[Update: I ‘m not working on the business I mention below. Not because the idea itself isn’t feasible, but because my circumstances make it unfeasible for me. I’ve left the article in the present tense to save me from making non-substantive edits. I’ve also added some random additional comments at the end, rather than integrate them into the article.]
I’m working on a business idea that, if feasible, is likely to be bigger than me. It will require my time and energy. But it will also require funds. Money for offices. Money for staff and/or contractors. Money for engaging professionals. Money for furniture, hardware, subscriptions, and insurance. Money for travel.
My wife and I could probably fund the venture ourselves. It wouldn’t be comfortable, but we could probably do it at a stretch.
However, I’m not prepared to fund the venture completely by myself. To the extent I give it a real go, I will be looking for external funding.
This feels “wrong” in some way. My gut says this must mean I’m not willing to put my money where my mouth is. Shouldn’t an entrepreneur want to put as much skin in the game as possible? Don’t I want to maximise my long-term equity position, and the financial rewards that I’d get if I can bootstrap the business?
I wonder whether this is an intuition that most other people share, or whether it’s an intuition that I acquired from reading articles and books during a “sensitive period” of my learning and thinking – most of which stressed the importance of retaining equity, and the importance of founders having as much skin in the game as possible. The importance of crossing the Rubicon, etc etc.
There may be some truth to this in some situations, but intellectually, I think it’s baloney. In fact, it’s a view that probably prevents a lot of ventures from existing that would otherwise have created a lot of value.
For one thing, it comes down to the fact that different people are in different situations, and certain types of investment are more appropriate for some people at some stages than for others. For us, it doesn’t make financial sense for us to make such a speculative investment, especially since it’s not just an immediate financial risk but a professional risk as well.
This is an investment that’s fundamentally unlike investing in financial products like term deposits or shares. If you invest in these appropriately (including dealing with reputable organisations and diversifying), the likelihood of losing all of your money should be low. Over the long-run, you probably won’t lose a lot of money and will probably end up better off.
Here, there are a wider range of potential outcomes, none of which are guaranteed or certain, and each of them very plausible. There’s a very real chance of “wild failure” – of losing everything you put in. But there’s also a chance of “wild success” – of making a life-changing return on a single investment.
Having said that, it’s important to recognise that the range of outcomes is not binary. There are lots of gradations. For instance:
- Wild failure – losing everything invested into the business (and possibly more, at the personal level)
- Failure – the venture doesn’t succeed, but investors get some of their money back
- Mild failure – the business basically keeps its nose clean, in the sense that investors (and I) don’t lose much money, and might even make a small amount of money, but not as much as hoped, and not as an adequate return for the risk and opportunity costs
- Mild success – the business generates enough money to generate a modest return on investment
- Success – the business generates a good return on investment, and everyone involved is very happy at the financial level
- Wild success – the business is successful at a level where it is life-changing for the people initially involved.
Even this is a massive simplification. This is more nuanced than the black-and-white thinking of “fail” versus “succeed”. But there are many other ways you can think about the venture. Some people might be happy if a venture is a mild success (or even failure) based on the descriptions above, but it creates a business that generates an enormous amount of value for the community. There are others who might take the money from a wild success scenario, but consider it “blood money” in the sense that they don’t like what the business became. I’d take the money from an early investment in Facebook, for instance. But I wouldn’t feel good about it.
In any case, let’s give some numbers to these scenarios – give each scenario a probability, and a payout, and see if we can get a sense of expected return. Let’s assume the initial investment is $10,000.
| Scenario | Probability | Outcome | Expected value |
|---|---|---|---|
| Wild failure | 10% / 1 in 10 | -$10,000 (lose full investment) | -$1,000 |
| Failure | 20% / 2 in 10 | -$6,667 (lose 2/3 of investment – ie, business winds up and investor gets $3,333 back from the initial $10,000) | -$1,333 |
| Mild failure | 20% / 2 in 10 | -$3,333 (lose 1/3 of investment, get $6,667 back) | -$667 |
| Mild success | 20% / 2 in 10 | $5,000 (get the $10,000 back plus a modest 50% return within a reasonable period of time) | $1,000 |
| Success | 20% / 2 in 10 | $20,000 (parlay the initial $10,000 into $30,000) | $4,000 |
| Wild success | 10% / 1 in 10 | $100,000 (10x your money) | $10,000 |
| $12,000 |
With the numbers above, I’ve assumed an equal level of “success” to “failure”. I’ve assumed that the tail scenarios are less likely than the less extreme scenarios.
The major asymmetry in the figures above relate to potential downside and payoffs. If you invest in a venture, downside is generally limited to what you put into the venture. However, the upside isn’t capped. If you give some credence to the possibility of success or wild success, then the expected value can be positive and large.
This is where I stand with the venture I have in mind. I think the possibility of failure (and more specifically, garden-variety failure or mild failure) are fairly high. It might even be more likely than not. But the possibility of a big payday makes it a positive bet, from an expected value perspective.
