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For nearly a decade, Americans have tuned their televisions to ABC’s hit show, Shark Tank. For 60 minutes each episode, founders of up-and-coming start-ups pitch their ideas to highly successful entrepreneurs. It’s exciting, emotional, and entertaining all at the same time.
The normal lineup of sharks includes a mix of Mark Cuban, Daymond John, Kevin O’Leary, Barbara Corcoran, Robert Herjavec, and Lori Greiner. However, every so often, Shark Tank’s producers give guest entrepreneurs the opportunity to critique the start-up pitches. Personalities such as Alex Rodriguez, Sara Blakely, Chris Sacca, Richard Branson, and Bethenny Frankel have all made an appearance. With that said, there is one person that will never assume the role of guest Shark — billionaire investor Warren Buffett. Value investors do not make good entrepreneurs. Here’s why.
Too Many Questions
The rationale behind value investing is quite simple. First, you will find a business that you feel comfortable becoming part owner of. Conditions such as a strong competitive advantage, capable management, or attractive key ratios may play into this decision. Next, you need to determine the intrinsic, or real, value of the business. Many different techniques can be used for this step. Lastly, you will compare the intrinsic value to the selling price. If their stock is selling for less than its value, this is considered a good buy.
Sounds easy? You’re right, it’s not overly difficult — unless you’re valuing a start-up.
In the early stages, entrepreneurs face so many variables that it is nearly impossible to give the operations an intrinsic value. How large is the market? Is there any demand for the services? What is the most effective way to make a profit? Can competitors do it better? Is there a long-term future for the business? How much capital is required? Can profit margins be expanded? Is the business model sustainable for the future? How will we market to customers? Is it the right time for this business?
They go on and on.
As entrepreneurs are answering these questions, value investors are finding surefire, calculable, and certain opportunities. Consider the publicly traded company Nabisco. Although you may not recognize the name, you are sure to know their popular cookie, Oreo. They have mastered everything there is to know about two chocolate biscuits with creamy filling in the middle. They are not trying to create a brand, fine tune profit margins, or gauge the perfect recipe. This allows value investors to determine an intrinsic value and invest with confidence.
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Avoiding the New Kid on the Block
Many entrepreneurs also tackle the challenge of entering new or up-and-coming sectors. This could reap massive rewards, but value investors are normally not interested. Instead, we prefer sectors that are established and easily understandable.
Shortly after Bill Gates took Microsoft public, he met with Warren Buffett and pitched him the investment. Gates labeled the computer industry as having a highly successful and profitable future. Buffett simply questioned whether computers would change the way people chew gum, to which Gates obviously replied with no. Based off that, the Berkshire Hathaway CEO deemed Microsoft unfit for his portfolio.
Gates, the entrepreneur, saw Microsoft as the next big thing with a low chance of failure. Buffett, the value investor, saw Microsoft as an uncertain investment within an unknown industry. Looking at it now, they were both correct. Sure, Buffett would have made massive profits if he had purchased the shares — but his perspective at the time was still correct.
Risk? No Thanks
An entrepreneur can be described as a person who organizes and operates a business or businesses, taking on greater than normal financial risks in order to do so. The latter part of that definition is a major reason why value investors are not good entrepreneurs. We hate risk.
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There are plenty of ways to define or measure investment risk. Economists have no shortage of mathematical formulas for this purpose. However, value investors prefer to consider risk as the likelihood of total loss.
Although the definition is simple, it does not put an entrepreneur’s business venture on the safe side of the scale. As mentioned earlier, a business’s early stages come with many variables that have yet to be answered. Value investors would prefer something without the likelihood of their capital going to zero.
Is this risk-tolerant label given to entrepreneurs warranted? Many research findings would say yes. A professor at Harvard Business School studied the success rate of venture back companies — such as the those being pitched on Shark Tank. What he found is that between the years 2004 – 2010, 75% never returned cash to investors. It gets worse: Up to 40% of these companies end up liquidated and leaving investors with an empty wallet.
Another study concluded that 50% of start-up companies fail after five years. Astonishingly, the percentage increases to 70% after 10 years. A common technique amongst value investors is to only consider companies that have been functioning for at least a decade. Much of the uncertainty should be worked out by that point.
Debt Brings Sleepless Nights
Starting a business is challenging! Most, if not all, entrepreneurs will face the same road block before their great idea becomes the next big thing. How am I going to pay for this?
Apple was initially funded with the sale of Steve Jobs’s microbus and Steve Wozniak’s calculator. A mere $1,350 initial investment is now worth over a trillion dollars. The entrepreneurial duo started their tech empire with zero debt. This is not the case for many other business ventures.
The easiest way for an entrepreneur to fund their great idea is with a loan. In 2016, the Small Business Administration provided $33,333,955,197 to hopeful business owners. Now, we won’t get into whether that is a good idea or not, but what we can say is that debt financing will give a value investor nightmares.
Remember all those uncertainties that entrepreneurs face? Going into debt will create some guarantees: The liability will need to be paid back; profits that could be used to grow operations will be spent elsewhere; in case of a default, the lender will have first grabs at any assets. Value investors prefer to avoid a business with a debt/equity ratio higher than 0.50x.
Simply Different Territories
Over 600 hopefuls have pitched their ideas on ABC’s Shark Tank. In return, the established entrepreneurs have invested a combined $100 million into these ventures.
These numbers will continue to grow as Americans continue to dedicate their time to entertainment. As they do, don’t expect Warren Buffett, or any other value investor, to assume the role as a Shark. They tend to avoid the uncertainty, innovation, risk, and debt that comes with entrepreneurship.
Let’s put it like this, value investors are lions and entrepreneurs are sharks. Both are predatory business people that simply occupy different territories.
About The Author:
Colin Richardson is an intelligent investor, contrarian, and student of the world. His personal philosophy is to base reasoning not on speculation but rather on back tested systems and confirmation. Although he successfully completed the Canadian Securities Course certification, majority of his financial knowledge is self-taught. When not writing, he monitors a quantitative deep value stock portfolio.