Investing and Probabilistic Thinking
I’ve been learning more about successful investors. I want to know what led to their outsize success and why they’re able to repeat it. One common trait I’ve noticed is probabilistic thinking.
Most people are binary thinkers. They think only in terms of an outcome 100% happening or not happening. But binary thinking doesn’t reflect the reality of the world. Most outcomes aren’t 100% guaranteed because the world is full of randomness and uncertainty. There is usually more than one possible outcome, each with a probability of happening (even if it’s small).
These investors understand this and factor probabilities into their decision-making. Outsize returns usually result from betting on non-consensus outcomes that have a probability and return profile the investors like. For example, when the prices of assets are falling continually, most people think to sell to avoid further losses. These investors will buy (non-consensus) if the probability of these assets rising is higher than them falling further and the return could be outsize.
They also understand that probabilities and outcomes are different. The probabilities of an outcome can be on your side, but that doesn’t ensure a favorable outcome. Randomness and other factors are still present. When your desired outcome doesn’t happen, that isn’t a reflection on the quality of the decision. It just means the probabilities didn’t work out in your favor this time.
When the Decision Is Easy but the Implementation Is Hard
A founder asked me for some feedback because he’s not sure what to do. He has a team member who isn’t pulling his weight. If he keeps the team member, a critical part of the company will continue underperforming. The team is small, fewer than ten people, and everyone, including the founder, is stretched thin. If he parts ways with the team member, he will have to do this person’s work until he finds a replacement.
After more conversation, this founder acknowledged that he’s wanted to let this team member go for some time but has avoided it. He isn’t sure how he’d manage his current workload, do this team member’s work, and recruit a replacement simultaneously.
This is a common early-stage founder dilemma. The founder knows what he needs to do but isn’t sure how to do it. Said differently, the decision is easy, but the implementation is hard. I was in this exact same position as a founder. I learned that it’s better to rip the Band-Aid off and deal with the pain than to let the problem linger and turn into a bigger one. Taking on the departed team member’s work wasn’t ideal, but it better prepared me to train the next person and motivated me to get the right person in place so I could reduce my workload.
When faced with an easy decision but onerous implementation, I learned that delaying the decision isn’t feasible and can make bad situations worse. I needed to make the tough decision and view its implementation as a learning experience. Just as I’d figured out other seemingly impossible parts of entrepreneurship, I could figure how to navigate the side effects of decision-making too. Ironically, when it was done and I was on the other side of it, I realized that anticipating going through with decision had been way worse than doing it. I always wished I hadn’t waited so long (especially with personnel changes)!
Venture Capital, In-Kind Distributions, and Registered Investment Advisors
Yesterday’s post was about in-kind distributions that venture capital (VC) funds make to their limited partners (LPs). A friend pointed out that some larger funds, such as Sequoia, A16Z, Thrive, and a few others, may be focusing more on making in-kind distributions to their LPs. These and other firms are starting to become registered investment advisors (RIAs), which my friend assumes is related to making in-kind distributions. I’ve been reading about funds becoming RIAs, and I don’t think it’s related to making in-kind distributions to LPs.
A VC fund that makes an early-stage investment in a company doesn’t need to be an RIA to do in-kind distributions. If one of the fund’s portfolio companies goes public or is acquired in a deal where some or all the purchase price is paid in stock of the acquiring company, the general partners can distribute that equity to their LPs. There may be reasons to wait to do so: for example, an IPO lockup period or wanting the acquirer’s equity value to increase before distributing stock to LPs. There are nuanced rules around VC funds holding a material percentage of fund assets in something other than private companies, but I won’t get into those details.
All the firms my friend mentioned are run by very smart people who have had a lot of success over several years. I don’t have any inside information on their strategic reasons for becoming RIAs, and I’m curious and plan to learn more. I wouldn’t be surprised if it’s related to their ability to invest in and hold a broader variety of assets for a longer period. Said differently, I wouldn’t be surprised if it allows them to expand their firms into areas outside traditional venture capital investing.
LP Distributions: In-Kind or Cash?
I had a chat with a friend and fellow venture investor recently. He’s raising a fund and pitching lots of limited partners (LPs) to invest in it, which got me thinking about what LPs want.
In general, there are various types of limited partners: high-net-worth individuals, family offices, corporations, pensions, endowments, and more. LPs are motivated by different things. To understand whether your fund strategy is aligned with a particular LP, it’s important to understand their motivations.
