A new model for investment
From Unfocusgroup.org
Originated by Brendan Fernandes
In this article I will argue that the best way to determine whether a company is investable is whether it satisfies the following conditions:
- It offers something unique that lots of people want.
- It has a "way" - i.e. an ethos - that everybody can support.
Furthermore, I will argue that satisfying the above conditions will somewhat mitigate the risk of failure.
Background to investing
Investing is not rocket science. However, conventional wisdom would suggest otherwise. In particular, there is a culture of acceptance of failure within the investment world. Risk factors are incorporated into investment plans. However, it is done so in a very naive manner. In particular, there is a misunderstanding of what "risk" and "failure" actually mean. I will argue that it's ok to take on a risky project, but not ok to blindly accept failure. You should always endeavour to succeed.
Business plans
I've been there. Pitching a business plan to potential investors, and trying to get a bank loan for a business idea. It's nonsense. The world of finance is full of suits, mystery, dodgy maths and corporate symbolism, rather than a serious attempt to ascertain the value of investments. This is why our economy has been collapsing.
The main problem with a lot of investors is that they don't have a clue what they are investing in. So rather than finding out more about the companies that they are investing in, they will do a few dodgy sums and try to hedge their bets. They seem to accept that investment is little more than a lottery.
The sums
Life would be simple if companies and investors got together and worked on their projected figures and came up with realistic figures: for example, a rate of return on investment (ROI) of around 10% would sound about right for many startups.
However, what actually happens is that most businesses fail catastrophically. This makes the risks a lot worse than they seem. For example, let's say that startups go bust 90% of the time with a complete loss of capital, and make a 10% return 10% of the time. Let's calculate the Expected Return on Investment (EROI): say we invest £1m in 10 such businesses. For a total investment of £10m, we can expect to get back £1.1m. This makes for an expected loss of £8.9m, i.e. an EROI of minus 89%! This is very bad.
Investors know this, and so tend to ask for a higher rate of return than 10%. But the rate has to be waaay higher than one might imagine. To explain, let's look at this another way, via the idea of reward factors.
Percentages can be a good way of visualising things, but often present a skewed viewpoint. For example, an ROI percentage of 10% equates to the reward being 1.1 times the initial investment. But an ROI of 100% equates to the reward being 2 times the initial investment. A seeming increase of 10x in the ROI figure equates to an actual increase of less than twice when looked at from a mathematician's perspective. This is one example where financiers have a different way of visualising figures than a mathematician. It's easy to think that if you invest 10 times in investments that project a ROI of 100% and a failure rate of 10%, then you will get an average of 10% ROI. But this is wrong.
Let's forget percentages and just use proper maths. We can call the mathematical figure a "reward factor" (RF). It's subtly different from risk/reward ratios (this can be left as an exercise to the reader). To generalise,
ROI=(RF-1) * 100
in other words
RF=(ROI/100) + 1
We can see that if each business has a 10% chance of gaining a 10% reward, and a 90% chance of losing the investment altogether, then the calculation is as follows:
Reward Factor (RF) for each business=1.1
Expected Reward Factor (ERF) for all businesses=1.1 * 0.1 = 0.11
So, if you invested across companies that had this reward profile, you would lose money.
In fact, in order to get a 10% Expected Return on Investment - i.e. a 1.1 Expected Reward Factor, where businesses only had a 10% chance of success, each business would have to have an individual reward factor of 11 - in other words, 1000%!
This leads to a problem - namely, that investors look for businesses that post insanely high ROI figures.
The risks
The problem is that when looking at reward factors, which are a flat, mathematical way of looking at investments, it's clear that the risks really do present a serious consideration. And in order to mitigate the risk, investors look for supposed "high growth" companies. However, any company that posts insanely high projected growth figures must be viewed with suspicion. So how do we move forward?
The obvious conclusion is that we really need to minimise the risks.
Invest in decent companies
The best way of minimising the risk of an investment is to ensure that you are investing in a company run by decent people who aren't likely to let things go to pot, and who are likely to give you realistic ROI projections. One may admire "reach for the sky" entrepreneurs, but unless they have a sensible plan for how to get there, they are likely to fail. It's compelling to think that a never-say-die attitude is all that you need, but there is only so much that you can "will" things to happen. You also have to have a good idea, and the skill and the means to make it happen.
In particular, I would like to assert what I think is a bit of a golden rule:
An organisation is less likely to fail if it has a universally compelling ethos.
The more people who want a company to do well, the better it will do. You have to get everyone on board: staff, customers, etc. People have to believe in the company, rather than hate it. (Even competitors have to not mind the company: in fact, you should avoid having competitors). The willpower of the founder is not enough. They also have to be skillful, and nice enough to everyone around them such that they make friends rather than enemies.
Most things fall out of the golden rule. If a leader has a compelling ethos, the entire management and the staff will have the same ethos, and will not tolerate people who don't agree with the ethos. Naturally there needs to be some diversity of opinion, but with regards to the core principles of the organisation, there should be widespread agreement.
