These Four "Thinking Flaws" Will Erode Your Company’s Value

It’s interesting when you mash up ideas from three different books, all from big thinkers, by reading them at the same time.  When you meld multiple ideas and then pour them over client challenges and issues, you arrive at compelling conclusions. I tend to view most new insights from a “value creation” perspective which clients appreciate and others find slightly annoying.

That said, I’m mostly finished reading three great books; Think Fast and Slow, Skin in the Game and BIG Mistakes.  Their ideas speak to all entrepreneurs and support each others ideas in interesting ways. For entrepreneurs and CEO’s considering how best to maximize their company value, I uncovered a few interesting and concerning insights.

For example, Danuel Kahnemann (2002 Nobel Prize economics) researched how the human brain works and validated that most of the time our judgments are sound. However, we are prone to make expensive systematic errors (let’s call them “Thinking Flaws”) that result in poor decision making (cognitive biases) at the most critical times.  Kahneman uses a lot of descriptive words to describe these bad assumptions and poor decisions, the worst of which was value destroying.

Now, overlay these observations on Big Mistakes, which chronicles the best investors of our generation, Buffett, Paulson, Steinhardt, Ackerman, etc and chronicles their worst investment mistakes.  Cognitive bias is a constant theme in many of these mistakes. Batnick points out that “our ability to process information that challenges our ego is one of the biggest reasons why investors fail to capture market returns".

In Skin in the Game, Taleb builds on the narrative fallacy from his prior work in Black Swan.  This particular thinking flaw arises from an entrepreneur's inevitable and continuous attempt to make sense of the world around us and the fact that “the explanatory stories people find compelling are simple; are concrete rather than abstract… and focus on a few striking events”.  Its why we find stories so compelling. Its also why entrepreneurs leave so much company value unrealized.

OK, enough of the fancy, high brow language.  Your brain, like the brain of most successful entrepreneurs, is impacted by these four thinking flaws, and it is likely eroding some of your company’s value, particularly if a “liquidity event” may be on your radar in the next few years.

1 The Optimistic Bias

Optimism is a requirement for most successful entrepreneurs, however, this thinking flaw "may well be the most significant of the cognitive biases" because it can be both a blessing and a risk. Kahnemann advises to be both happy and wary if you are temperamentally optimistic.

If you are allowed one wish for your child, seriously consider wishing him or her optimism. Optimists are normally cheerful and happy, and therefore popular; they are resilient in adapting to failures and hardships, their chances of clinical depression are reduced, their immune system is stronger, they take better care of their health, they feel healthier than others and are in fact likely to live longer.

Optimistic individuals play a disproportionate role in shaping our lives. Their decisions make a difference; they are the inventors, the entrepreneurs, the political and military leaders – not average people. They got to where they are by seeking challenges and taking risks. They are talented and they have been lucky, almost certainly luckier than they acknowledge… the people who have the greatest influence on the lives of others are likely to be optimistic and overconfident, and to take more risks than they realize.

Problem is... optimism can lead to delusional tendencies, particularly for entrepreneurs.  For years I’ve spoken with CEO’s about their outlook for year ahead and almost always find their project revenues to be about 20% higher than actual results when I check back a year later.  They almost always count on perfect execution and never consider the unexpected; losing a key customer, a contract delay, unrealized pipeline, etc. let alone the impact of macro economic events.

Fred Luddy is currently on the the cover of Forbes 100 Innovators issue.  They talk a lot about his current success, but only 2 sentences on how he lost a $30 million personal fortune to a Black Swan event he never saw coming.

2 Entrepreneurial Dissonance

CEO’s as leaders often need to chart new waters leading employees and customers into new markets, green fields and blue oceans.  Problem is most people, CEO’s included, only seek out and consume information that makes them feel better about their current opinions, not challenge them.  Worse yet, the more experience you have the less likely you are to accept you are wrong, even when most of the evidence indicates otherwise.

A client sold their company last year even though they were very profitable providing PBO services to large enterprises.  With 3-5 year contracts and fat profit margins, they had great visibility into their future and continue growth and profits... “Unless we don’t”, the CEO told me.

It a rare example of recognizing and accepting his vulnerability, the two founders were willing to give up some of the upside (assuming perfect execution) in order to secure both company and personal financial success.  Ultimately we found a transaction that not only provided immediate liquidity, but created greater opportunity for upside success which they are executing against currently.

3  Control Bias

Most entrepreneurs require control in their life and business, the more the better for most. However, when lower middle market CEO’s considers a liquidity event or an evolutionary transaction during this current window of opportunity, the ability to maximize company value and the effectiveness of a transaction, will require an adjustment your expectation of control.

Truth is, as a smaller company, there little control around the actual timing of how best to maximize transaction value and deal structure.  In fact, the most important elements of a successful transaction will likely occur outside your company.

Buyers will decide to acquire or not based on issues related to them, not you.  Other buyers will want to acquire a “capability” and once accomplished that window of opportunity will close.  Today's current market multiple values will adjust.

I’m not smart enough to identify when this current window of expanded multiples will come to an end, but the transaction valuations we are getting for clients, and that others are realizing, are well above just 2 -3 years ago and are unlikely to continue indefinitely.  The impact of market multiples could be more important to your eventual company value than your internal timetable. If a transaction is in your five year horizon, this should give you plenty to consider.

Assume a $10 million revenue company with 15% ebitda that could fetch a 7x valuation on ebitda and valuation is $10.5M. If both revenues and ebitda growth 20% each of the next two years but valuations fall back to 5x ebitda... Your are back to a $10.5M valuation. If the market shifts back to historical averages, two wonderful years of perfect execution would evaporate. Sorry, but lets add “market multiples” to the list of items beyond the your ultimate control.

4 Independence Bias

Lastly, some combination of the above points will create independence bias.  As an entrepreneur, you may decide you like being the master of your domain which is completely acceptable and an honorable life decision.  However, if you are focused on maximizing corporate value, growth rate and profitability, remaining small and independent is usually a more difficult challenge.  If the focus is to create shareholder value, perhaps becoming an important part of a strategic acquirer is a better alternative.

It’s often more common for entrepreneurs to consider raising growth capital from private equity with the specific intent to grow in areas or from services/products where they have no or little experience.  This dilutes shareholders value, at least temporarily, in the hopes of richer rewards at some point in the future.

Compared to the opportunity for some liquidity, exposure to new clients, access to needed capabilities with infrastructure and resources already developed and managed by talented executives.  These opportunities are in abundance today and when compared to “independent life” with your new PE partner, many CEO’s eventually learn about independence bias through bad experiences.  

The life of an entrepreneur is full of hazards, rewards and challenges.  Many of the most effective (and wealthy) CEO’s are at least aware of internal bias that may impact their strategic thinking and harm their company value in the long run.  I hope highlighting a few of them here creates awareness and makes you more effective.

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Todd Taskey is an advisor to CEO’s and entrepreneurs and a Principal at Potomac Business Capital, Inc. in Bethesda Maryland.