Over the last few years, I've begun to work with more private equity entrepreneurs, venture capitalists and business executives. I really enjoy working with these people because they are so bold and willing to take risks. These individuals live and breathe the American Dream every day. They put it all on the line.
Yet I've also noticed that their penchant for risk-taking sometimes hurts them when they miscalculate an opportunity. Private equity entrepreneurs are willing to take huge risks because they know that's how they'll realize huge rewards. But this mindset can be a hindrance to building and preserving long-term wealth.
We all have to take risks to achieve rewards. But it’s essential to fully evaluate the opportunity while being realistic about best-case and worst-case scenarios. The key is to take the right risks at the right time. When we take the wrong risks, or take reasonable risks at the wrong time, we diminish the likelihood of achieving our goals. Here are lessons I've learned about risk-taking from working closely with private equity entrepreneurs.
Factors To Consider In Taking Measured Risks
I believe in taking measured risks, not just risks. What’s the difference? A risk is when you are willing to try something without being certain of the outcome. You could win or you could lose. A measured risk is when you are willing to try something without being certain of the outcome, while being fully confident that you’ve made the best possible decision.
It's the confidence in the decision based on proper diligence that equates to a "measured" risk. There are a few steps in the process. This means you've likely:
- Identified a risk you could take.
- Analyzed your motives for why you want to take that risk.
- Assessed the upside (what you could gain if things go well) and the downside (what you could lose if things go wrong).
- Gathered as much information as possible to support the decision process.
- Taken counsel with people you trust and respect.
- Considered the impact of your decision on the ones you love.
Here is what I’ve learned after working with private equity entrepreneurs. Whereas a common investor is prone to being risk-averse, entrepreneurs, venture capitalists and executives often take too much risk. They are so used to putting it all on the line, so comfortable with risk, that they sometimes lose focus and become overly aggressive when it's not necessary or advisable.
This is why I’ve developed a set of criteria for helping my clients think through the risks they are considering. My five criteria include:
- Timing – knowing when to take a risk, and when not to.
- Portfolio construction – concentrated versus diversified portfolios.
- Career goals – it’s not always about the money.
- Due diligence – making well-informed decisions based on accurate information.
- Family goals – protecting the ones you love along the journey.
Early on in the career of a private equity entrepreneur or venture capitalist (PE-VC), they usually take a lot of risk. They have to. It’s part of the job. This is sometimes referred to as “eating your own cooking.” This means that a high portion of their personal net worth is tied up in the companies they back. They prove that they’re confident in the companies they recommend to investors by putting in their own money.
This requires nerves of steel and a level of self-confidence that most people simply don't possess. PE-VC people take on levels of risk, especially early in their careers, that would be unthinkable for a lot of people. And when those risks pay off, their net worth skyrockets as does their self-confidence. It's important to note, however, that these folks often have a direct hand in growing the business and managing the strategic direction.
Yet it's not just private equity people who follow this same career arc. Entrepreneurs and business executives often practice a similar approach. Many entrepreneurs risk their own capital, sometimes their life savings, to start a business. I've worked with numerous executives who defer cash compensation and take company stock instead because they believe in the company and the strategic plan.
This approach makes sense early in the career of these people. But it may not make sense later in their careers, once they’ve achieved greater financial success. Timing is everything. This also relates closely to my next criteria.
I think it’s important to differentiate between a concentrated portfolio and a diversified portfolio. When I use the term portfolio, I’m not merely referring to an investment portfolio. I’m referring to how your net worth is structured.
For many PE-VC people, most of their net worth is probably tied up in the companies they invest in early in their career. This is a highly concentrated portfolio. The same is often true for entrepreneurs who put their life savings into a company. It’s also true for executives who forego high salaries and instead take company equity as compensation.
Here is a guiding principle. The more concentrated a portfolio, the higher the risks. The more diversified a portfolio, the lower the risks. You’ve heard the old axiom, don’t put all of your eggs in one basket.
But herein lies the paradox. To achieve a big payoff, most people need a highly concentrated portfolio at some point in their careers. When this concentration strategy pays off, sometimes in a big way, they gain confidence in concentration. They get addicted to big risk.
This can be a difficult mindset to transition away from. Some PE-VC people, entrepreneurs and business executives come to love the feeling of risk. In fact, if they are not taking risks, they are not comfortable. They come to believe that if taking a big risk paid off one time in their career, it will pay off again.
This may not be true. It certainly wasn’t true for Mark Twain who bet big on a typesetting machine that failed. Twain spent several years on the speaking circuit, much later in his life when it was hard to travel, to pay off that debt and recover financially. It was not necessary for him to take this risk.
