The Barbell of Pricing Risk

Blair borrows a concept from finance and fitness to help creative agencies find the balance between low risk and high risk pricing strategies.

Transcript

David C. Baker: Blair, you've titled this The Barbell of Pricing Risk, and just for the audience, a few notes for the audience, it's a little bit different. This is sort of a provisional notion you have. You're not super sure about it, but what we're going to do is just have a conversation, almost as if you just called me up out of the blue, and the tape isn't running, and we're just testing this idea out, and you want somebody to bounce it off of, and so on. We're just going to have that conversation today. This isn't all neatly buttoned up. It's just a conversation about a concept that you find interesting, right? You want to explain the concept first?

Blair Enns: Yes. I really like this format too, because I expect to be smarter at the end of this, and I shared that with you earlier, and you said-- what did you say to me in response to that?

David C. Baker: I don't know what I said. Probably something smart-ass, yes.

Blair Enns: I said, I'm going to be smarter at the end of this conversation. You said, I can't do miracles in 25 minutes.

David C. Baker: I'm proud of myself for coming up with that line though, that's true.

Blair Enns: You didn't remember it. It was only 20 hours ago. The idea is, I'm hesitant to say this, because by the time this airs, we're recording a couple of months in advance. I don't know what the state of this project will be, but I've been writing daily. I'm taking a cue from our mutual friend, Jonathan Stark, who's been writing daily for years. He got the idea from our very good friend, Philip Morgan. He should get some credit. I've been writing daily to see if I can maintain the cadence, and I'm pleasantly surprised.

One of the trade-offs that's necessary and wonderful about writing daily is you have to write shorter. I'm writing 200 and 250 words. I pulled out this thing I wrote a while ago. It's in the library of a whole bunch of stuff I've written. I may publish it one day. I may move to a daily blog post in addition to the one every two weeks or not. I shared this thing with you I wrote a while ago, and it's basically me trying to reconcile two different models from two different brilliant human beings. One is Nassim Taleb's idea, the Barbell Risk Strategy.

I think he's probably the smartest, most interesting person to listen to or read on the subject of probability and risk. I don't follow him on Twitter anymore. I'm not really on Twitter much anymore because I don't like the way he treats people. If you put that aside, he is a genius on this subject. He says about risk broadly, and then we'll get to specific domains, you should take more risk in your life, but it should be balanced. His original domain is finance. In the world of finance. He says your investment portfolio should be, I think he says, 85% to 90% safe, solid, low-risk, low-return investments. The remaining 10% to 15% should be high-risk investments, and you ignore everything in the middle.

That's what he means by Barbell. You've got low risk out on one end and high risk out on the other, and you ignore the middle. Then he's extrapolated that to other domains in life. Let's stick with investing. The other brilliant person I've also learned a lot from is Ron Baker, his numerous books on pricing and his great podcast that he does with Ed Kless called The Soul of Enterprise. Baker has this model that I cite often, and that is that we should view our client base as we do our investment portfolio. It's essentially the same thing. I think I've talked about this before, but like any investment advisor, before they sold you some financial instruments, they would do some sort of risk analysis.

Let's say you come out with a moderate risk tolerance. They're free to sell you high risk, medium risk, and low risk investments as long as it balances out to meet your risk profile so that you're able to sleep at night. Just because you have a moderate risk level doesn't mean there isn't room for some high risk investments in your portfolio. Where they differ here is Ron is fairly insistent that you should never price your time. When we look at the various things that you can price, you can basically price the inputs of time and material, the outputs of the deliverable, and then you can price the value, getting higher risk here as we go, or the outcomes.

Then there's a version of value-based pricing known as performance pay where you're guaranteeing value. This is really high risk. Ron's a big fan of value-based pricing, as am I. I believe there's a time to sell time. He's fairly insistent. I'll check with him on this to make sure I'm not putting words in his mouth, but we've had conversations on this point. He's fairly insistent that at no point you should sell time. What I'm trying to do in this 250-word post that I sent you and what I wanted to talk through with you is reconciling these two different things.

I'm really enamored with this Barbell Risk Strategy of Talebs, and I've thought about it across multiple domains, and I think it's really wise, and I think it's wise to adopt that. When we look at our clients, the message would be sell time. If we applied Taleb's model to the idea of seeing your clients as an investment portfolio, the majority of your investments, 85% to 90%, you would be billing time, and then a very small number, you would be doing performance pay.

