Photo: Shutterstock.com

Risk of Being Too Risk-Averse at Early Stage Companies

My life as an in-house lawyer started inauspiciously: It was my first week, and I had already gotten into a big fight with the CEO. The next morning, he summoned me to his office. As I grabbed my legal pad and headed over, sure I was about to be fired, I wondered how I had gotten myself into this mess, what I was going to tell my family and friends, and where my career would be headed next.

After 20 years in BigLaw, I had finally made the move in-house. It wasn't just any move; it was a drastic one. I left the comforts of a high-rise office building in midtown Manhattan for a warehouse space in Brooklyn, where I joined a fast-paced, high-growth early stage company as general counsel. The company I joined made money by charging its customers for the privilege of running through walls of fire, swimming through large containers of ice, and navigating fields of wires with 10,000 volts of electricity running through them. The company was Tough Mudder. What was I thinking?

I certainly wasn't thinking about risk. If I had, I wouldn't have taken the job. I, like most of my colleagues, had crafted a risk averse career: good college, top law school, summer associate at a big firm, work hard, make partner. As outside counsel to large companies, there was no tolerance for ambiguity in the hourly advice we gave clients. Clients wanted 150% certainty, and we left no stone unturned. Risk aversion was the expectation and the reality.

Now at Tough Mudder, I struggled to adjust. Risk and ambiguity were not just on the menu, they seemed to be the steady diet. My disagreement with the CEO was over a course of action he had proposed and that I opposed. (I have changed the facts of these conversations to a fictional scenario in order to maintain confidentiality and privilege. The lessons learned remain the same.) There were major upsides for the business in terms of revenue and marketing, but, of course, there were risks. As I ticked through the downside scenarios, I could see the CEO turning red. I stopped. After a pregnant pause during which his face seemed to return to its natural color, he asked me what I really thought the downside would be, not what was theoretical. In an effort to win the argument, I told him that it was within the realm of possibility that the company could be held in contempt of court.  And that's when, for the moment at least, I lost credibility.

In trying so hard for my point of my view to prevail, I lost track of three things I knew to be true with respect to the proposed course of action:

• The realistic downsides were minimal legal cost and a small potential reputational hit.
• The likelihood that those impacts would be felt were quite low (i.e., there was virtually no chance that anyone was going to be the subject of contempt proceedings over this).
• There were significant revenue and marketing upsides to the company that were critically important at that stage of our growth.

Fortunately, I had overnight to think about this, and I came prepared the next morning to have a more logical discussion with the CEO. Even more fortunately, the CEO appreciated that I was new to the job and it would take me some time to achieve the right mindset for an aggressive, fast-moving, high-growth company such as Tough Mudder. He was prepared not to fire me, but to talk about how to have a more productive conversation the next time.

Reframing Risk Assessment for a High-Growth, Early Stage Business

This experience, along with many other ones in what became a rewarding and enriching experience as Tough Mudder's general counsel, helped me to develop an effective framework to assess and manage risk at a high-growth early stage company. Almost every day at Tough Mudder, and multiple times on many days, I was asked whether the legal department had any issue with something the business wanted to do, and often those things were aggressive and risky. Most often, the business wanted to take the action immediately, and so legal had to provide its view without the preparation, research and discussion that lawyers prefer. In addition, we were striving, as are all in-house legal departments, not to be the "department of no" but to be facilitators of the business from a legal perspective. Thus, the framework we developed provided a short-hand formula that could be used quickly, and also accounted for business concerns that would provide business-focused, strategic legal advice.

The framework consists of answering three questions focusing on the following three factors:

1. If we take the proposed course of action, what are the potential costs? Here, we are focused on the things that are in our comfort zone as lawyers: lawsuits, fines, injunctions and associated costs and fees. But don't forget to identify business downsides, such as bad public relations, loss of customer goodwill, employee morale and the like.
2. What is the probability that the bad things identified in response to Question 1 will occur? Lawyers are often hesitant to put percentages on outcomes, but this is essential in assessing risk. The business wants to know: Will I really get sued? What are the rules and regulations related to what I am doing? Will we fly under the radar or raise a big red flag? These are hard questions to answer, but with experience, judgment and a knowledge of the law, most lawyers are surprised to find that they are actually quite good at finding an accurate, if not precise, probability.
3. What is the cost of mitigating or otherwise not taking the proposed course of action? This is the question lawyers most frequently ignore in assessing risk. If we recommend not taking the action or if we decide to take mitigatory acts to guarantee no legal liability, what is the company sacrificing? This includes legal fees to mitigate, but also must include the loss of the upside factors that caused the business to want to take the action in the first place and are always top of mind for the business folks. These are things like revenue, publicity, goodwill and market share. If you are going to take those opportunities away by recommending mitigation or no action, you are only going to maintain credibility if you demonstrate that you have made that recommendation by appropriately balancing the upsides that the business values most.

