I began my last post, “To think like Midas”, by saying that great entrepreneurs think like investors. I spent the rest of it explaining how a great investor might think. Using the past to see the future, we discussed trends and megatrends, and how the winners - the “Great Men” - see them coming, make them happen and shape them. Those are the people you want to bet on if you’re an investor, and if you’re an entrepreneur, those are the people you want to be.
By the way, this way of thinking shouldn’t just apply to founders. Leadership should be fractal. If you work for a startup, this is how you want to think. Everyone is an investor. Everyone is an entrepreneur.
If great entrepreneurs think like investors, then what follows is the corollary: your business is your investment thesis.
A business is an argument, of sorts. It’s a statement about value: about what you find valuable, what other people will find valuable, and how best to create that value in the world while making a profit.
Every business asserts that it has found the best solution to a problem – and that the problem is not only worthy, but that it is the most worthy of all the problems it could possibly solve – given limited time and capital, risk, and the passions and talents of the team.
Framing the decision
Starting a business is an investment decision. Dating is an investment decision. Hiring someone is an investment decision. Paying for a service, using a product, working on a project – every application of time, money or energy – is an investment decision.
Here’s a framework for thinking about investment: cost plus opportunity cost must be less than expected value. Or, to put it the other way: expected value must be greater than cost plus opportunity cost.
Expressed in symbols: V > C + O.
Let’s run through one of those decisions…
Q: Should we hire someone?
A: Well, how much do they cost in dollars (salary + equity + incentives + overhead)? Okay, X dollars a year. How much do they cost in time (including recruiting, setup and ongoing communications)? Approximately how much does all of that time cost, if you put a dollar number, Y, to it? Okay, add X to Y get the cost, C.
Now comes the hard part: estimate the opportunity cost. Who else could we hire? What else could we buy? Or what else could we build? What else is competing for C dollars? Of those alternatives, estimate their expected values then subtract their costs to calculate their expected profits. Take the highest positive number and call that option B: the next best alternative. Opportunity cost is the profit forgone from the next best alternative, or O = V(next best) – C(next best).
Q: Should we continue to employ someone? Should I use your product? Should I pay for your service? Should I spend time with you? Should I invest in your startup? Should I start this company? Should I keep working on this?
A: Repeat the thought process above. The same framework applies to many different contexts.
Why decisions are complicated
If it’s such a simple formula, then why are some decisions so complicated?
There are at least three reasons.
Liquidity - the ability to trade something for cash - is an acute constraint on the cost variable in the formula.
Do you have capital?
Sometimes it takes years before the expected value pays off. Can you shoulder the costs long enough to receive the benefits? Can you afford to pay them right now and keep paying them as long as it will take for them to pay for themselves?
That’s what capital is for. To solve the company’s liquidity problem, you have to sell debt or equity. The amount and terms you’re able to raise depend on how capital markets, specifically the investors which make the market, perceive the risks associated with your company and ‘the deal’.
Can you back out?
Many decisions can’t be reversed, or only with a penalty. That’s unfortunate, because when circumstances change, so do the variables. Costs, opportunity costs, and expected values go up or down. But you can’t always double down when times are good and pull out when times are bad, or when a more attractive opportunity shows up. Cash investors in a startup cannot generally back out early or easily. And sweat equity investors - the startup’s team - can’t either. The natural and inherent inability of all the investors to back out quickly and regain liquidity has critical consequences on the framework for decision making in startups.
Do you have time?
- “The first rule in business is to never run out of money.”
- “What’s the second rule?”, I asked.
- “Never run out of money!”
Someone once told me that. I promptly forgot it, but it’s a lesson that life doesn’t let you forget for very long. For me, the day of reckoning has come and gone three times now, once per financing. When it’s over, and the money is in the bank, it’s such a relief. Running out of money is running out of time, which is a stressful experience. Ahead of you, there’s a looming ‘cliff’ - that date, that ‘dead’ line - after which you can’t make payroll.
This process is not fun, but it’s inherent in the game. Until a startup has established its unit economics - its cost per user/customer acquisition and lifetime value per user/customer - and shown that it can continue to raise venture financing as a “scale-up”, it will always be racing towards a cliff.
So it’s not true that if things are going well, you can always raise more money. It is true that if things are going well and there’s plenty of money in the bank so that they will keep going well, that you can always raise more money. Liquidity is no joke. When you run out of money, you run out of moves. The runway ends before you can take off. Game over.
