Risk, and Other People’s Money
After I wrote about how timing when to take risk might matter more than what risk you’re taking, I heard back from Spencer who said that he’d love to hear more about the spectrum of risk (shoutout nerds). Because in addition to timing, he noted, “whose capital is at risk matters a great deal too.”
And he’s right.
Way back in season one when mere dozens subscribed to this rigmarole-whatever-it-is, I wrote about “Growth, and Other People’s Money.” The gist was that a small retailer that aspired to be a premium global consumer brand had taken outside capital from a big firm and used it to mash the pedal down on growth (advertising, inventory, etc.). What ended up happening as a result of that decision was a significant increase in sales, but a significant decrease in margins and free cash flow as inventory turns slowed and the company had to mark down product to make it move, which is obviously bad for the long-term value of the brand.
I concluded that every company faces inflection points and that what happens next depends on what the organization is optimizing for. Very often what the organization decides to optimize for ends up matching what its investors are optimizing for. And while everyone says they’re a “long-term” investor, people define that term differently. This is why one should figure that out before taking someone else’s money and choose carefully before you do.
In other words, whose money you’re risking absolutely matters when it comes to deciding what risks to take and when as does how much and historically that has had some interesting implications. For example, SBF (gross!) took some catastrophic risks with not only investor capital but also customer deposits to protect his company and therefore his reputation. Doing the math in his head, I suspect that reputational currency was more valuable to him than the other people’s money he put at risk.
In fact, there are lots of interesting insights in the literature about how people view different flavors of money in different situations even though it’s all money. What I mean by that is that a dollar is a dollar is a dollar and in a rational world that none of us live in the only bets one would make, regardless of source of capital, would be those with a positive expected future return. Yet house money is a thing. This is the idea popular in gambling but also prevalent in business that risking profits is somehow less risky than risking staked capital. And then there’s interesting observation that the safer regulators have tried to make banks by overcapitalizing them has led them to take on more risk. What are we doing?!
Another paradox we’ve observed across small businesses is that the owners best-positioned to take risk (experienced, financially well-off, and with no outside interests to answer to) are often the least likely to take it. And while it seems like loss aversion theory would explain that fact (why experience the pain of losing your own money when you can lose someone else’s?), what such an explanation misses is that by losing someone else’s money, you risk losing agency, which means you also risk losing everything.
For example, the retailer mentioned above lost someone else’s money buying inventory, but also damaged its brand in doing so, permanently impairing the value of any residual equity. That’s a big loss. And SBF, of course, went to jail.
So when it comes to risking capital, ask and answer the following:
What are we risking it on and why?
When are we risking it and does the timing make sense?
How much are we risking and is the potential return worth it?
Whose money is it and what happens if we lose it?
Then go for it. Maybe. You know, if the math checks out.
– Tim