“Rule #1: Never lose money. Rule #2: Never forget rule #1.”
— Warren Buffett
This is lesson #3 in our “Startup Buffettology” series.
Readers will observe that we’ve illustrated this rule with only one quote from Buffett. But it’s a deeeeeep quote…
To understand the rule properly as an entrepreneur, you first need to understand it from an investment perspective. For the investor, one of the implications of Buffett’s quote is that downside protection is more important than upside maximisation.
We will use the investor mindset to explain the rule using a somewhat contrived example:
- You have $100 and you seek to make a 50% return on investment, so that you will end up with $150. You find a “good” investment that fits the bill and provides a degree of certainty that you could make $150 in the optimistic scenario.
- Since this is a realistic contrived example 😉 there are no guarantees given, and in the pessimistic scenario you could also lose 50%. In the pessimistic scenario you would end up with $50.
- The average person, with a keen eye on the potential $50 profit, would focus on doing enough due diligence to assure himself that the probability of the optimistic scenario is truly higher than that of the pessimistic one, and having achieved that assurance he would take the risk.
- A Warren Buffett, bearing this rule in mind, would act differently. Buffett would seek some sort of downside protection arrangement with the investee…something like:
– If the optimistic scenario is achieved, give me only $25. That is, you (the investee) can make even more (i.e. the $25 that I am sacrificing) than whatever you were going to make. Good news for you! BUT –
– I want a guarantee that if we end up in the pessimistic scenario you will give me $90. Whatever happens, my losses are capped at $10.
The stat-heads amongst us will recognise that while the maximum value of the normal approach is higher, the expected value of the Buffett approach is superior.
The more mathematically interesting part of the story comes when you consider the following: in the normal pessimistic scenario where you end up with $50 you would need another investment that can make a 100% return on investment just to arrive back at your starting point ($100), and to hit your original target of $150 you would now need to find a super investment that can net you a 200% ROI. That $100 is now a distant memory…
The bottom line is that you need to allow the power of compounding to work for you, and it doesn’t when you don’t have downside protection.
For the entrepreneur (particularly the bootstrapper), I suggest we use time and energy as proxies for money. You need to treat your time and energy as Buffett treats his money. You need to avoid the risk of having to work twice as hard just to get back to where you started. You need to ensure that your efforts compound over time.
Thinking in this way, this Rule reads something like “Never lose time or energy…”, and this turns out to be precisely what Eric Ries and the Lean Startup movement are saying. Or as Ash Maurya puts it in Running Lean: “Life is too short to build something that nobody wants”.
“Downside protection” for the entrepreneur has many elements, and they all boil down to managing uncertainty. Therefore a second and totally different way of expressing this rule from an entrepreneur’s perspective is “Don’t front load”. How front loading is addressed is one of those things at the heart of the difference between the entrepreneurial method and the “traditional MBA” method. In the corporate world, front loading is generally a good thing — in project management (FEL, PPP), software development (waterfall methodology), and many other areas. It works when uncertainty is relatively low. For the entrepreneur, it is almost always to be avoided…think Lean, Agile, etc.
From one’s own experience, here are a few areas where front loading often causes huge time/energy wastage for entrepreneurs:
- Recruitment: Don’t spend a lot of time on candidates until they’ve jumped through some hoops. I remember advising an entrepreneur who subscribed to an online aptitude test service for job candidates. Because the provider charged per test, his normal practice was to interview candidates and test only the good ones, to save money. Each interview took significant time. I was able to show him clearly how it would make much more sense if he adopted a three-step process of scanning CVs (very quickly), testing the people with good-looking CVs, and then interviewing only those that passed. He spent a bit more on testing but gained several hours of extra time per week and avoided “interview fatigue”. Furthermore those gains in productivity outweighed the “loss” occasioned by a small number of qualified individuals who refused to take the test without first being interviewed.
- Product Development: Prove beyond doubt that there are willing buyers for the product or service before the product or service is built/assembled/produced. You can even sell the product before you build it (but be 100% sure that you are capable of building it on time and within budget before you take the customer’s money!). As discussed above, Ries’s “The Lean Startup” offers a lot of good advise in this regard. Tim Ferriss’s “Four Hour Workweek” also contains useful guidance on low-risk idea testing.
- Enterprise Sales: Do not spend time developing a detailed proposal until the client has already explained exactly what they want in great detail and have basically already verbally agreed to the deal. This is one of the black arts of enterprise sales — Skip Miller’s “Proactive Selling” is a useful guide.
By the way, the fact that you have found a surefire winner after following a Lean approach doesn’t necessarily make it your best opportunity; i.e. the best possible use of your time and energy. If you have fallen afoul of either Rule #1 or Rule #2 you run the risk of getting seduced by suboptimal local maxima, and missing the forest for the trees.