Entrepreneurs and Risk

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

32 thoughts on “Entrepreneurs and Risk

  1. “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.”

    Bullsh*t. That is the definition of “financier”, “banker”, or maybe “trader”.

    Businessmen run organizations whose output has greater value than its input. No financial firm has ever done anything of the kind. Financial firms do not create wealth; they merely push wealth around. Calling those leeches “entrepreneurs” is just another example of modern NewSpeak, which has perverted all of the words describing real capitalism so as to make it impossible to distinguish true wealth creation from feudal rent-seeking.

    P.S. Gladwell is one of the most overrated “thinkers” alive today.

  2. I don’t have much to say on this topic. I’m sure Gladwell is a great writer, I don’t know of any hacks that ever worked at The New Yorker magazine. But sometimes people just get carried away with some writers, and they get over-hyped. Frankly I think Gladwell is one of those guys. He’s good, but come on folks, let’s get over this celebrity crush sometime soon please??? As Tiger Woods taught us, all of these folks are human underneath the little eminence front they put up.

  3. “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;”

    This formulation has become a truism, but at a certain point, I just don’t think it’s true. The problem with stock options as payment is well known, but the question is, do payments in stock really align the interest of CEOs with the stockholders? On the face of it, it seems obvious that the answer is yes. But I think in many ways, CEOs are more indifferent to big drops in the stock price than most shareholders. This is because CEOs are a different kind of shareholder than, say, a pension fund or mutual fund.

    Here’s why. Many CEOs are already quite wealthy. They could lose their jobs and never work again and still not want for anything. Therefore, if you are getting paid in restricted stock that vests over, say, the next four years, and you already have plenty of money, you have no disincentive to take risk.

    If you are a CEO in this situation, and you engage in a risky but potentially high-return strategy, there are three possible outcomes. 1) It pays off big for the company (and thus for you as your stock vests). 2) it is neither a failure or a success. 3) It is a big failure, causing the stock price to drop (or the company to go bankrupt)–and you get fired.

    If I get fired, it’s a personal disaster. But if a CEO who is already worth, say, $100 million dollars, getting fired is an inconvenience. And since that is the worst that can happen to him, I don’t see how getting paid with restricted stock would make the CEO as risk averse than other shareholders. (And therefore, we can’t really say that their incentives are aligned.)

    Therefore, for CEOs who are already very wealthy, a better form of compensation might be futures. With futures, if the company’s stock price fell, the CEO would be required to pay out of his or her own personal wealth. That, I suspect, would tend to sharpen the mind when it came to taking big risks.

  4. All this talk about entrepreneurs and CEOs is nonsense. The chief executive of an established public corporation is a hired manager. He deserves a salary like the president of a university or the United States. That he receives more than this is the consequence of legal inadaquacies, the fictions of corporate governance, the proxy system, resume peddling celebrity directors (including the race and gender variety), a culture of ideology and stupidity and stock market gambling. Entrepreneurs create something out of nothing. They do not chose one of three strategic plans to increase market share in an ogolopistic economy. Have you studied corporation and securities law yet? The Devil is in the details.

  5. I want to give a few examples of entrepreneurs and ask why these are different:
    I live in Lansing Michigan. We used to have 30,000 GM employees working here. Now, we have 4,000. There are still remnants of small businesses that were founded here in Lansing in the boom times of this city. Many small businesses that were once powerhouses of growth in the community are now gone. My question in regards to entrepreneurs is that, would these individuals/businesses had been as successful had their not been those 30,000 middle class jobs here in Lansing? Things are the same in Detroit and Flint as well. I am not crying to have the auto companies come back. I just want to know if the success of the entrepreneur was based more on his realization of “hey this town is booming. I’m going there to start my business.” Or was it just dumb luck that many of these businessmen were born in the right place at the right time? Maybe I am off the topic you were focusing on. And I believe there are parts of this country that as long as you work hard as a businessman there is success. But here in Lansing, especially in this disaster of an economic meltdown, even a great entrepreneur would have a hard time starting a business right now. Our city was heavily weighted on those factories. And now they are gone.

  6. It is also a function of the expanding definition of entrepreneurs, and coparison to what the Brin’s of the world make. As you say, they are totally different things.

  7. Gee, I always thought of McKinsey as the world epicenter of meaningless, jargon-filled slide decks (which typically contain unhelpful statements from my perspective).

  8. Amidst the current crisis (metastasis?), the “entrepreneurship” concept is being stress-tested just as well. Gladwell-types only catalyze the process by which we may well come out with a de-mythologized take on entrepreneurship.