I'll just say one more thing before I turn it back to you about Taleb's Barbell Strategy, and that is, he says, you never take existential risk. He's adamant about this. It might even be the first rule. You never bet the firm. Rule number one is survive. You never take a risk that is so high that if it fails, it's going to be existential to your life or the existence of the firm in this case. You've seen my notes. I've just unpacked the idea. What do you think?

David C. Baker: You and I haven't talked about this at all, so there's some confusion in my mind, and then a couple of pushbacks, but the confusion is maybe the way he names this, the Barbell thing.

Blair Enns: It's a pretty lopsided Barbell.

David C. Baker: Yes, it's 90 to 10 or 95 to 5. My first thought was I struggled to think, okay, what's in the middle? You can sell time, which is at one end, or you could price by value where you're guaranteeing some outcome, but what's in the middle? When I think about applying this concept to our own financial situation, and this would probably be duplicated with most of the people listening, it's like you own a home. Very likely that you're going to make money on that home over time, not as much as you think when you wrap all the costs in taxes, utilities, all that stuff, but that's your really safe investment.

If you're in the stock market, you might take more risks there. I think the biggest investment mistake people make is they don't realize that their home is a part of their portfolio, and it's on the very safe end of this Barbell, and the more risky thing might be options. Then the middle would be just buying an index fund. I didn't understand what the middle was here on this. I understand selling time, I understand selling value and guaranteeing the outcome, but I don't understand what the middle is.

Blair Enns: I think the middle would be if we've got these four rungs, time, the deliverable, pricing based on value but not taking any risk, and then pricing based on outcomes, performance pay, will I get paid based on the actual results. The middle two would be deliverables and then value-based pricing without any risk, where it's a set fee based on value, rather than tying the fee to the actual outcomes rather than the desired outcomes. There's a bit of a distinction there. When you're value is pricing, it just means you're pricing based on value, but you can be pricing based on the expected value you uncover in a value conversation that the client wants to hit certain metrics, achieve a state, hit certain metrics, and let's say create $5 million in net new profit.

David C. Baker: Even productizing could be in the middle too, where it's uncoupled from time a little bit?

Blair Enns: Yes. Productizing, for the sake of this conversation, I would put it at pricing the deliverable. He's adamant you stay away from the middle. To me, if you apply this model, just because the absolute safest is time, I don't know, it doesn't mean that you couldn't move in a little bit from that absolute end. I suspect Ron would say, no, on the low end, the safe end, you're pricing the deliverable. It's not completely safe because when you price the deliverable, you're costing it, you're making an analysis of what it's likely to cost, and you have this range. It's going to take us between X and Y time, therefore it's X and Y price.

You're taking some risk and the risk is, well, how long is it going to take you to do it? If you could do it quicker, you'd make more money. If you do it slower, you'd make less money. That's where you take a little bit of risk. I don't even know if it's considered a moderate amount of risk. It'd probably be a smaller amount of risk in exchange for price certainty, that's what the client gets in exchange. You could make the argument, like if we switch this to an exercise domain, maybe we'll do that in a couple of minutes because I think there's more to say here.

The exercise equivalent is actually something just in from the lowest risk. In the finance world, lowest risk is, and I'm going to push back on, this isn't a finance podcast, but there's a famous book in Canada written 30 years ago called The Wealthy Barber by David Chilton. I write it as a young adult. A lot of people in this country have read this book. I don't know how far it's traveled, but one of the first points he makes is your home is not an investment. It's the place that you live in.

Yes, it's an asset that accrues, but it's not like you're going to sell that at the end of your life and cash out and leverage it. He said, the reality is my parents did this. They had a big home. They sold it, not for the financial reasons, but to move to a smaller space. They downsized to a smaller space, much smaller, same price.

David C. Baker: Oh, I know. It's a wealth building tool. It does build wealth, but you just invest that wealth in the next home. You don't live on the difference in wealth that you're generating with the home. It's like at the end of your life, you have more money tied up in home, but it's still tied up in home. This is one of the problems for me when I hear arguments like this from other people. I'm not saying that applies here necessarily. It's the idea of, okay, we've mastered getting paid for our time. Now we're in a position where we can risk maybe the 5% or 10% or 15% over here. Let's experiment with some pricing things. In almost every case, they have not mastered that. They are not getting paid for their time.