Another wise piece of advice I once heard: “Create options, then make decisions.” To that, I would like to add: “Improve your options, then improve your decisions.”
Taken together, this advice adds up. Let’s pull it together…
Liquidity is about scarcity and runway. The lack of liquidity for investments in a startup means cash from investors is justifiably scarce. And it can only provide liquidity for a limited time, giving you a certain amount of runway. Without that liquidity, you can’t make decisions, even good ones. Liquidity buys you time. Without options, you can’t make decisions. So spend the time creating options. Then, improve your options and your decisions.
That’s a recipe for success.
Asymmetry is about expanding the opportunity cost variable in the formula.
In economic literature, information asymmetry refers to principals and agents, but its a subset of a larger class of problems caused by imperfect information. In this essay, I’d like to explore the asymmetry between a decision maker and reality, which is immense and complex, such that the cost of acquiring more information is very high, upward curving, and ultimately infinite.
There’s an infinite amount of information. You have access to a tiny fraction of it. When you make decisions, you’re dealing with imperfect knowledge. The decision you’re weighing is infinitely more complex than you will ever know, or need to know.
Say, for example, your startup has just received enough funding to make some additional hires, and you set out to hire your first marketing person. Suppose you reach out to ten marketing people, three become serious discussions, and you hire one. By pulling the trigger, though, you were also, by definition, ruling out every other eligible marketing candidate on the planet for that role. You were comfortable doing that, because, of course, you were not willing to interview them all, and you judged that your sample size of ten was sufficient. You knew that you might be missing out on some incredibly superior candidate who’s out there – somewhere - but your sense for how hard it would be to find that candidate and how very few exist is such that you’re comfortable pulling the trigger on the candidate in front of you. But what if you’re wrong? What if you didn’t look far enough, or in the right places? What if an incremental increase in time invested upfront in looking beyond your immediate network would have uncovered a trove of talent?
We acquire information in order to create and improve our options. Your sense for the opportunity cost of a decision is based on the very limited information you have about all the possible alternatives. Making decisions with limited information is an art. The mature response to “the information problem” is not to get squeamish when you don’t have enough information to make a perfectly informed decision. Rather, it’s probably to identify which data points, of those available, are most operative to making a decision, and then, if those are not sufficient, to identify which data points, of those necessary but not available, will be cheapest to acquire. Then, the game becomes getting the right information, and getting it rapidly and at lowest cost.
Which begs the question - how? I use three processes to support my overall strategy: networking, canvassing and landscaping.
Networking is an art. I don’t profess to be a master. However, I do dislike the stereotype of the charismatic-hustler-schmoozer-wheeler-dealer-connector-talker that some people associate with sales people. Many people who profess to be salespeople are decent at one or two aspects, but may not get the rest. They may be acting as pawns instead of queens. It’s not enough to make a move; one has to comprehend the entire board.
By meeting lots of new people, you are acquiring information. Every individual is a data point on the grid. The more data points, the more complete your understanding of reality and the fewer your blind spots. You are also creating an option, because friendly relationships don’t have an expiration date. Once you’ve established rapport, respect and trust with someone, and you become their friend, you can lean on them, at any point in the future, for information, advice, perspectives, ideas, introductions, help, opportunities and even capital - as long as the relationship is maintained. Not every relationship is lucrative, but every relationship has potential upside. It’s an option. Preserving and expanding your optionality is wise. And it’s a two way street…
Let’s suppose that you know 50 venture capitalists, but you don’t know any current high school students. Then, you happen to take a short plane flight with a venture capitalist and a high school student, but you can only sit with one. To maximize your benefit, which do you choose? Now, obviously, there are unknown variables here, so there’s no right answer, but I’d like to make a case for the high school student. There is marginal benefit in meeting an additional VC, but there’s a lot of valuable information built-in to the high school student that you don’t currently have access to. High school students are a blind spot for you. If, for whatever reason, you someday need to design a product for them, or recruit them as interns, or be aware of trends in popular culture or public education or any number of intersections that this individual represents, albeit, with a sample size of one, then you could get back in touch. Repeat this exercise with Norwegians, salsa dancers, gun control lobbyists, material scientists and Franciscan priests…
Canvassing is asking questions of others systematically to gain information, perspectives, advice and insights to achieve what I called “parallax” in a previous post. So while you network, you’re extracting information. Earlier this week I found myself standing next to a Franciscan priest from Italy while standing in line waiting for a bus at JFK. Through the conversation I learned a lot of interesting information about the Catholic Church. So, if networking is about going broad - knowing more people - canvassing is going deep - knowing people more. To be good at it, you have to be curious and fascinated.
