Visualizing Risk and Reward When it comes to the matter of risk and reward in venture,a business plan be fits enorm stors that th two graph naps graphs ir money that illustrate the most likely relationship between nd it High aip ce ther the middle of thes ures say more The first pic e depicts the amount of mone need there is a smal ve cash ihspawn a 200% rate invest i Microsoft when it was a private company. money rale of relurn per year termin hat cla w venture drill ing for No orth sea carly and often.But most d hy the picrure ve hen the cash ouow is high and of a Thi ogical gamble and proba ably less Of course inc the world of new ventures is popu- tion.It's then up to the investors to decide how much d by wi you might expect the they want tol With ag st what kind of ard slope than it should.It usaly s.But to be that apicture ngs in the b a signinicant return is d the nright hug the new venture's is con mpletely out of touch e picture's beauty.Whatit The sccond picture complements the first.It shows investors the range of possible returns and the like caveat emptor. Who else might be able to observe and exploit the plan doesn't whitewash the latter.rather it p me opportunity? Are there ways to co-opt potential or actual com bad.and the ugly that the venture faces ahead. petitors by The Context plan that describes an insuperable lead or a propri Opportunities exist in a context.At one level is inition written by naive at goe le macroeconomicctivitoncluding the ther exc cussion of the opportunity.All opp rtunities have wide ra nge of government rules and regulations promise:all have vulnerabilities.A good business that affect the opportunity and how resources are 104 HARVARD BUSINESS REVIEW July-August 1997graphs is the This image helps the investor understand the depth – lated by wild-eyed optimists, you might expect the lihood of achieving them. The following example – risk they want to live with against what kind of odds. Again, the people who write business plans might and the possibility of loss is negligible. And, again, I money potential reward time depth time to positive cash flow of hole probability 15% 15% -100% (total loss) 45% 200% (big hit) flat section Visualizing Risk and Reward When it comes to the matter of risk and reward in a new venture, a business plan benefits enormously from the inclusion of two graphs. Perhaps wrong word; these are really just schematic pictures that illustrate the most likely relationship between risk and reward, that is, the relationship between the opportunity and its economics. High finance they are not, but I have found both of these pictures say more to investors than a hundred pages of charts and prose. The first picture depicts the amount of money need￾ed to launch the new venture, time to positive cash flow, and the expected magnitude of the payoff. and duration of negative cash flow, as well as the rela￾tionship between the investment and the possible re￾turn. The ideal, needless to say, is to have cash flow early and often. But most investors are intrigued by the picture even when the cash outflow is high and long as long as the cash inflow is more so. Of course, since the world of new ventures is popu￾picture to display a shallower hole and a steeper re￾ward slope than it should. It usually does. But to be honest, even that kind of picture belongs in the busi￾ness plan because it is a fair warning to investors that the new venture’s team is completely out of touch with reality and should be avoided at all costs. The second picture complements the first. It shows investors the range of possible returns and the like￾shows investors that there is a 15% chance they would have been better off using their money as wall￾paper. The flat section reveals that there is a negligible chance of losing only a small amount of money; com￾panies either fail big or create enough value to achieve a positive return. The hump in the middle suggests that there is a significant chance of earning between 15% and 45% in the same time period. And finally, there is a small chance that the initial outlay of cash will spawn a 200% internal rate of return, which might have occurred if you had happened to invest in Microsoft when it was a private company. Basically, this picture helps investors determine what class of investment the business plan is pre￾senting. Is the new venture drilling for North Sea oil highly risky with potentially big payoffs – or is it digging development wells in Texas, which happens to be less of a geological gamble and probably less lucrative, too? This image answers that kind of ques￾tion. It’s then up to the investors to decide how much be inclined to skew the picture to make it look as if the probability of a significant return is downright huge would say therein lies the picture’s beauty. What it claims, checked against the investor’s sense of reality and experience, should serve as a simple pictorial caveat emptor. rate of return per year � Who else might be able to observe and exploit the same opportunity? � Are there ways to co-opt potential or actual com￾petitors by forming alliances? Business is like chess: to be successful, you must anticipate several moves in advance. A business plan that describes an insuperable lead or a propri￾etary market position is by definition written by naïve people. That goes not just for the competition section of the business plan but for the entire dis￾cussion of the opportunity. All opportunities have promise; all have vulnerabilities. A good business plan doesn’t whitewash the latter. Rather, it proves that the entrepreneurial team knows the good, the bad, and the ugly that the venture faces ahead. The Context Opportunities exist in a context. At one level is the macroeconomic environment, including the level of economic activity, inflation, exchange rates, and interest rates. At another level are the wide range of government rules and regulations that affect the opportunity and how resources are 104 HARVARD BUSINESS REVIEW July-August 1997