Unfortunately, expected value isn’t the decisive factor in most situations, and this includes my own. Many people have to spend their money on things that have negative expected value. The best example of this is insurance. If you have car insurance, health insurance, or one or more forms of personal insurance, the expected value is likely to be negative. The most likely scenario is that you will pay more in premiums than you will get in return. (This is also the best-case scenario, since nothing bad has happened!) In total, people pay more in insurance premiums than are paid out – some of the premiums need to go to the organisation(s) arranging and underwriting the insurance. For most people this is rational – perhaps not in financial terms, but in terms of utility, since being wiped out financially is much more impactful than being slightly worse off due to paying premiums and getting little in return. You have to be pretty wealthy before you can self-insure against all risks that insurance normally covers.
It’s also sad to say, but many (or most) people can’t make positive expected value decisions, due to the constraints of life. There are many people who are likely to be much better off financially if they could take some career risks. However, they can’t take these risks, because they have bills to pay and commitments to keep. A lot of the time you need to prioritise certainty (or some semblance of certainty), even if there’s a chance that you could achieve more.
When it comes to an investment venture, this is my position. My wife and I could technically afford to take this risk. However, the cost of pursuing this venture, and it not working out, would be high, especially with respect to the opportunity costs of not spending the money and repaying debt and/or investing money elsewhere in more reliable ways. It could negatively impact our future lifestyle and/or our ability to help loved ones and causes we care about. More dramatically, it could make the difference between having a comfortable retirement or not. The downside, from a life satisfaction perspective, outweighs the upside of being in a better financial position.
If we were in a better financial position, the balance would be different. If I were confident that we had plenty of buffer, then I’d be happy to roll the dice. The balance would be less about whether we’ll be personally fine (ie, it’s the difference between nice cars, house, and holidays versus really nice cars, house(s), and holidays), and whether we’ll be able to assist loved ones, and more about whether and to what extent we can assist causes we care about. Where it is less about our personal needs (except at the margin) and more about assisting others, I would take a view that was less influenced by utility and more about the raw numbers.
There are lots of people who are in a worse financial position than us, where considering this wouldn’t be a possibility.
But there are also lots of people who are in a better financial position than us, or at a different stage of life. There are lots of people for whom these more speculative investments are appropriate.
I wouldn’t generally recommend that someone who has the means invest everything they have in ventures like this. Certainly, I think most people should diversify across more conventional and reliable types of investments. But for some people, some of the time, it’s worth putting some of their resources towards these more speculative ventures. Some people might not just do it for the potential return, but because it’s meaningful or exciting to them. There’s something to be said for putting your money towards helping to create goods and services that wouldn’t otherwise have existed without your investment. It’s hard to say that when you’re investing in index-based managed funds.
For most people for whom this is appropriate, the challenge isn’t whether they should make investments like this. The challenge is actually finding these opportunities, and assessing for themselves whether it’s a risk worth taking.
I’m in a position where I know some of these people. I know some of these people in a personal capacity. I also know some of these people in a professional capacity.
Regarding people I know in a professional capacity, this is really awkward. In most cases, I know this because I’ve worked with them as a financial planner. I’ve worked with them from the perspective that I am as independent as it gets. There have been many times where I’ve foregone opportunities primarily because of the appearance or possibility of a conflict of interest. For example, a product issuer who wanted to pay some of its employees to engage me. Or approaching a product issuer who offers grants for ventures like this.
What would it look like if, after working with someone, and knowing that they have the means, I approached them and asked them whether they wanted to invest in this venture? I need to explore both the professional obligations (for example, relevant Codes of Conduct, and look at how other professions such as accountants and lawyers might treat this), and to think about it from a broader perspective – among other things, in terms of protecting my integrity, both real and perceived. My preliminary thought is that I won’t actively solicit anyone for whom I’ve provided advice, but I will consider anyone who becomes aware of the opportunity and actively tells me they are interested in investing in the venture.
Regarding people in a personal capacity, I am very mindful of the maxim that you shouldn’t lend to, or borrow from, family members. There’s a degree of truth to it, but I also think there are exceptions to this rule. My wife and I have borrowed money from family members, and it worked out well for everyone involved. If anything it added another level of trust and depth to the relationship. However, this was a fairly simple situation, and one that we formalised. It was an amount of money that we agreed to repay based on the terms of the agreement.
What about a situation where this is a possibility – or perhaps a probability – of money being lost? Of an investor wanting liquidity at a point where I can’t provide it? Could that negatively impact the relationship? I value relationships more than money, so I don’t want to risk that. But what about if this understanding was clear from the start?
There’s another risk as well. What about if the business does achieve wild success? Could it create resentment if I could have offered the opportunity to someone I know, but I didn’t, perhaps out of some paternalistic view that I know better than them? This might be especially relevant in a wild success scenario, where the returns could be life-changing.
In sum, I think I have an opportunity. I’m still in the prototyping/proof-of-concept stage, where I don’t require capital. But in the foreseeable future, I might need or want capital to make the most of the opportunity. And on balance, it will be a bet worth taking. Not for everyone, but some people. It would be great if I could create a success situation, and bring some people I love and respect for the ride.
[Some random additional thoughts: If I were chatting with someone else who was in a similar position, I would recommend that they seek external funding, rather than fund it themselves. For one, maintaining their own financial stability would position them to focus more effectively on the business rather than getting caught up with how it impacts other parts of their life. Another thing is that getting external funding might be subjectively valuable, in terms of providing external validation of the concept (which might also be valuable for marketing, both for additional funding, and for the products/services themselves, depending on the funder(s)). It’s also important to remember that people can contribute more than capital – credibility, knowledge, experience, contacts, support.]