Blair Enns: They haven't mastered the first part. Is that what you mean?

David C. Baker: Yes, they haven't mastered the first part. Right. Don't talk to me about value pricing until you're at least getting paid for all your time. Now we can talk about value pricing, but this is like skipping four grades because you want to go to grad school or skipping college because you want to go to grad school. It's like, no, value pricing requires tight positioning, arms around your systems, knowing exactly what time it takes because that's the floor. You can't be charging less than that. Ideally, in some cases, you're charging a lot more. Other cases, maybe a little bit less. Based on the risk you're taking and so on. It just seems a little bit empty when people do that.

Blair Enns: I'm going to push back on that. I don't think you have to master input pricing time and materials to be able to move on to value-based pricing. In fact, I think one of the challenges, and we did a podcast on this. I wrote a post on it called The Five Levels of Pricing Success. The first one is labor arbitrage, my label for selling time. The second level is maximum efficiency. The point I made about maximum efficiency is it's a trap. By the time you get to the place where you're really good at selling time, it gets hard. It's very difficult to let go of that and move past it.

I actually think you don't need to nail selling time. You don't need to be a master at it to get good at value-based pricing. The point that I did agree with that I was deriving from what you made is if you're just dabbling in not just value-based pricing, but performance pay, if 90% of what you're doing, is just billing time or pricing the deliverables, and you're just dabbling at it, I think it's a good question. It's an open question. How good can you get at performance pay if you are just dabbling at it? I think that's the provocative point for me.

David C. Baker: Okay, so let me just expand on what I was thinking and tell me if you still push back on it. Because when I say that people aren't getting paid for their time, what I really mean to say is they are not good salespeople for selling something that costs them more than it should in the first place. Why don't you get better at selling all the time you're actually spending, then we can talk about the advanced selling. You're going to have to sell the same stuff for a lot more money.

Blair Enns: Is that a pricing problem or is it a scoping problem?

David C. Baker: I think it's probably both.

Blair Enns: Yes. Because sometimes it's a surprise to people.

David C. Baker: I think you're right.

Blair Enns: It's a surprise to people. It's like, "Really? Oh, I didn't realize we were leaving that much money on the table." Then what's the solution to that? Unless they change to value-based pricing, then they're just simply saying, "Oh, we made a mistake. The same job that cost you $28,000, now it's going to be $37,000. Sorry, my bad." Clients aren't going to go for that, right?

David C. Baker: Yes. I think your point is that the high-risk investments shouldn't be there to compensate for all the mistakes you're making in managing your low-risk investment portfolio.

Blair Enns: That's a better way of saying it.

David C. Baker: Yes.

Blair Enns: We could have saved a lot of time if you just corrected me.

David C. Baker: I was just thinking of a client you and I have both worked with in the last year or two, and they're a great example of low-risk and one high-risk investment that's just added millions to the top and bottom line. It's basically, it's been the difference maker in that business. I think that's a great example. I think of another firm that you and I have both worked with, the owners have become pretty good friends of mine. One of them was visiting me in Palm Springs one year and telling a story, I think I've told this story too, about this consumer product where he wanted to get paid in the fees in cash and it was low millions. It was past startup. It was in scale-up mode, but it wasn't a publicly traded company yet.

The founder of the business offered half in cash and half in equity. He insisted on taking the cash. The guy went and raised a little bit more money and paid the fees. I said, so what's your equity worth today? The equity that you didn't take. He very calmly said, $250 million.

Blair Enns: Yes. To make that story complete, you would have had to have asked, "Okay, what about the other equity that you were offered?" I don't know if you read the Union Square guy, Fred Wilson, but he came out with an email this week that I found really fascinating because you always hear that VC people, not so much PE, but VC people are going to-- they're going to lose their shirts on almost everything. Then they'll make up for it because a small percentage is going to hit really big, right?

David C. Baker: Yes.