    To think of Gladwell’s attempt at writing something that’s not only non-conventional but also serving the status-qvo(sic!), he only manages to show how little to nothing he knows about entrepreneurship.

    Your points, Jim K, are well made and taken!

  9. That’s the dirty little secret. I personally am fairly successful and I have worked and studied very hard to get where I am. But there are many other people who worked just as hard or harder, were just as smart or smarter, that were just as educated or more so that have failed because of circumstances beyond thier control. Hard work and intelligence are necessary for success, but they are not a guarantee of success. Every successful person owes some percentage of that success, and it’s probably double what they think it is, to luck. Ironically that one of the subtexts of Gladwell’s Outliers. Sure Bill Gates was brillient, but his high school also had computer programing equiptment in the late ’60’s etc.

  10. Perhaps the real truth is even more complex: there are many routes to being successful entrepreneur and the deciding factor is often luck that when viewed with hindsight looks like genius.

  11. Luck is the unappreciated component in all success stories, but glorifying success justifies punishment of failure. Most of the lucky are born to privilege; their privilege can be justified only by creating a right of the successful to transmit their wealth. Once an individual joins the ranks he acquires a vested interest in continuing the paradigm.

    For years and years the society justified corporate power because it ‘creates jobs’, even while the jobs were being shipped out. Today banker privilege is justified by the claim that the world will end if banks are allowed to fail. In a sensible world, corporate privilege would be conditioned on service to a range of constituencies. Just for example, why are stockholder claims paramount if most large stockholdings are inherited?

  12. “Some men wrest a living from nature. This is called work. Some men wrest a living from those who wrest a living from nature. This is called trade. Some men wrest a living from those who wrest a living from those who wrest a living from nature. This is called finance.” ~ Fr. Vincent McNabb

  13. “I just want to know if the success of the entrepreneur was based more on his realization of “hey this town is booming. I’m going there to start my business.”

    Sounds like my grandfather. He was a good businessman, but he moved to where opportunity was, too.

  14. I do not see how you can possibly draw conclusions about entrepreneurs and risk by looking only at successful entrepreneurs – talk about selection bias! Naturally success will appear, ex post, to be by design, and the entrepreneur will appear to have been smart rather than lucky. But as noted by others above said, many, many people have tried to start businesses with every intention of success and thinking they had all the bases covered, yet failed.

    This is vintage Gladwell – an interesting and provocative point, which probably has some merit to it, supported with arguments that fall apart under the least pressure.

  15. James said, “(starting a company is rarely the best way to maximize your expected aggregate income, and never the best way after adjusting for risk)”

    Do you have evidence for this statement? I’m very curious. It seems contrary to conventional wisdom.


  16. Want to talk about dirty secrets??? IBM handed the DOS program to Bill Gates on a silver platter. Take away the rights to DOS (which underlies Windows) and I think a STRONG argument could be made the guy would just be an upper-middle class stiff. And I don’t think he even realized at the time what he had in his hands AFTER he bought it (DOS).

  17. Great comments all. I’ve written before about Gladwell and how, as SRB says, his arguments don’t stand up. This piece was worse than most, because to call a hedge fund manager an entrepreneur, while technically true (he sets out on his own to build a business), is so far from the common usage of entrepreneur as to be misleading.

  18. The payoff can be big, but the frequency of big pay offs is small.

    Think about all the enterprenuers out there — from your local dry cleaner to restaurants to Google — and note how many of them provide only modest aggregate income.

  19. I am no fan of Gates, but I, err, sort of want to stick up for him on this one. Gates wrote an excellent Basic language. Unlike other hackers of his time, however, he was not into sharing, but guarded his intellectual property. Getting DOS from IBM was a great opportunity for him, but he was primed to take advantage of it.

  20. The bottom line is this: He better quit stretching sh!t to raise the entertainment value or he’s going to get into freakonomics territory.

  21. I am speechless.

    This is HR 4173, “‘The Wall Street Reform and Consumer Protection Act of 2009.

    Click to access 111_hr_finsrv_4173_full.pdf

    On Section 1701 (ADDITIONAL IMPROVEMENTS FOR FINANCIAL CRISIS MANAGEMENT.) starts on page 436 and on subsection C (FINANCIAL CRISIS MANAGEMENT) talks about unusual and exigent circumstances. Page 437 says “Upon making any determination under this paragraph, with the consent of the Secretary of the Treasury, the Financial Stability Oversight Council shall promptly submit a notice of such determination to the Congress. The amounts made on available under this subsection shall not exceed $4,000,000,000,000.”

    Basically this bill allows future $4 Trillion back stop to WallStreet casino.

