Everything is Obvious…Once You Know the Answer
Lenders and investors approach uncertainty differently. It might seem obvious that lenders abhor uncertainty. It might be a little less obvious that equity investors seek uncertainty (though they’ll work hard to skew the benefits of uncertainty in their favor). To be honest, it took me years to feel like I really understood these truths. This lesson will (hopefully) accelerate the process for you.Everything is Obvious
Bringing Some Key Concepts Together
Previous lessons introduced these key ideas:
- The elements of risk – Uncertainty describes the odds of receiving a potential payoff, and “skin in the game” is what you have to lose.
- Gauging uncertainty – Uncertainty ranges from Level I (a clear enough future) to Level IV (true ambiguity). Levels I and III (a range of futures) are the most frequently encountered in business.
- Confidence intervals – A confidence interval is the range of possible values in which you can have a high degree of certainty. The confidence interval in the case of Level I uncertainty is narrower than the confidence interval for Level III uncertainty.
- Functional differences between debt and equity – Debt holders get the “first bite at your cash apple.” Equity holders get what’s left. Debt claims are typically fixed; equity’s residual claims are variable.
Taken together, these factors influence how lenders and equity investors respond to uncertainty and risk. If you understand why they view the world as they do, you’ll know who to approach and how to make your pitch.
Watch the lesson video for a more thorough description of this hypothetical opportunity:
- Claire sees an opportunity to invest $120 today to receive $150 in one year. That represents an expected return on investment (“ROI”) of 25% = ($150 – $120)/$120. The actual value of the investment in one year is uncertain. It could be more or less than $150.
- Claire has $20 to invest. She borrows $100 from Bob and agrees to pay him 10% interest for his one-year loan. In other words, she is promising to pay him $110 in one year.
The following graph shows the net profit or loss to Claire and Bob as a function of the total realized value of the investment at the end of the year. This type of graph is called a payoff function:
- If the expected value of $150 is realized at the end of the year, Bob gets $110, and Claire gets $40. That yields a $10 profit for Bob (his interest income) and $20 for Claire.
- If the investment opportunity were characterized by Level I uncertainty, the confidence interval for the total value at year end would be relatively narrow. For purposes of illustration, let’s say the Level I range is $130 to $170. Across that interval, Bob would still make a profit of $10. However, Claire’s profit could vary from $0 to $40.
- If the investment faced Level III uncertainty, the confidence interval would be wider. Let’s say the Level III interval stretches from a year-end value of $90 to $210. The lender, Bob, now faces the possibility of a $10 loss in addition to the $10 gain he could make if the year-end value is at least $110. Claire could lose her entire equity investment of $20, but she now stands to profit by as much as $80.
Lenders Manage Risk by Avoiding Uncertainty
This simple payoff function reveals a subtle but important distinction between how Bob and Claire perceive uncertainty. As uncertainty increases from Level I to Level III, Bob’s maximum payoff (his “upside”) doesn’t change. However, his minimum possible payoff (his “downside”) decreases by $20. In other words, Bob’s downside increases faster than his upside in the face of increasing uncertainty. A lender manages risk by avoiding uncertainty because their upside is limited.
Equity Investors Seek Uncertainty and Manage Risk by Minimizing Their Investment
Claire, as equity investor, views uncertainty in a different light. As uncertainty increases, her upside increases faster than her downside. As a result, Claire actually prefers uncertainty.
Of course, an equity investor wants to maximize exposure to upside while minimizing her exposure to downside. Consequently, equity investors will seek to invest incrementally.
That’s why you’ll hear venture capital investments described in terms of “seed,” “Series A,” and “Series B” rounds of investments. By investing incrementally, equity investors seek to minimize their downside risk early on when uncertainty is highest. As necessary, equity investors will make follow-on investments to retain their upside.
Sharing Risk Between Debt and Equity is a Complex Game
Lenders and equity investors share a desire for the success of the business in which they invest. Even so, their respective approaches are almost diametrically opposed.
To a degree, lenders and investors will seek to minimize their respective financial commitments and have the other take up the slack. Through restrictive loan agreements (“covenants”), lenders will attempt to limit the pursuit of uncertain upside by the equity holders. In order to more closely align their financial interests, lenders will often require equity holders to provide guarantees secured by collateral from outside the business. That increases equity holders’ downside relative to their upside. By changing equity holders’ payoff function, lenders can persuade equity investors to seek more certainty.
The game is difficult. It’s good to know which game you are playing.
- Lenders’ and equity investors’ payoff functions differ. As a consequence, lenders avoid uncertainty, while equity investors seek uncertainty.
- Lenders reduce uncertainty and manage risk through collateral requirements and restrictive covenants.
- Equity investors manage risk by investing in increments. That way, their downside is limited relative to their upside.
Implications for Raising Financing
Lenders don’t want to hear “blue sky” stories. Ambitious growth plans imply uncertainty. That translates into higher risk for the lender. Instead, provide lenders with evidence of what is probable. Be careful, though. If you “sandbag” your forecasts, your lender might saddle you with an overly restrictive loan agreement.
On the other hand, don’t try to sell equity investors a “sure thing.” Most likely, they will think you are naive. If they believe you, they won’t be interested.
In other words, it’s perilous to try to persuade financing sources to act contrary to their interests. It is easier and better to really understand your opportunity and pitch it to the right audience.