When I help my clients think through a risk they are considering, we always look at where they are in their careers and how their portfolios are constructed. A highly concentrated portfolio is usually not the best choice once you’ve realized a lot of success in your career.
Speaking of careers, it’s important to balance financial risk with career risk. One of the biggest risks I’ve seen business executives take is jumping ship. I’ve written another article about this that provides some guidance about when to switch companies.
In some instances, financial risk may not be the primary driver in this decision. For instance, I’ve been working with an executive at a major software company. This client had a substantial portion of their net worth tied up in company stock. Some of the stock options had not yet vested. But this individual was thinking about moving on.
We spoke at length about this decision and I discovered several things about this bright executive. He was a visionary and very disciplined. He was very self-confident. He loved to inspire other people to bring out the best in them. He was born to lead and his current role was not fulfilling his potential as a leader. He believed he would never find career satisfaction unless he ascended to the top of an organization. He craved this.
We analyzed the financial risks of leaving behind his not-yet-vested stock options. Of course, this depended on the financial performance of his current company. But we were able to come up with a reasonable projection that this client found credible.
If he switched companies, he would be leaving behind stock options that, when fully vested, would likely be worth at least five million dollars. If the company realized their strategic growth plans, the value of the non-vested-stock could be worth many times this number, possibly greater than twenty million dollars.
By comparison, the opportunity he had to lead a new company was also very attractive. If the company performed well, his equity could be worth far more than twenty million dollars. At the end of the day, however, this client was going to do well no matter which direction he chose. For him, this decision was not about money. It was about his career. He was willing to take a huge financial risk not for more money but to fulfill his potential as a leader. Sometimes it’s not about the money.
When considering risky moves, it’s imperative to get accurate and up-to-date information. People who make snap decisions, without all of the facts on the table, almost certainly take unnecessary risks. This is not wise or necessary.
For example, recently I’ve been working with a serial entrepreneur who was thinking about launching another business. This individual started a successful transportation company and with the cash-flows acquired real estate and built commercial buildings. His holdings had become successful enough that he knew he had the capital to start another business, which fascinated him.
But he wasn’t sure how much cash-on-hand he had from his numerous businesses and how much they would generate in the coming years. He wasn’t sure how much cash the new business would require and what other options he should consider besides starting the new business.
I spent several hours digging through his financials and looking at his projections. We made numerous adjustments to his cash-flow analyses to make the data more accurate and current. The results showed that he had far more cash-on-hand than what he had projected, nearly five times more.
This was an exciting proposition for him because it meant he had more than enough capital to fund his new venture. But I cautioned him about this. His net worth was not very well diversified. The new venture was in a related industry to his current businesses. The new business would have put even more of his net worth in a highly concentrated and risky position.
While it was not my goal at the outset to change his mind about starting the new business, the due diligence process proved to be very important for this entrepreneur. I helped him see how he was taking unnecessary risk through a highly concentrated portfolio. We also identified other options that would reduce that risk and help him protect his family’s financial interests.
Nearly every PE-VC person I work with is a family steward. Most of them are men and most of their wives do not work outside the home. Most of them are also fathers who love their children dearly and want to be active in their children’s lives. But far too many of them unknowingly put their families at-risk. I have seen these same tendencies in entrepreneurs and business executives.
The risk-taking mindset I referred to above is part of the problem. Once a person achieves a certain level of success from taking risk on a concentrated portfolio strategy, they are inclined to stick with this strategy. But if their risks do not pay off, they’re not the only ones who suffer. It’s also their family.
At a rational level, these individuals know this. But they often seem torn between two impulses – the desire to win versus the desire to protect. Part of my role is to help them figure out how they can both win in business and protect the ones they love.
I do this by looking carefully at the age of their children and their need for college funding. I look at insurance planning, particularly private placement life insurance. I also like to interview the spouse and understand what’s important to them. I often find that protecting the home through paying down the mortgage is near the top of the spouse’s list of financial priorities. But for many of my clients who are risk-takers, this is much lower on their list.
We also examine where they are in their careers, how much wealth they’ve generated, how much needs to be safe-guarded to protect the family and how much can be reinvested back into the business. For my PE-VC clients, capital calls can produce a high level of financial stress, even when they have an acceptable line of credit.
I have not yet encountered a situation where I could not create a plan that satisfied the needs of protecting the family while also accelerating the success of a risk-taker. This takes dialogue, strategic planning and digging into the details, but it absolutely can be accomplished.
If you are a risk-taker who knows that your family is at-risk or who simply wants someone who appreciates risk-taking to closely examine your situation, we should talk. I’m quite confident that if we put our heads together, great things can come out of this.
© 2018 Whitnell & Co. The information contained in this article is provided for informational purposes only.