  22. I totally agree about CEOs that become wealthy too soon losing focus and incentive.
    Typical example is Carly Fiorina.
    Less than 5 years of disastrous tenure at HP, flashy and incompetent, she got fired rather abruptly.
    She will never lead another Fortune 500 corporation in her life.
    However, other than a bruised ego, for her was just an inconvenience, she doesn’t need to work one more day in her life and still living the golden life.
    Those that can’t make it in business will try politics or teaching…any surprises that Mrs. Fiorina is interested in a senate seat?

  23. Entrepreneurs (vs. small businessmen) face uncertainty, (unknown transformational product) and unknown cash flow. See Schupeter new product, new process, new markets. Entrpreneurs should not be conflated with small businessmen who deal with conventional products with known demand but unknown cash flow. Uncertainty, wether Knightian or Bayesian, should not be conflated with risk. Both have similar small size and both can scale but face different randomness profiles.

  24. New jobs begin with pebble droppers, people making waves and wakes, the entrepreneurs who start business ventures. The “soil” must nurture them, not discourage them. Pebble droppers must be saved and admired for the service they provide. Instead, they are envied by the few, taxed and punished by government whose only purpose is to protect all people against injustice. SAVE PEBBLE DROPPERS & PROSPERITY defines a pebble dropper and the environment that is best to encourage their success. Today’s politicians are dismantling the American ideal of a prosperous, free nation. The 2008 election did seek “change,” but made community interests superior to individual interests. What has happened to the voices who believe in the importance of the individual? That is why America differs from the rest of the world. If “change” is inevitable, will we lose that which sets us apart from the Old World. Claysamerica.com

  25. Stock-based compensation should be illegal; it’s a dilution of the stockholders and provides incentives for execs to run pump-and-dump schemes.

    Top execs should instead be *paid* in cash, but required to *own* large amounts of stock which they purchase with their *own* money. If they won’t bet their own money on the company, the stockholders shouldn’t trust them to run it. A few companies do this, but it’s rare.

  26. “According to Gladwell, the study is based on case histories of successful entrepreneurs, which sounds an awful lot like selecting on the dependent variable.”

    Basing a theory of entrepreneurial behavior on only the behaviors of entrepreneurs who succeed is like making bets on the housing market based on the premise that housing prices never fall.

    Such a study overlooks the fact that entrepreneurial behavior often ends up in bankruptcy.

    It also overlooks the fact that gambling (which seems to be the occupation of a portion of our financial sector) is not the mark of a true entrepreneur. Taking risks when gambling is different than taking risks as an entrepreneur.

  27. Schumpeter emphasized that entrepreneurs made new combinations (of capital, labour, and technology) and these almost by definition involve risk. I suspect that most established firms are inherently conservative – risk averse – hoping that whatever brought success (i.e conditions) will remain constant. One can think of U.S. automobile manufacturers continually lobbying Congress to restrict imports (competition) defeat safety and economy standards (costs and techniques of production) – in other words, any thing but innovation and risk.

  28. French academics “discover” that smart business people think like Sam Zell and call it “predatory”.

    “‘Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” Sam Zell

    Presumably these academics think that only business people who (1) make bets with a symmetrical big upside and big downside or (2) bet stupidly when the odds are against them might be somehow be worthy of being called an “icon.” In other words, if you look for a capped downside and a big upside like Paulson or Turner, you are not worthy of being called an icon. Stated in yet another way, to be noble, you must be ignorant of the laws of probability identified most closely with two Frenchmen named Pascal and Fermat.

  29. I would like to add a modifier. What we are seeing here in Lansing that is killing local business is volume is down. The small businesspersons I was referring to in the above post have taken steps to improve efficiencies and make sure their company’s made money but the number of people walking through the front doors continues to decline. As improvements are made to save 10%, they take affect in time to counter another 10% decline in volume. The only reason Lansing is holding up better than Detroit is because the white flight have as far to travel; most moved within 5 minutes of Lansing versus places like Novi, Auburn Hills, etc.
    I wish I had a way to document and then communicate to all of you what a mess things are here in Lansing Michigan. Suggestions would be appreciated. Another Roger & Me would be too much a copycat.

  30. I disagree with your point about reducing the risk of failure. Without significant downside risk–without skin in the game–the incentives to show good judgment go away. The best way to get the “productive” part of risk-taking is to force the entrepreneur (or CEO, or manager) to assess the reward against some benchmark hurdle that’s set by the cost of failure. I agree that we want to limit the catastrophic consequences of failure, but with a few exceptions that’s not a problem in our culture (as you note). I posted on this at http://colinrmathews.com

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