The ethos will be infectious. Skills, knowledge and principles are shared and developed throughout the organisation. The company develops a reputation for this, such that customers also believe in the ethos, and use the company because of this. This is far better than clever marketing.
An ethos in itself does not guarantee success, but it does help to prevent catastrophic failure. A key reason that businesses fail is due to internal conflict: for example, between management and staff. A business with a shared ethos knows where it's going, and stands for something. Nobody takes the piss and everybody is treated fairly. A sensible reward structure is in place for staff that is linked to profitability and other such important measures.
It's easy to overstate the importance of ethos, and be accused of utopianism. However, it's practical for investors to take a dim view of any business that is not founded on a compelling and unifying set of principles. It's a big sign that the business will fall apart at the first sign of trouble.
notes
Rely on skill, and developing skill, rather than clever marketing.
In the olden days, people looked at an investment in terms of Return on Investment (ROI) as a percentage. They tended to look at the risk factor as a separate entity, and often overlooked it. This overlookage ultimately contributed to the global financial crisis.
A new model will emerge, where secure investments will be given more weighting than trendy, "air-money" investments that promise high returns (such as the dot-com pseudo-boom of 1999).
The idea is that quality companies with realistic plans will get investment, rather than ridiculous high-risk adventures. You don't set up a taxi company by buying 5000 taxi-cabs, doing massive marketing and seeing what happens. What you do is to buy one cab and try a few things out, then learn lessons and grow at a reasonable pace.
You also need to grow managers rather than to parachute them in from other firms. And to have a company ethos.
There will no doubt be "fakers", who feign the appearance of quality. So we need mechanisms to root this out. These mechanisms are largely investigative.
We need ways to quantify the risk, and produce an expected ROI (EROI) as a frequency-probability. This is perhaps done by looking at past data of previous failure rates. We have to accept that we don't have knowledge of how likely it is to fail, but we can look at various parameters as a guide. There are various models out there that quantify the risk.
Rather than being based on mathematical models, a new economic model will emerge that is based on a universally compelling shared ethos. Rather than relying on balancing opposing tensions.
Old-school proponents of laissez-faire have this idea of "emergent rationality", whereby as long as everyone individually follows the basic rules and acts in their own self-interests, then everything will be ok. However, this has been shown not to work.
How to calculate the expected failure rate
This is a contentious issue. You could look at the failure rate of all businesses, or all businesses of its type, or all businesses founded by an investor of a certain type, or indeed a whole host of all parameters. Of course, with the parameters being non-independent, you could not use strict Bayes, although I would concede that the idea of conditional probability is still reasonably valid.
I will confess that I'm not a huge expert in the mathematical side of statistics or financial modelling, but I do have a good grounding and particularly emphasise that these models have their limitations, as could be seen in the hedge fund/black-scholes debacle of the last century. I do stand by the point that it's worth looking at Expected ROI (EROI) as a better measure of potential success than ROI, as it integrates the risk factor, and anyway, predicted ROI figures are pulled out of one's ass anyway. In fact, we should also factor in the relationship between predicted ROI in business plans, and actual ROI. But I fear that there is a lack of data to go on, because business plans are not usually publicly available.
Acknowledge that many of the above calculations are simplifications, and in fact businesses tend to deliver depending on a probability distribution rather than a succeed/fail basis.
How to quantify the idea
The highest-quality ideas are the ones that will have a sustainable business model behind them and lead to a proper corporate ethos that employees can get behind. However, it's hard to judge ideas. What we need is a number of parameters that characterise the idea, that can then be plugged into the EROI model.
Thoughts for parameters include:
- Whether the idea is patented, and whether the patent is likely to be disputed.
- Whether the ROI on the business plan is proportional to what is achievable, given limitations on the natural growth rate of an organisation.
- Whether the idea is:
- a new idea
- an amalgam of 2 existing ideas in a new way
- an improvement on an existing idea
- a copy of an existing idea with the promise of a
- more robust implementation
- more reliable implementation
- higher-quality implementation
- cheaper implementation
- more eco-friendly implementation
- The number of existing business partners involved
- The number of new ideas involved
- The number of exaggerations and/or false claims in the business plan
Who will invest?
The idea is that high-street banks will be more willing to perform venture capital, especially now they are state-owned and the government may want a return on the money used to buy the banks. The public should demand a share of the proceeds of the economic recovery, and this is a potential way to do it.
Notes
A new model will incorporate the parameters implicitly and cancel out the risk, by wrapping them in factors such as:
- Giving the staff a vested interest.
- Giving customers (who provide the profit) more of a say. Investors provide capital, but customers provide the profit. Business reputation is important.
- Give workers something to work for. General thesis of: the rich have to give the poorer people something to work towards... otherwise, they will not work if they give up on owning a new home, then they will not need to work so hard. They will think that it's futile.
