to the new technology.
Business models can often change the risk-return equation for existing products and technologies as well. Consider risks faced by most service organizations like hotels and airlines. Given their highly rigid and perishable capacity (a seat on a flight today has no value tomorrow), filling it up with paying customers is the top priority. To better manage these risks, airlines invented dynamic pricing as early as the 1980s as a way to deal with information risk. Instead of posting fixed prices before knowing how popular any particular day will be for travel, prices are continuously adjusted depending on how demand shapes up. So the person next to you on an airplane could be paying three times more, or less, depending on when you purchased the tickets.
Business model innovation through risk management has many advantages over other approaches. First, unlike traditional innovation through new products or technology, business model innovation does not require huge investments into research and development. It can be done systematically, with the main expense being the time of top management. Second, business model innovation often succeeds in industries where other types of innovation may fail. For instance, traditional commoditized industries (such as travel-related industries or oil and gas) find it hard to innovate by constantly introducing new products and technologies. Third, in innovating business models, some well-known risk management tools can be applied to identify and evaluate the right risk-return tradeoffs. Finally, business model innovation is often transferable across industries so that the best risk management practices in one industry can be transferred to another.
Finally, any new business models must be piloted and gradually introduced to fine-tune their design and identify best launch strategies.
The reinvention of business models to change the way they bear risks is a promising and underused technique for innovation. At the heart of this technique lies an ability to better understand and manage business strategy. This requires elevating risk management to the boardroom level and reconfiguring the organization to use risk management as a tool to innovate and disrupt rather than to just limit downsides.