Blair Enns: He actually went back and studied that for their entire portfolio over the last 30 years. He compared that with the same results from Andreessen Horowitz, who did the same thing. They discovered that, one, maybe 2 out of 10 investments make up for everything. 3 or 4 out of the 10, just like nothing. It's like the money's completely gone. We wasted that. The other three or four, it's like, "Oh, we got a return of, but not a return on capital." Then the one or two just blew us away. These are people who have money, it's their money and other people's money they're risking. They're also pretty good at assessing those kinds of things.

I just wonder if our audience is good at that stuff. Just think about all the firms that have tried to build a product or an app or something and how few of them actually take off. You wouldn't necessarily see this, but I see their financial projections all the time. It's like, "Really, let's just compare what you said you'd do this year and what happened." They just don't even conform to any sort of reality.

David C. Baker: That would point back to your very first point. Don't take an existential risk. Don't go out of business if you mess up. People in this field are definitely good at taking risks. Are they good at taking the right risks? I don't know.

Blair Enns: Yes, it's a good point. The VC model, that's a hit maker model, like Hollywood studios, like publishing, like pharmaceuticals, all of those follow-- I guess it's a Pareto principle where the majority of returns come from a minority, a small minority of actions or in this case investments, and the rule of thumb that's used is 80-20, but it's not always 80-20. Pareto himself didn't say it was 80-20.

David C. Baker: The last time I did some just basic web research on the hit ratio of venture capital firms was a few years ago when I was preparing for a webinar. The ratio I came up with was 1 in 26. 1 in 26 goes big and there's a small few that cover the cost, maybe make a little bit of money, revenue positive. That's a crazy ratio, even if it's 1 in 10 and then pharmaceuticals I don't know what it is, movies I don't know what it is, but if you look at those other businesses, they're really interesting and interestingly different from a creative or a marketing firm in that these hit maker models have investors.

Venture capital firm has these limited partners, the general partners are not risking all their own money, they have some of their own money in it. They're involving others to underwrite the risk. In a studio making a movie, it's not the studio taking all the risk, the executive producers are the financiers and money raisers, so they go out and get investors. A pharmaceutical firm is really well capitalized at publicly traded company and the investors understand what the model is, so there isn't an equivalent in the agency world. Those hit maker models they're betting everything.

They understand that-- Let's use your ratio of 1 in 10, that 9 in 10 are not going to produce revenue. That's not what we're talking about here, but if we take that model, let's say 80% of your portfolio base is safe, maybe it's inputs or outputs, and then the other 20%, you apply that 1 in 10 hit maker model to, so of the 20% of your client portfolio, 9 of those performance pay deals are going to go to zero or close to zero. Maybe the 9 together net out at something approaching your cost, and it's the 10th one of 20% now in a creative firm where you've got 10 to 20 clients at any one time, that's a lot of years before you get to that volume of clients.

Blair Enns: Yes.

David C. Baker: Here's the final thing that when I got your note that stirred up in my mind. Let's say I buy, and I do, I buy the notion of this Barbell, let's keep a lot of stuff towards the safer end. Let's do some thoughtful risks on the other end. Why does that have to be in pricing. Why couldn't it be in something else like service offering design or developing a product or an app or something. I'm not fighting for that, I'm just asking the question because it seems to me like pricing is so difficult to get right. It takes so much training.

I'm not sure a firm is going to master different pricing methodologies and it seems like the staff, they're just going to get confused with it unless maybe this is just something the principal does and say, "Hey, we're taking this risk. Here's why." It doesn't have to be in pricing. You could believe in this Barbell distribution of risk, but you could acknowledge that it should show up in other areas besides pricing too, right?

Blair Enns: Yes, I suppose it could. You're the pricing guy.

David C. Baker: Yes, and I really wanted to look at this issue through the lens of pricing specifically. When we get to other domains, exercise is really interesting. If you know anything about Nassim Taleb, he wasn't in very good shape. Other people call him a philosopher. He describes himself as a flaneur. Do you know the definition of flaneur? It's a French word.

Blair Enns: uh-uh.

David C. Baker: It means to wander without a destination. He refers to himself as a flaneur. When he travels, I hope I'm getting this right, he spends a lot of time, like an entire day sometimes, just wandering through a city aimlessly without a destination. It's basically, there's something in the word or the meaning of the word that implies like a delightful discovery, not being planned, not being prescribed. His exercise routine is a whole lot of walking, and then he does high-intensity heavyweight training.

