Published in the San Diego Union-Tribune, August 20, 2018
Skin in the game.
The origin of that phrase has been attributed to various folks, ranging from Warren Buffett to William Shakespeare in the play “The Merchant of Venice,” in which Shylock stipulates that Antonio must promise a pound of flesh as collateral in the event of default on a loan. And you think your bank is unreasonable!
OPM — we all know that those letters stand for “other people’s money” — so you can see a perfect storm beginning to form. When a promoter/entrepreneur asks you to invest, your first question should be, “Do you have any skin in the game?”
Peter Koudijs, a professor at the Stanford School of Business, recently conducted some research and found that in mid-19th century New England those bankers who had very limited personal liability, “were more willing to take risks than their counterparts, who faced personal liability.” But not all bankers at that time were the same.
What informed the banker’s decision-making was his marital status. Prior to the 1860s, husbands legally had unconstrained access to their wives’ assets, and so their “joint liability” allowed the husband/bank manager to play “fast and loose” with the dough. After all, his bride and her wealth would be on the hook as well. When the marital laws changed in the 1880s, (separate property) the incidence of losses related to excessive risk greatly decreased, and bankers became more careful with their investments. You might consider this change as the harbinger of the prenuptial agreement, as informed by the current concept of community property.
The research is clear. If you had no skin the game, why not put it all on red and see what happens? There is always another casino down the street. Koudijs points out that in the United States, prior to the 1930s, bankers faced “great personal risk if they made unsafe investments with their depositor’s money.” These bankers often owned stock in their bank. If depositors needed their money back, it was the bank owners who had to come out of pocket personally to make good. So a current political debate deals with the question of what level of personal risk should a banker assume who is using depositors (OPM) money.
An important concept in technology investing is the concept of “liquidation preference,” which is a fancy phrase that dictates in what order the investors get their money back — particularly if the triggering event is disposed to return less than the original amount of money invested. It is usual for the investors to get their “preferred stock investment” money back ahead of the common stockholders (think of our favorite bank manager).
What this all means is that I think it is both critical and reasonable that the entrepreneur be exposed to some level of risk when he comes in and wants an investment of other people’s money. Do not tell me that your sweat equity alone is skin in the game. I know that song, and even if ABBA sings it, I am not there for you baby. But neither am I a Simon Legree. I believe in proportionality, and the level of the requested commitment is keenly dependent on personal circumstances. The goal is to make sure everyone is rowing together — and also is wearing a life jacket.
In the final analysis, I still remember 2008 and the fact is that not one significant investment banker, not one CEO of the five major banks that managed to lose several trillion dollars of our money, went to jail. Several “junior” individuals did go to jail, but the big boys did not visit the slammer.
I think of this issue as one of “aligning our mutual interests.” If the investor makes the deal too hard or the penalties too great, the entrepreneur just walks away, and the investor is stuck. Even worse, harsh clauses can dramatically stifle innovation and appropriate risk taking. (The investor knows he is not buying a T-bill.) On the other hand, OPM is not a free meal ticket to rock and roll without accountability.
Rule No. 573: “Fast and Loose” is a Renaissance con game once called “Pricking the Gartar.”