5 Ways to Tell If a Risk Is Shrewd … or Stupid

Risk-taking is second-nature to most entrepreneurs, but it pays to be smart about it. These 5 red flags can stop you from taking the wrong risks.
Journalist, freelance writer
July 28, 2014

At heart, most entrepreneurs are risk-takers. That's partly because you can't start a business without taking at least one.

From the moment you start a company, you're risking your time and your money. And the risks never really stop: Growing a business often means tweaking your formula, testing out new marketing campaigns, and doing something just a little different from your competition. And that little something different can bring great results—or not.

So how do you know whether a risk you're about to take is calculated and shrewd—or stupid and reckless? You often don't, but after picking up the pieces from a risk gone bad, most entrepreneurs realize there were ample red flags fluttering in the breeze.

To help you see the hurdles that could stop your plans cold, here are five red flags to watch out for.

1. You're Rushing the Process

"Many of us get so excited about our new idea that we feel like we have to start tomorrow. While passion and excitement are good things, it can sometimes blind us to potential hurdles," says Dan Weedin, an insurance consultant who advises insurance buyers. For years, Weedin's been immersed in an industry that's all about minimizing risks.

But Weedin says, "There aren’t smart or stupid risks. There are simply just risks."

Rushing into something, however, certainly improves the odds that your risk will turn out badly, Weedin adds. In fact, he learned the hard way about the downside of rushing into a business decision when he and his wife bought a franchise 20 years ago. "It was a children’s gym, and we had the skills to manage and operate it," Weedin says. "The problem was, we didn’t do a good job of strategizing, planning and executing."

With 20/20 hindsight, Weedin admits the location wasn't ideal—it was in a community of military families who are transient by nature and not around long enough to become regular customers. The couple also had to pay too high of a rent in an area where the families couldn't afford the prices the Weedins had to charge to cover their overhead.

"We simply were under capitalized and didn’t fully understand the demographics," Weedin explains. "While the risk was worth taking, the execution to make the risk work wasn’t. But we were too much in a hurry."

Weedin estimates he and his wife lost well over $100,000 from the franchise. But they rebounded, and Weedin started his consultancy.

2. You Aren't Seeking Feedback—or You're Ignoring It

One of the most common risks that Susan Baroncini-Moe, a business coach and author of Business in Blue Jeans, sees people taking is spending their life savings on an idea that they haven't fully tested. And if a focus group isn't practical or something you're interested in doing, the least you should do is make sure you're hiring the right experts to help you move forward, Baroncini-Moe says.

For instance, having an attorney help you write your operating agreements or protect your design, using an accountant to help you with bookkeeping, or hiring a consultant to review your idea and guide you through whatever stage of business you're in can be very helpful.

"You don't have to spend a lot of money on experts, but choose them carefully and make sure to check references," Baroncini-Moe warns. Because while experts can save you a lot of money, the wrong ones, she adds, "can actually tank your business."

3. You're Expanding—But Outside of Your Core Competency

Blindly jumping into an area you're unfamiliar with can be dangerous to the health of your business. Take it from someone who knows: Attorney Mark Chatow now practices entrepreneurial and small-business law, but back in the 1990s, he was the co-founder of a company that manufactured a line of soft-sided sewn cases to hold CDs and DVDs.

"One day, a buyer at a national catalog asked us if we could make something that wasn't in our product line—a wooden CD tower," Chatow says. "While it wasn't an area we knew well, they promised a big opening order, so against our better judgment, we designed what they were looking for and found a plant that could produce them."

If they'd had more time to test the new product, it might have been a profitable addition to their product line. But that wasn't the case. "Everything went fine until we started to drop ship the units," Chatow says. "What we failed to realize was that our shipper would take the 'drop' in 'drop ship' a little too literally. We had an immediate influx of complaints that the end customers' products had arrived in splinters.

"It turns out that packing and shipping a heavy wood tower is a bit more challenging than shipping lightweight, soft-sided cases," Chatow says. His company ended up spending tens of thousands of dollars on the new product, only to get blindsided by the high number of damage claims, which ruined the company's relationship with its buyer.

4. You're Ready to Spend Money Without Doing Your Homework

About 10 years ago, when David Ciccarelli and his wife, Stephanie, were starting Voices.com, an online marketplace that connects businesses with voice-over talent, the couple decided to do a marketing campaign. But Ciccarelli and his wife had just spent a small fortune designing a logo, he says, and didn't have money to waste. Unfortunately, he adds, "We were young and misguided and eager to make a big splash."

So the couple decided to do a huge direct-mailing campaign to the tune of $30,000. Because they didn't have that kind of money lying around, they took out a bank loan, then sent out 16,000 postcards to a list of advertising agencies that seemed like a good fit with the company's services.

Two people replied, Ciccarelli says, "resulting in a cost per lead of $15,000 each." As an online company hoping to get people to use its Web service, Ciccarelli says sending out a postcard mailing probably wasn't the best way to reach prospective clients.

“For small and medium-sized businesses, the most precious resource is capital, so big expenditures are best done carefully," adds Kip Caffey, managing partner at Cary Street Partners, a financial services firm. "If the expenditure won’t clearly drive strategic success—ultimately measured by profits—it’s probably dumb.”

5. You're Worrying About the Details—Later

While you may be a "big picture" kind of person, the devil is in the details—at least when it comes to running a business. Early in his career, entrepreneurial motivational speaker and author Mark St. Cyr says, "In the rush to start a project or close a sale, I would take chances and skip the procedure of first filling out the proper paperwork in order to get my foot in the door and not spoil the mood as the sale closed."

Each time, by closing quickly and worrying about the paperwork later, St. Cyr thought he was avoiding the risk of putting a damper on things—but he was actually creating very risky situations that could have blown up in his face.

"I learned it was not only harder to get the paperwork or documents after the fact, it was nearly impossible and it cost me far more financially in some cases than if I'd lost the sale in the first place," St. Cyr says.

When to Ignore the Red Flags

When it comes to business, not all hurdles should put a stop to your plans. Sometimes the smartest thing you can do is to note the obstacles in your path, then do everything in your power to find a way around them.

David Moore, president of IT outsourcing company Phantom Consulting, recalls a risk he took 15 years ago when he was the owner of a marketing company. To help create an image of success, he purchased a company car—a $50,000 Ferrari.

"It was pretty risky," Moore says. "Our company's entire budget was about $150,000 per year. We were trying to start a franchise program, and I was personally living in a very small apartment with not much furniture. We had four employees, and we all could have used that money."

But the calculated risk paid off: Moore says the car absolutely helped drive more business to his company, more than enough to justify the vehicle's expense.

Would he be willing to make such a large gesture today? Not likely. "The world has changed," Moore says, referring to the Great Recession. "I don't think that investors or potential customers would look favorably on that now."

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