You can see him applying that Barbell Strategy to exercise. I was thinking about that. Then I was thinking, I'm a big fan of Peter Attia, the longevity doctor. He talks about spending most of your exercise time in zone five is basically 100% of your maximum heart rate, and zone one is, I think, something 10 to 20%. Taleb would be spending the majority of his time in zone one and then a very small amount of time in zone five. Attia's prescription is similar, a little zone one, a lot of zone two, and then zone five. He completely misses the middle. What I love about that is it's an argument against jogging, which I hate.

Blair Enns: That's why your ear's perked up, because you hate jogging, yes.

David C. Baker: Walking, yes. Sprinting, yes. Heavyweight training, yes. The stuff in the middle, it just strikes me as somebody who spends a lot of time exercising and observing other people exercise, especially as you get older. There's a whole lot of people doing the stuff in the middle, and it just, the benefits don't accrue to you. I am really enamored with this Barbell Strategy and thinking about applying it to different domains in life and business.

The pricing one, I don't feel like I've solved this problem or we've solved this problem in this conversation. I don't feel smarter on the subject, so you win. You can't work miracles. I appreciate the conversation, and I hope the listeners appreciate the conversation too, because I'm still completely fascinated by this, and I'm going to keep working through this until I come up with some sort of recommendation for our clients.

Blair Enns: I'm drawn to his flaneur thing. We're recording this September 12th, and early tomorrow, I'm flying to Chicago, and I'm flaneuring for three days with this other Leica guy from the Netherlands. I've never met, but I follow a lot of his stuff, and we're meeting there. We're just going to wander Chicago aimlessly for three days taking pictures.

David C. Baker: That's right up your alley, flaneuring.

Blair Enns: Oh, I do it all the time. I did it in Madrid for three days recently, and I'm doing it in Guatemala and Havana in the next two months. Yes, absolutely, but I don't run fast anymore anywhere. Okay, but one last question here for you. Let's say that people are buying this. They want to experiment with it. They want to get up to the existential line, but not cross it. How much would you risk? When people ask me that question, I say don't risk more than your total profit. Maybe that's 10% a year like that. Maybe normally it's 20%. What would you risk? Where's that line where if it fell through, you'd still have what? What would you risk?

David C. Baker: I think it would be scenario dependent, and it would also be dependent on where the firm is and what your propensity for risk is in that moment. It would depend on your prediction of your ability to actually create the value and earn the money. I think there would be scenarios where you would consider a total contingency basis, which is you risk all revenue.

Blair Enns: All revenue.

David C. Baker: On that one account or one project. Yes. I don't see why not. As long as the total amount of investments that you make at the high-risk end, do not become an existential threat, do not cause you to give up all profit in the firm across the board. I wouldn't risk the profit of the firm.

Blair Enns: Yes, so let's say you're a 20-person firm. You expect 20% profit, and some client comes to you, and they want you to take that equity, like what you just mentioned about your Palm Springs friend, and they want you to make some money or maybe risk it all, but it's for massive equity. If it works out well, you're going to get very rich. If nothing happens, that person that's running that firm is risking everything. That's existential risk for them. For you, it would just bring you back down as a firm to breaking even and not making profit, but you wouldn't lose any money. You'd lose all the money you bet on that firm, but you wouldn't lose money on your firm itself. Is that a repeat of what you said?

David C. Baker: Yes.

Blair Enns: I think that makes sense. Until you get better at managing those risks, my wife does options trading, and I want nothing to do with it.

David C. Baker: Why?

Blair Enns: I get too emotional. I don't want to know what the investment decisions are she's making because I'd have something to say, and it would almost always be wrong.

David C. Baker: Yes, stay out of it. Knowing your wife, she's fine. Leave her alone. Yes.

[laughter]

Blair Enns: All right, so neither of us is smarter, but hopefully the people listening to this are smarter, right?

David C. Baker: It is a mental challenge. It's a puzzle. I'm fascinated by it. I'm really interested in it, so if you've got some ideas on this, if you can help me think through this, or you've got some experience in this, I'd love to hear from you. All right, thanks, Blair.

Blair Enns: Thanks, David.