Understanding Risk Assignment and Reward

There’s a fundamental element of business that I think a lot of people don’t fully understand – or even realize exists. Yet it’s such a driver of how business works that to not understand it is to not understand business itself, and to open the door for great frustration.

Perhaps the simplest illustration of this concept is in royalty agreements. Suppose you agree to write a book for me. You will invest a certain amount of time, and I, as a publisher, will also invest time and money. I will hire and pay editors, indexers, designers, marketing people, payroll people to pay all the other people, and so on. If your book flops, you will have risked and lost a certain amount of your time, which equates to money – since you could have been doing something more profitable with that time. As publisher, I will also have risked and lost, since I could have deployed those resources to profitable projects.
So as part of our financial agreement, suppose I offer you a $10,000 advance against your royalties. I have now significantly increased my risk as publisher – if the book flops, I won’t earn that money back. You, on the other hand, have vastly decreased your risk. If the book flops, some or all of your invested time will have been paid for. So when we start discussing your royalty percentage, I’m going to want to make it quite low. You have very little at risk, and so you will share relatively little of the reward.
You see the same thing in everyday loans. If you’re a good credit risk, you don’t need to share very much money with your lender, and so you get a low interest rate from them. On the other hand, if you’re a poor risk, then you’re going to have to share more of your money with the lender, in the form of a higher interest rate. Percentages – whether interest rates on a loan or royalty rates on a book – represent an assignment of risk. Were you to lower your lender’s risk – say, by putting down more of your money up-front – then you’d lower the lender’s “reward” by getting a lower interest rate.
Conceptually, this probably makes sense to you. But it often makes less sense for full-time employees of a company to think about risk assignment. Yet the concept exists, is very real, and is very much applicable.
Employees are, in almost all cases, taking on the lowest possible form of risk. Yes, there’s always the risk that the company will go under, but that’s a shared risk for everyone in the firm. Otherwise, employees typically enjoy regular pay, benefits, a paid-for office environment, and numerous other perks – with essentially the lowest possible risk factor. Yes, the failure of a company product could result in layoffs, but you can never have zero risk. Employees’ risk includes nothing out-of-pocket – they’re not going to be asked to return pay should the company fail. Being employed is a pretty good deal, and it’s one reason why so few people work for themselves (which is obviously much riskier).
So it should come as no surprise that employees are so rarely cut into the rewards of the company. Certainly, many companies have profit-sharing programs, and those are a wonderful thing. Many companies cut employees into an equity stake in the form of stock or option grants, which is also wonderful. But those are perks, and given the extremely low level of risk the average employee is under, there should be no expectation of a significant share in the rewards. If the company has an amazing quarter, must employees get a bonus check? Well, it’s certainly nice – but since you weren’t likely to lose your job or take a pay cut had the quarter been a bad one, a bonus certainly isn’t deserved. At least, not by the basic tenet of risk/reward assignment.
So why do companies even offer bonuses, profit-sharing, and the like? Mainly for retention. In highly competitive areas, you simply have to work hard to retain quality talent, and those are tools for doing so. They do not represent a share of the company’s rewards, in other words, but are rather an inducement to stay on – and inducement connected to the rewards, certainly, but definitely distinct in the sense of the risk/reward algorithm.
So how can you get greater rewards in life, if that’s what you seek? Take on more risk. Become your own boss, or engage in some enterprise that has a real chance at loss. Once you’re risking loss, you’re entitled to a share of the success, commensurate with the risk you were taking.

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