In my conversations with LPs, I’ve noticed that returns matter to all LPs—but not always cash returns. Most people think that when a fund makes a distribution to its limited partners, it’s in cash. This is often the case. But general partners (GPs), who manage venture capital funds, can choose to distribute stock in a company to their limited partners. This is called an in-kind distribution. For example, if a company has an IPO and goes public, the GP can give the public shares to the fund’s LPs. The LPs can then choose to hold the stock or sell it based on their objectives.
Some LPs want their returns paid in equity. They want in-kind distributions. If a GP invested in a great early-stage company that will produce large profits and distribute dividends to equity owners, or that will continue to grow rapidly and increase in value, these LPs want to go along for the ride. They’re less interested in companies that have no clear path to profitability because they want to own assets for decades.
I’m not sure if this type of LP is in the majority or the minority. I suspect that most GPs target cash distributions (for a variety of reasons). If GPs target investing in companies that LPs can own for decades, I imagine that changes what companies GPs invest in and how they want the companies’ founders to grow their companies.
Imagine if the venture investors who seeded Apple or Microsoft distributed securities to their LPs and the LPs still held those shares today. Between appreciation and dividends, the returns would be amazing. So would the rate of compounding from the initial investment by the GP until today.
I wonder how many venture funds target in-kind distributions so their LPs can own the companies they’re investing in for decades?
Weekly Reflection: Week One Hundred Fifty-Two
This is my one-hundred-fifty-second weekly reflection. Here are my takeaways from this week:
- Edge – Most people are good at something. They have a natural strength or skill. What you’re good at is your personal edge. If you play to your edge, you increase your chances of achieving outsize success. Play to your edge.
Week one hundred fifty-two was productive. Looking forward to next week!
Will More “Spotters” Look for Investor Capital?
Today I was chatting with a “spotter” entrepreneur about the details of an opportunity he’s considering pursuing. He plans to build a business to solve an overlooked problem of solopreneurs. He needs capital to launch the business but doesn’t have experience raising capital from investors, so he asked for my thoughts on structuring a deal that includes investor capital and bank debt.
As we chatted about the business model and numbers, we began discussing the bank debt portion of a possible deal. In the past, he’s used his own capital and bank debt to launch businesses. But interest rate increases mean that debt service on a loan would materially reduce cash flows from the business. This spotter has his own capital, but not enough to finance this entire project. Nor does he want to take on that much risk. Given this reality, he’s considering, for the first time ever, raising capital from investors. The problem is, he doesn’t know where to start.
When interest rates were low, spotters could partner with banks exclusively. The principal and interest on their loan payments didn’t materially impact cash flow, and they maintained 100% ownership. They preferred to work with a banking partner and cheap debt rather than give up equity to investors and have to report back to those investors.
In today’s interest-rate environment, selling an equity stake to investors can be a more attractive alternative. Deals where bank debt would significantly reduce returns or cash flows because of high rates can be more palatable with investor capital. Of course, this depends on how the deal is structured. The devil’s in the details.
Today’s conversation got me thinking. How many more spotters are doing the same math and coming to the same conclusion: I should consider raising capital from investors. If it is—or will be—a material number of people, this could be an interesting market that will likely be underserved.
Coinbase: An Example of Transactional Revenue Challenges
I want to follow up on yesterday’s post about recurring and transactional revenue with an example. Coinbase is a publicly traded company whose financials are publicly available. It offers a variety of products, but most of its revenue is made on fees charged when customers buy or sell cryptocurrency assets on its platform. This fee-based revenue is transactional since Coinbase doesn’t know when customers will transact or how much revenue it will receive when they do.
Coinbase’s latest 10K filing for the fiscal year ending December 31, 2022, shows us how the transactional nature of its revenue affected its financial performance:
- 2020: $1.27 billion in revenue and $868 million in operating expenses for $409 million pretax income (profit). Pretax income was ~32% of revenue. Operating expenses were ~68% of revenue.
- 2021: $7.83 billion in revenue and $4.76 billion in operating expenses for $3.02 billion pretax income (profit). Pretax income was ~39% of revenue. Operating expenses were ~61% of revenue.
- 2022: $3.19 billion in revenue and $5.90 billion in operating expenses for a $3.06 billion pretax loss. Pretax loss was ~96% of revenue. Operating expenses far exceeded revenue (~185% of revenue).
