I planned to write about Malcolm Gladwell in this post a couple of days ago, but I had rambled on long enough, so I deferred it until later. Well, Felix Salmon beat me to the punch, which is all for the best anyway, since the connection was going to be John Paulson, and Felix knows much more about hedge funds than I do.
The topic is Gladwell’s still-subscription-only article, “The Sure Thing: How Entrepreneurs Really Succeed,” in which Paulson plays a starring role. The sub-sub-head in the table of contents says, “The myth of the daredevil entrepreneur,” so even though I expected Gladwell to be annoyingly contrarian again, for once I expected to agree with him. The conventional wisdom, in this case, is that successful entrepreneurs get that way by taking big risks.
I’m inclined against the conventional wisdom because I co-founded a company, it’s done pretty well, and I’m about the most risk-averse person I know. (Want proof? I even worked at McKinsey, the world’s epicenter of risk aversion; two of the other founders were also former management consultants.) In my opinion, based on limited experience, to start a successful company you need to have a solid plan, a realistic assessment of your chances, the willingness to take on a modest amount of financial risk (starting a company is rarely the best way to maximize your expected aggregate income, and never the best way after adjusting for risk), and the belief that the non-monetary satisfaction you get along the way will more than compensate for the financial disadvantages.
Gladwell, however, wants to say something much more provocative, and in the process says something much more confused. To begin with, as Salmon points out, his definition of “successful entrepreneur” is unusual–looking at his examples, it seems to mean “anyone who makes a large amount of money as head of any kind of company, even if he made the money in the act of acquiring that company at a lowball price.” (The implied definition of “entrepreneur” is “anyone who heads any kind of company,” which includes, say, Chuck Prince. While Prince may be a failed CEO, calling him a failed entrepreneur seems silly.) Although hedge fund managers do technically head their own companies, they fit with almost no one’s conventional definition of an entrepreneur; they are investing other people’s money, and they don’t create anything except new trades.
Much of the conceptual substance of Gladwell’s article comes from “From Predators to Icons,” a study by Michel Villette and Catherine Vuillermot (which I haven’t read and won’t read, so I’m counting on Gladwell’s summary).* According to them (this is a direct quote), “The businessman looks for partners to a transaction who do not have the same definition as he of the value of the goods exchanged, that is, who undervalue what they sell to him or overvalue what they sell to him or overvalue what they buy from him in comparison to his own evaluation.” Gladwell adds, “He repeats the good deal over and over again . . . his focus throughout that sequence is on hedging his bets and minimizing his chances of failure.” This is certainly a smart thing to do, and a good way to make money if you can do it, but it’s an awfully narrow definition of what it means to be an entrepreneur; it’s a better definition of a successful investor–Warren Buffett, for example. But how does it apply to, say, the founders of Apple, Google, Amazon, or Microsoft? In the case of Google, for example, everyone knew Internet search would be big; Page and Brin simply built a better mousetrap.
Also note that Gladwell’s added sentence is a poor description of John Paulson’s behavior: “But if he was genuinely going to make a trade of the lifetime, he needed more. Like a cocksure Las Vegas card-counter, he was eager to split his winning blackjack hand, again and again.” [Greg Zuckerman, The Greatest Trade Ever, p. 177 in free pre-publication version.] And his short position got to the point where it simply count not be hedged. “Now that the ABX had tumbled from 100 to 60, Paulson had a lot more to lose–the index easily could snap back to 100. If the mortgage investments recovered in price, Paulson would be known as the investor who let the trade of the year slip through his fingers.” His colleague Paolo Pellegrini tried to get Paulson to lock in more of his winnings, but he refused [p. 198]. And how can a real entrepreneur–Page and Brin, Gates and Allen, etc.–possibly hedge his position? When you have years of your life’s work tied up in one project, it can’t be hedged. You only have one life.
Gladwell wants to use his theory of “entrepreneurialism” and “risk-taking” to take a shot at stock-based compensation for corporate executives, arguing that we actually don’t want CEOs taking risks. But the point of stock-based compensation isn’t to encourage risk; it’s to align the interests of CEOs and shareholders, because otherwise CEOs have the incentive to sit on their cushy jobs and cushy salaries and avoid mistakes that will get them fired. I don’t think the problem with CEO compensation is stock per se. It’s stock options, which give CEOs asymmetrical payoffs; in particular, it’s stock options that get reset when things go badly,** so CEOs make money no matter what happens; and it’s stock-based compensation that can be cashed in too early (as opposed to, say, three years after the CEO retires), creating short-term incentives to pump up the stock price.
The best encouragements to productive risk-taking are measures that limit the cost of failure for people who are actually creating something new, and this is one reason why Silicon Valley has been so successful. The financial risks of starting a company aren’t that big, for most people. High-tech companies are typically started by people who could pull in low-six-figure salaries working for other companies, so they’re giving up a couple of hundred thousand dollars in opportunity cost; the rest is typically angel investor or venture capital money. More importantly, there is (historically, at least), little stigma attached to failure, so there’s little reputational downside to a failed startup. In a world full of risk-averse people, that’s very important.
Anyway, Gladwell is right about the myth of the daredevil entrepreneur , but this is the wrong article to prove the point.
* According to Gladwell, the study is based on case histories of successful entrepreneurs, which sounds an awful lot like selecting on the dependent variable. Again, I haven’t read it, so he may well be wrong–but if that’s what Gladwell thinks the study is based on, he should have steered clear.
** Typically by exchanging old options at a high strike price for new options at a low strike price.
By James Kwak