By using the answers to these questions to assess risk, you are not managing risk based on hypothetical scenarios. Rather, you have identified the real risks and real benefits specific to the company.

A Formula for Decision Making

But now that you have this critical information, how do you use it to arrive at a recommendation? That involves another thing lawyers are traditionally averse to: math. A simple mathematical equation will appropriately measure these factors in relation to one another to allow you to arrive at a balanced, business-focused, strategic legal recommendation. So, without further ado, here is your risk equation:

PCA x PPC% < or > CMNA, where:

PCA = Potential Costs of Action (answer to question one above)

PPC% = Probability of Potential Costs, expressed as a percentage (answer to question two above)

CMNA = Cost of Mitigating or No Action (answer to question three above)

If PCA x PPC < CMNA, then the real risk is not greater than the real benefit:  Take the action.

If PCA x PPC > CMNA, then the real risk is greater than the real benefit: Mitigate or do not take the action.

Let's look at some hypothetical scenarios to better understand how this risk equation can be applied:

Scenario 1: The Tough Mudder head of marketing just realized that we had our one millionth participant this past weekend. In order to mark the occasion, he asked the events team to set up one of our most famous obstacles, Arctic Enema, in the middle of the street in front of our Brooklyn office, and to film all of our employees going through it. The film would be sent as marketing content through all our social channels to celebrate this milestone. (Arctic Enema is a large shipping container filled with ice and colorfully dyed water in which participants enter at one end, cross to the other side, and must completely submerge themselves under a barrier covered in barbed wire halfway across—fun!) All the equipment for the obstacle and filming are on the way for the event to take place this afternoon, but no one bothered to get a permit from the city to close off the streets for an hour. Do we shut it down or dunk the crew? Starting with the potential costs, there is the possibility of a fine from the city and that the shoot will get shut down and all associated costs wasted. We peg PCA at $20,000. What is the probability that those things will happen? We will say it's 50%, depending on whether you get a nice or understanding cop. We then ask our CMO his view of the marketing benefit; he believes this will amass a huge amount of views and have at least a $250,000 bump in ticket sales and sponsor engagement. Plus, as an edgy brand, even if the cops shut us down, he believes the filming will continue and it will look cool to our core audience. This makes us reduce our PCA to $10,000, as we now know that the costs of setting up the event will not be wasted in any scenario. So our risk equation is:

$10,000 x 50% < $250,000. The Millionth Mudder marketing event goes on!

Scenario 2: Tough Mudder events are held on large tracts of private land, like racetracks, farms and ski resorts. Our Missouri event is scheduled to take place on a private hunting preserve this coming weekend, with over 15,000 participants expected. Two days before the event, we learn that the venue owner failed to tell its members that the preserve would be unavailable for the event, and that dozens of hunting parties will be out looking for game. Our contract with the venue allows us to cancel the event and get our money back, but it limits our ability to sue them for any lost revenue from the cancelled event. Our event director assures us that he'll do everything to direct participants away from any hunters, and that anyway "it makes it even more exciting to be dodging bullets and is part of the Tough Mudder danger vibe!" We are not so sure. Our instinct is to cancel the event, but we break out the risk equation: potential costs are high if a participant is injured or even killed, especially since we know of the risk in advance.  We peg it conservatively at $10 million. Loss of ticket sales and sponsors from the bad PR of someone getting shot at one of our events amount to another $10 million. Probability of that injury seems less than even, but not insignificant, so we peg it at 25%. If we mitigate by cancelling the event, it costs us $1 million in profit and $500,000 in loss of goodwill from disappointed customers.

$20 million x 25% > $1.5 million. Call off the Tough Mudder bullet-dodging bonanza!

Key in scenario 2 is that we have not just focused on the potential risk of having the event, but we have considered the lost potential upsides. When having the discussion with the executive regarding why we are recommending cancelling the event, we can demonstrate that we have considered the impact on business revenue and customer goodwill.

Conclusion

By employing this risk equation, we are now not just thinking like risk-averse lawyers, we are thinking like business strategists who can overlay a legal process and empathize with the executive and management teams on the front lines. This gives the legal department credibility when providing recommendations, increasing the likelihood that the business will consult us on other key decisions early on. And finally, it helps you, the in-house lawyer, avoid difficult discussions like the one I had during my first week.

Marc Ackerman is an attorney at Bass, Berry & Sims. Throughout his 25-year legal career, he has been a strategic adviser for executives and c-suite professionals providing counsel on a wide range of issues important to overall corporate strategy, with a particular focus on IP issues. Marc has a deep understanding of the in-house legal function, having built and led the legal, risk and compliance function at a high growth, multi-national corporation, and provided practical, business-focused legal advice. He may be contacted at [email protected].