The idea is that a collaborative model will, in some way, give enough people a vested interest and hence provide a form of risk mitigation. The simplest and least error-prone system will basically be to ensure that all interested parties have similar goals: investors, employees and customers alike. It's where a system relies on tension between interested parties that it falls apart, because it's hard to maintain the balance.
There is therefore a need for an organisation, if it is to succeed, to have an understandable ethos that is compelling both within the organisation and outside. There must be no conflict between, for example, investors and staff, management and employees, employees and customers.
This goes not just for companies, but for political organisations.
A universally compelling ethos.
corporate ethos
companies that work by ripping off customers will find that a culture of ripping people off prevails within the organisation too. Company bosses who rely on lies and false claims, will also find that their staff do not feel guilty about stealing from them. Teaching staff to lie to customers, also helps them to learn to lie to you. In the long term, it is high risk to invest in companies that tell lies. Furthermore, people who buy shares offloaded from investors who ploughed a lot of money in and who now want to get a return on their investment, should see this behaviour with suspicion. They are trying to get out before they are found out.
This is different from all this "corporate social responsibility" nonsense. CSR is a trendy idea, but there is nothing trendy about the idea that companies that rely on deception, or a system that relies on a balance of tension between conflicting parties, is bound to fail. It is far better to succeed if everybody concerned wants you to succeed.
What we're talking about is everybody being on the same side. CSR is often more of a marketing stunt than a realistic way of ensuring univsersal co-operation.
Of course, having a good ethos alone does not guarantee success. You also have to have a sound business proposition. But a company with a poor ethos does fail.
Projected (rather than expected) returns on investment: the higher it is, the more suspicious you have to be that the company is trying to be dodgy. To grow at a very fast rate is hard enough. To do it whilst being profitable - i.e. spending no money on advertising - is fantasy. Growth and profitability are often finely balanced, and there is no way out of this.
It's why banks lend money rather than doing VC. It's all too difficult. But VC investors expect too much in return. But equity is more in keeping with the ethos, as it creates convergent interest groups rather than divergent interest (i.e. with equity, the investor and the borrower want the same thing).
The way to mitigate risk is to look for moderate-return, long-term investments. High-return, short-term is "get out before you get found out", and there is a big chance of going wrong, primarily because there is a big chance that you are investing in a crook or a charlatan.
Invest in companies that don't need to "buy in" talent. Parachuting people in destabilises the team. It also irritates staff who are trying to work their way up to the top. The best companies will grow their managers. Obviously you can't always do this, and people have to occasionally leave a high-paid job and get another one, such that good people can always find a well-paid job in an organisation at a senior level. But I would stop short of bringing in somebody and making them manager on day 1. People should prove that they work well with the team before they are fully hired as managers. There should be an element of democracy in teams, where they can decide by consensus who should lead the team. Again, convergent interest - senior management shouldn't just impose people on their staff.
other parameters
High growth can be acheived, e.g:
- a patented idea that is very compelling (e.g. google pagerank) can lead to rapid growth without any crookery
Stupid logic
The stupidity is that because only 10% of companies succeed, hen if you are expecting x%therefore, you should expect 10x the ROI for the companies, such that the EROI is still x. This is just stupid.
WHat you should really do is to work with the companies to help minimise the risk. There should not be a laissez-faire attitude that says "failure happens, deal with it". You are seen as a bad businessperson if you do not accept failure. However, what you should to is to try to stop failure. It is good business practice to try to minimise rates of failure.
Many businesspeople who are brainwashed into the risk/failure thing tend to flit from one idea to the next, saying "oh well, that one failed", and to try to move on. Clearly, they have got their head round the idea that you have to ask 10 girls out before one will say "yes". But they have not got the idea of really trying their hardest to ensure that girls do say yes, by improving oneself and making oneself more attractive to women.
You improve their processes such that they are less risky. And, you simply do not invest in companies that are too high-risk. There should never really be a high risk. If a company is good, it won't be too risky for it to succeed. Risk is controllable. Your state of knowledge about a company helps to define the risk. Even though the universe is random, we can quantify the risk (this is where we are allowed to be a bit bayesian). Broadly speaking, risk is associated with 2 factors:
- Given a set of parameters, THe frequency of businesses that have failed with that set of parameters - Our knowledge of those parameters
The biggest parameters are:
- having a unique offering - such that there are no real competitors, or that you are doing something so much better than a competitor, that they are not really a competitor at all. Coming in and treading on people's toes is not the way to go. And that that offering is compelling in the marketplace. - Having a universally-compelling corporate ethos. A "way" that everybody believes.
businesses with high capital requirements
drug companies - and there is a risk that it will fail the clinical trials. Here, the risks are not associated with markets etc, but instead that the product will fail in wone way because of the fact that it speculates on a particular aspect of natural science. Here, the random element is our lack of understanding of science, and this is always a risk.
