Financial Clarity for Entrepreneurs

Innovating And The Smaller Company

In my previous post on Unbundling Business I said that product innovation was probably best left to “two guys in a garage.”  It was a bit of a throw-away line, and I’ve received some off-line feedback to explain myself.

A concept that applies to any investment, whether in your business, in the stock market, or Las Vegas,  is Risk of Ruin.  This is a statistical concept with lots of math involved and you can read more about it at these two Wiki pages (Kelly Criterion, Gambler’s Ruin) if you’re interested.

In brief, Risk of Ruin is a methodology for calculating how much of your available funds to invest in an endeavor with a positive expectation.  A positive expectation being one in which the return is greater than the odds.  If you were to bet $1 on a 50/50 coin flip and receive $2.05 (your original bet plus $1.05 in “profit”) when you won, that would be a positive expectation.  If you received $1.95 (a $0.95 profit) upon winning, that would be a negative expectation.

Even long odds can have a positive expectation if the return is big enough: a 2000-1 payoff on 1000-1 odds is positive.  The trick in this situation is to stay in the game long enough to take advantage of the positive expectation.  If you risked every thing you own, you’d go broke most of the time.

Guard Your Capital With Your Life

And that’s the lesson for entrepreneurs.  Even if the payoff is large, if the odds against success are long, don’t risk all or most of your available capital.

We read all the time in the business press about the entrepreneur who risked everything, beat the odds, and reaped the rewards of money and fame.  But we don’t read about the other thousand who didn’t win and went bankrupt.  It’s called Survivor Bias.

You can read more about Survivor Bias and how it applies to entrepreneurs in my post on Luck and Success.

Experiment, Evaluate, Repeat

A better approach would be to risk a little on a lot of opportunities, discard the ones that don’t work, and then invest more in those that look promising.  When you have something that’s clicking and starting to pay off, that’s the time to dedicate your all to the project.