Tuesday, January 11, 2011

Competence Kills

Competence isn't a bad thing, but it's no longer enough.

Maybe there was a time when you could build a successful life based on "pretty good." But those days are gone, along with three martini lunches and wearing hats all the time.

Pretty good works in a stable environment because of the principle of leverage.

In finance, if an asset guarantees pretty good returns, you can lever up your investment with borrowed money to generate outstanding returns. Of course, if the returns go south, the leverage will also generate disastrous returns--witness the housing bubble.

The same applies to hiring in business. If you know that each person you hire will generate so much in increased value, you can hire a lot of pretty good people and boost the value of your firm. But just as with the housing bubble, if the returns on people suddenly drop, you'll experience the downside of leverage.

Environments today are more volatile (read: unstable) than ever. And in a volatile environment, you're better off with either amazing or awful than with pretty good.

That's how the VC model works--we don't invest in pretty good companies and hope they'll generate pretty good returns; we invest in potential game-changers that will either blow up (in a good way) or blow up (in a bad way).

You're better off focusing on being amazing at a few things (and be willing to live with being awful at others) than trying to be pretty good at everything.

There's a reason why NFL kickers don't bother practicing their tackles--I'd rather have the world's greatest kicker who's a bad tackler than a pretty good kicker who can really lay someone out.

The funny thing is, this is such a universal principle that it applies to dating as well. The folks at OK Cupid have conducted an analysis that shows that having men think you're "cute" actually reduces the number of men who approach you. It's much better to have 7 men rate you as a "10" and 3 as a "0" than to have all 10 rate you a "7". As a result, your goal shouldn't be to maximize your average attractiveness--it's to maximize your differentiation. Here's what the authors of the study had to say:

As you've probably already noticed, women with tattoos and piercings seem to have an intuitive grasp of this principle. They show off what makes them different, and who cares if some people don't like it. And they get lots of attention from men.

Substitute your startup for that hypothetical 20something with a tramp stamp and ask yourself, "Where can we focus our efforts to be amazing? Where can we defocus our efforts and live with being awful? And why do men like nose rings so much?"

7 comments:

acgourley said...

This is a perpetual curiosity to me. When you say:

"...we don't invest in pretty good companies and hope they'll generate pretty good returns; we invest in potential game-changers that will either blow up (in a good way) or blow up (in a bad way)."

Is that backed up by any analysis, or empirical case studies in investment returns? It certainly seems to be the VC consensus, but I can't figure out why.

Sure there is plenty of analysis indicating the majority of VC portfolio returns come from a few big wins, but those portfolio companies are pushed into high risk high reward behavior - I'd be curious if there was proof the portfolio return would go down if the companies were allowed to fit their natural risk preference (high or low).

Finally, I understand the concept of limited investor bandwidth, but I'm not claiming investment size should be smaller, just that expected returns of 3-4x may still be a win.

Chris said...

AC,

It comes down to financial theory. In theory, risk and reward are correlated. Portfolio diversification helps you reduce risks without reducing expected returns. Therefore, a portfolio of risky, uncorrelated investments is preferable to a portfolio of less risk investments.

The risk/reward equation is very different for the entrepreneur, who doesn't have portfolio diversification, which is why you often see the two parties interests diverge.

acgourley said...

Certainly one theory says that, but it seems awfully academic, doesn't it? I'm concerned it misses the following nuance: If investors constantly say, "we only fund high risk / high reward companies" they should expect some entrepreneurs to modify (or misrepresent!) their business model to meet that criteria.

My concern is that those modifications add risk but not always proportional reward. Consider a thought experiment:

Business model "A" that will sell widgets and projects 5x returns and you estimate it has a medium chance chance of moderate success (lets say 2.5x expected returns).

No VC wants to fund it so they re-formulate as business plan "B" - an online platform that allows people to sell widgets. It has a small chance of making 20x returns. (lets say 2.0x expected returns)

Maybe these numbers are just don't track reality and this situation simply isn't common- I'm just wondering if there is any data or research on the matter. When I press people on this subject they respond like you do - that it is simply axiomatic.

Chris said...

AC,

It goes without saying that it only makes sense to assume risk if it increases expected value. But let's take an extreme case. Let's say that an investor is asked to choose between a certain $1 million return, or a 1% chance of a $1 billion return.

The VC investor will take option B in a heartbeat. At the same time, an entrepreneur would be crazy if they didn't take option A.

acgourley said...

Chris,

So I suppose the distillation of what you're saying is that following: Investors trust in their ability to pick high risk / high reward companies with at least break-even expected values.

I just feel like sometimes investors ignore that step and assume high risk / high reward companies must have a higher expected value.

Not sure if you agree, but it certainly has cleared up my own thinking, so thanks.

Mark Brophy said...

The quote I like most from this post is:
"There's a reason why NFL kickers don't bother practicing their tackles--I'd rather have the world's greatest kicker who's a bad tackler than a pretty good kicker who can really lay someone out."

I've been reading posts lately where advocates of small businesses claim that because startups take more risks than established businesses, the government should subsidize startups. They fail to realize that startups accept risk because they aspire to sell to large companies.

Chris said...

Mark,

The idea of the government trying to pick winners among startups should send chills down anyone's spine. I'd rather the government focus on reforming the education system, so that more people grow up self-directed, rather than simply seeking out the nearest convenient job.