Expand your network, ask them questions, gain more information - then what? Then, you put all of this information together into a coherent understanding of reality. I call that process Landscaping. It’s like an exercise in cartography: this is my map and here are the mountains, here are the rivers, the Black Forest and beyond here, there be dragons… Or, it can be likened to finding new puzzle pieces, then fitting them together. Landscaping lends itself to spending lots of time alone to think, read and write. New information and perspectives can be gained from conversations with others, but ultimately landscaping is about putting it all together into a story that makes sense about the world and the way it works.
Spending time on these three activities should expand your opportunity costs. You’ll increasingly realize that for every thing you do, you are choosing not to do many other worthy things. And the more options you create, the higher the likely value of the best option, and the greater the foregone profit of the next best option. An ironic take away might be: “At all costs, expand opportunity costs!” Even though deliberately increasing the “cost” side of the equation by increasing opportunity costs seems counter-intuitive, it’s what great business leaders do. It forces the bar ever higher for the value side of the equation, so that when they do decide to invest time and resources, it’s very high leverage.
Subjectivity is inherent in calculating the expected value variable in the formula.
For the sake of argument, so far we’ve assumed that human beings are rational actors, which isn’t exactly right. Are they irrational, then? No, they’re not. When economists talk about “rational” actors, they are referencing the classic textbook definition: calculated profit-seeking. But money is a store of value, so profit-seeking is only a subset of value-seeking, and value is fundamentally subjective. Let’s think about that.
What is valuable to you?
I do not value what you value. If we did, we would be the same. But we are not the same, we are different. We want and care about different things because we see the world in different ways. We may have some things in common, but not everything. And that’s why we trade.
Figuring out what you truly value is a process of self-discovery. Why are you starting this business? If you succeed, what will it do for you? What do I want more of in my life? Given all that I could be doing, why is this the best use of my time? Given trade-offs between freedom and security, or work-life balance and financial success, what would I choose? Ask yourself enough questions like this and you’ll quickly uncover your own philosophy.
What is valuable to others?
No two people value things precisely the same way, but there is usually a fair amount of overlap. Even if there weren’t, there would still be gains from trade. You want this? I want your money. I give you this, you give me your money. Prices coordinate supply and demand. Demand is subjective, so prices coordinate subjective inputs and make them visible, coordinating action across time for vast numbers of people.
Figuring out what is valuable to large groups of other people is a lucrative skill.
Are there social, cultural and emotional complications?
Do you give the job to your friend, or the more qualified outsider? Do you invest in the startup you love, or the startup that’s going to make your limited partners more money? Do you do what your told, or stand up for what you believe? Are you passionate about what you do every day, or do you just show up for the check?
Subjectivity brings color to a colorless ledger of profit and loss.
Justifying your decision to yourself and others
Remember the formula? Expected value must be greater than cost plus opportunity cost: V > C + O. It is a framework as disarming in its simplicity as it is enchanting in its complexity. The nuances, caveats, subjective inputs and infinite information that form the context for every investment decision must ultimately be weighed in the balance by you - the decision maker.
As I wrote this, the image that kept coming to mind was that of a pole vaulter. Sprinting down the track, every muscle pumping, then planting the pole, leaping off the ground and catapulting into mid-air. In that moment, there’s one question: will you get high enough to clear the hurdle? Get ready - you are that pole vaulter. That hurdle is your opportunity cost.
That formula is the test. Your business (and your life, for that matter) has to pass the test. Again and again and again. If you’re an entrepreneur, you know what it’s like. You pitch. Not just once, or dozens, or hundreds - but thousands upon thousands of times. Yesterday I had seven meetings and three phone calls. In every single one of those, I had to help other people see that the expected value of what I wanted them to do (invest, partner, etc.) was greater than their cost and opportunity cost. They’re not me, so they don’t necessarily value what I value. Every person asks different questions and has different reservations. Patterns emerge in these conversations – which you revisit, prompting you to reconsider your logic again and again. You have to justify your investment decisions.
Your business is your thesis. It is your ultimate answer to how you will create value, both for yourself and for others, both now and in the future. It is your grand statement, your philosophy in motion, your logic incarnate. Given all the costs. Given all the opportunity costs. Given all the context and considerations. Given the world in which you find yourself. Given you.
Answer the question: WHAT IS VALUABLE?
This. This is what is valuable. This, this, this!
What you work on, speaks.
Speak your passion.