I have to admit that I was surprised by the reception to my last post. It was shared and discussed literally 10X more than my typical posts. It spread through the core Banking ecosystem as well as the startup community and was being used by Executives, Entrepreneurs and Investors as a framework to discuss a critical and age-old topic —- […]
I have to admit that I was surprised by the reception to my last post. It was shared and discussed literally 10X more than my typical posts. It spread through the core Banking ecosystem as well as the startup community and was being used by Executives, Entrepreneurs and Investors as a framework to discuss a critical and age-old topic —- relationship Banking. It was fun to watch the discussion take on a life of its own!
So, in the spirit of writing another thought piece in the same vein, I decided to tackle another topic that’s unfortunately becoming more and more true in the Banking world. The theme: “How to make bad decisions and not get fired.”
Let’s start with a thought exercise. Imagine getting a call about a “once in a lifetime investment opportunity” from a trusted friend who has an amazing long-term investment track record. She describes the opportunity to you and you get very excited because if the investment thesis does pan out, the company behind it would transform its ecosystem. In the spirit of full disclosure, she wants to let you know that there are two important characteristics of the investment worth internalizing before making a yes/no decision.
- It’s risky and could be a complete wipe-out
- The minimum investment would put your life’s savings at risk
But being the great investor she is, your friend has run thousands of scenarios and done all the number crunching she can to project the risk/return profile of the opportunity. Her conclusion is that the investment has the following profile:
- Odds of a complete wipe-out: 50%
- Odds of a 1-3X return in 3-5 years: 40%
- Odds of a 25-50X return in 6-8 years: 10%
She needs to know if you want in on the deal. What do you do? Most people would pass (not everyone!) because the thought of the “wipe-out” happening is terrifying. This is totally understandable even though the math behind the investment returns suggests it’s a great investment.
Now let’s change the conditions of the investment a bit and then ask the same question regarding your investment appetite (we’ll call this Scenario #2). What if the minimum investment were dramatically reduced such that you could invest 10% of your net worth instead of 100%? Now would you say yes? Just about everyone would, and the poor souls who don’t have the stomach for this type of risk/return investment are probably socking money away in mattresses because they think the men in black suits are watching them.
And let’s change the conditions even more (Scenario #3). What if your friend were able to source 10 investments with the same risk/return profile? In this case it’s even clearer that you’d want to invest and the operative question would switch from “whether” to “how many” investments you would make.
It shouldn’t come as a shock that this type of return profile exists in the Banking ecosystem and can be found over and over with the right amount of outreach, diligence, analysis and insight. It’s why many fintech VC funds (like ours) have great historical returns and the truth is that all the fintech investors I know believe that if anything the opportunity set is increasing.
And while this “investment opportunity” is available to three separate constituencies (Incumbents, Entrepreneurs and Professional Investors), the only “rational” constituency in the ecosystem is the Professional Investor! We take risk in order to generate attractive returns for our LPs. And without risk there’s no return, so in order to do our jobs well we have to get used to a risk profile that is comprised of equal parts failure and success.
In contrast, Entrepreneurs are really just people who believe enough in their own ideas that they’re willing to go “all-in”. They refuse to internalize their real odds of success and instead believe with certainty they’ll end up in the best 10% of outcomes. They put their lives on hold for years to chase their ideas and sometimes end up wiping out their personal financial resources along the way. If they succeed they look like geniuses, but there’s a very large and deep graveyard of failed Entrepreneurs littering the path to success.
On the other end of the spectrum are the well-established and financially healthy Incumbents in the Banking ecosystem. They have the ability to exist in a Scenario #2 or #3 world but somehow can’t figure out how to engage or pull the trigger. If a typical Incumbent is able to put 10% of the company’s excess earnings at risk each year chasing the probabilistic outcomes mapped out above, why do they say “no?” And if they have the opportunity to take the same 10% and spread the investment in 10 opportunities with similar return profiles then why aren’t they? If I were in charge and found out that someone on my team passed on this type of opportunity, I’d seriously consider firing them and at the very least would question their judgment. But Incumbents aren’t chasing these opportunities internally nor are they aggressively backing Entrepreneurs in the manner that VCs are. They have access to these opportunities every day but can’t pull the trigger. Why? Unfortunately, the answer is structural which means it isn’t easy to solve.
- Duration mismatch – The common unit of measurement at a Bank is either current quarter, next quarter, or current year. You rarely (if ever) hear Banks talking about how the projects they’re working on now will pay off in 5-7 years. You might hear a CFO talk about how very tactical cost reductions are going to help their ratios in the next year or two, but you rarely hear about longer term bets. But, to build anything meaningful takes time. Real time. 5-7 years’ time, not 3 or 4 quarters’ time.
- Accountability issues – Long term accountability doesn’t exist. While many Executives have 20+ years’ tenure at their organization, it’s almost always comprised of many 2-3 year stints in roles with a “rotate and pass the baton” mentality.
- Small sample size – No individual Executive assembles enough investments to play the “portfolio odds” game. Without a portfolio to fall back on, the best an Executive can hope for is to back one or two investments that statistically will probably fail. And unfortunately, the adage is true that lemons ripen early, so the failures will likely be the first “results” posted in their risk-taking career.
- Misaligned incentives – A typical Executive earns their bonus one year at a time based on goals handed down to them from the powers above. They can earn 90% of their bonus by saying “no” to every risky opportunity and it’s not difficult for them to earn their full bonus by being really good at making marginal changes around the edges. In contrast, an Entrepreneur is underpaid for years, but if they can string together enough “yes” answers and successes over a long enough period of time (6-8 years is typical) then they can earn many many multiples of what they would make working at one of the established companies in their ecosystem.
- Too much process and too little autonomy – The easiest way to reduce the risk/return of an investment is to move slowly. At best, burn stays constant on a daily basis, so when process slows down decision making, it slows down learning and makes the ultimate outcome more expensive to produce. It also makes failures more expensive which is a major driver of an organization’s risk appetite. And, when process creates barriers to “yes” answers it reduces the ability for a team to innovate at all (and crushes job satisfaction as a bonus).
By no means am I suggesting that Incumbents can’t directly drive or at the very least participate in funding innovative business opportunities. What I am highlighting is that most Incumbents aren’t doing either even when faced with overwhelming evidence that they should. By making “no” easier than “yes”, Executives can and are making poor decisions without any consequences. The result: More opportunity for Entrepreneurs and Professional Investors. I’ll take it!