Coinbase’s transactional revenue fluctuated wildly during those three years. As revenue soared from 2020 to 2021, Coinbase’s expense structure also increased. This makes sense because you need more people and resources to service an increase in customer demand. As revenue plummeted from 2021 to 2022, the company’s expense structure continued to increase, causing a massive pretax loss.
Revenue increased over 600% one year and dropped almost 60% another year. While this is an extreme example because of macro factors, Coinbase demonstrates how hard it can be to forecast and plan when there are no agreements between a company and its customers that produce recurring revenue.
All Revenue Isn’t Recurring Revenue
I’ve chatted with a few founders who proudly share their recurring revenue numbers to show how their businesses are growing. But their revenue isn’t recurring. They aren’t trying to mislead—they often don’t know what “recurring revenue” means.
Revenue is recurring when the customer has agreed to pay a predetermined amount over a predetermined time. Subscription revenue is a great example. A customer signs an annual contract for $1,200 and agrees to pay $100 per month on the 1st of every month. Alternatively, the customer could give you the entire $1,200 up front to gain access to your solution for the year. Either way, the duration is a calendar year and the amount paid is $1,200.
Another wrinkle on subscriptions is monthly software with no contract. Let’s say a customer signs up for a SaaS tool such as Calendly, agrees to pay $10 per month, and can cancel anytime. This is still subscription revenue. It’s a one-month subscription that auto renews at the end of every month unless the customer cancels. The duration is a month, and the agreed-upon amount is $10.
The great thing about recurring-revenue businesses is that they start with a known amount of monthly revenue that customers have agreed to. Customers must notify the company when they plan to stop paying, which gives the company prior knowledge of when revenue from a customer will decline. This revenue base makes planning and forecasting more accurate for small and large companies.
If revenue isn’t recurring, it’s likely transactional. Transactional revenue doesn’t involve predetermined amounts, and the frequency of payments varies. Grocery stores are great examples of transactional-revenue businesses. Customers can walk in whenever they want and buy as much or as little as they want. There’s no commitment between the store and the customer. Every month, the store starts with a revenue base of zero. Customers don’t have an obligation to notify the store if they’ll stop shopping there. This can make planning and forecasting difficult until the company has a large customer base.
If you’re building a transactional-revenue business and want to demonstrate that revenue is growing, don’t use terms like “recurring revenue” or “annual recurring revenue.” Consider something like “revenue run rate” or “annual revenue run rate” if it makes sense for your business.
Wealth, Income, and Company Building
In yesterday’s post, I shared the difference between wealth and income. Here are some ways for founders to think about wealth, income, and company building.
A business that makes creating income for the owners top priority is usually optimized to do so. That means that cash generated by the business is removed from the business for the benefit of the owners. And it usually means that the company isn’t reinvesting in growth opportunities as heavily as it could. The focus is on how much cash the company can generate and distribute to owners.
A business focused on creating wealth is focused on growing the value of the business. To make that happen, the business is trying to scale its solution quickly. Cash generated by the business is reinvested in growth opportunities within the business. The company may even raise outside capital (i.e., venture capital) to accelerate growth. The founders of these companies usually target getting a windfall when they sell all or part of the company after it reaches material scale.
Most companies I see fall in one of these two buckets. But there are exceptions. Some founders build companies that are hybrids: extremely profitable and high-growth companies that generate income for owners and increase the owner’s wealth rapidly because the business value skyrockets. The hybrid businesses I’ve seen have high profit margins, which drives their profitability, and solve a painful problem well, which drives their growth. This type of business is very attractive and tends to be valued richly. The founders of these companies (if they have majority ownership) control their destiny because they’ve created an asset that both materially increases their wealth and provides income.
Wealth vs. Income
I had a conversation with a friend about the difference between wealth and income. They’re not the same thing. I realized through this conversation that some people aren’t aware of the difference between the two.
Wealth is the value of the assets you own (minus your liabilities, or debts). Assets include real estate, personal property (art, jewelry, etc.), and equity (i.e., ownership) in public or private companies.
Income is the money generated from your labor, wealth, or ingenuity.
Money isn’t wealth. It’s more of a medium of exchange that facilitates trade. It allows you to buy goods and services.
One of the hardest concepts for people to understand is that you can have high income but not wealth. For example, if you make $1 million a year and have $999,999 of annual expenses, you’re not increasing your wealth.
Conversely, you can have wealth but not generate enough income to pay your living expenses, which depletes your wealth.
Wealth and income are different, and it’s important—especially for entrepreneurs—to understand why.