Entrepreneurial success, Gamblers’ ruin and partial diversification

As an entrepreneurial business grows, its shareholders face a continual choice around how much of profits should be reinvested. Given entrepreneurial optimism, early or continued success and a while to go before retirement, most re-invest profits continuously for years, if not decades.

The result (if things go well) is that successful founder-shareholders end up with most of their personal wealth tied up in the business – and are very exposed to business risks.

Fire remains a significant business risk

Although successful entrepreneurs tend to be far more risk-averse than popular belief would suggest, we should remember that every business started either eventually goes under or is sold. Few achieve the latter.

Don’t bet everything on the last roll of the dice:

To keep reinvesting all one’s earnings is not too dissimilar from a gambler betting against the house. The statistical phenomenon called Gamblers’ ruin suggests that if a player (entrepreneur) with limited funds keeps betting against an opponent with unlimited funds (that is, a casino, or the global economy), he will eventually go broke, even if the game is fair. All lucky streaks come to an end, and losing runs are fatal.

To get around this, the wise man betting in a casino takes chips off the table at every opportunity…and leaves them off the table, walking out with a share of the winnings earned along the way rather than risking everything on the final roll of the dice…

Entrepreneurs rarely diversify as they go: when we value their shares in the business and compare this to other assets they own then in most cases 99% of their personal wealth sits in the business.

Why entrepreneurs find it hard to diversify risk:

This extreme asset concentration is a global phenomenon.

It exists because it’s really hard to sell a minority stake in a privately-held company: there is no ready market of buyers who want a minority (non-controlling) stake in an illiquid investment where information is hard to get, the price is negotiated over months with loads of legal and accounting complexities (i.e. high transaction costs) and where there’s little external scrutiny or regulation.

The alternative is to sell the whole business; to diversify all in one go and bank on the final roll of the dice. This too is problematic – the business must be built into an asset of value and then sold outright. The process can take years. Valuation expectations are often unreasonable – and when confronted with the reality of a 3 to 4 earnings multiple, many entrepreneurs chose instead to work for another 3-4 years and take all dividends off the table. They remain exposed to the concentration risk along the way.

What has this got to do with BEE you ask?

The BEE act forces privately-held companies to transfer minority ownership stakes – something that’s very hard to do.

It’s hard because the business needs to find trustworthy BEE shareholders to whom they’ll effectively be “married” for a long time. These partners need to add value to the business. They probably don’t have money, so the business will need to vendor-finance the deal…and there’s a valuation, due-diligence, and loads of legal agreements to get through. The BEE shareholders will want to sell at some stage too, in which case the company needs to re-do its BEE deal and the exiting BEE shareholders need to find someone who wants to buy shares in a private company. Not so easy actually.

Our models show that most BEE deals (vendor-financed) destroy value and concentrate risk: selling 25% of a business to a BEE partner typically destroys 30% of value and leaves the entrepreneur with a bit more cash but still with most of their wealth in less of the business.

Join the Tusker herd:

Tusker was initially conceived to be a diversification play for the shareholders of large, privately-held companies; we wanted to create a system to help unlock private capital and reduce the risk to successful entrepreneurs. When we looked at the rules around BEE we realised that we had a superior way of financing legitimate BEE ownership deals that achieved both a far higher ROI (an increase in value of ±40% is typical) and significant shareholder diversification.

If you are looking to diversify risk, and/or do a legitimate BEE ownership deal, then please contact us for confidential analysis of your business.